A Strategy for Reorganizing Medium-Size Businesses With Too Much Debt For The Small Business Reorganization Act

By: Donald L Swanson

Hypothetical:

You are an owner and operator of a closely-held business that has been successful for many years. But recent financial reverses are jeopardizing its future.

You’d like to reorganize the business and discharge a bunch of debt, under the Small Business Reorganization Act of 2019.  But you can’t because the business has $10 million of debt ($2.72 million is the debt limit for Small Business eligibility).

Problem:

The main reason the Small Business Reorganization Act exists is this:

• historically, the absolute priority rule has prevented small- and medium-size businesses from reorganizing under Chapter 11, in the vast majority of cases.

The Small Business Reorganization Act solves this problem by eliminating the absolute priority rule for small businesses.

But the problem remains: the absolute priority rule is still an impediment to reorganizing medium-size businesses in Chapter 11.

Question:

How can your medium-size business deal with the absolute priority rule problem?

Answer:

You put the business into a regular Chapter 11, with a creative strategy for solving the absolute priority rule problem.

Strategy:

What follows is an attempt to explain one such strategy. This strategy is rarely used.  But it can be successful in the proper circumstances. I know this is true, because I’ve used it, successfully, on multiple occasions and in various bankruptcy districts.

The strategy is this: upon plan confirmation, conduct an auction of all ownership interests in the reorganized debtor, with an insider presenting the opening bid. This solves the absolute priority rule problem, provided the insider is the highest bidder.

It’s tricky, of course. Some critical judgment calls need to be made, before even attempting the strategy.  Here are examples of questions that need to be asked:

1. Who might want to be a competitive bidder?
2. What might be the nature and strength of an outsider’s interest in bidding?
3. What impediments might exist to a bid from an insider or to a bid from an outsider?
4. Does the business own any unique or unusual assets that an outside bidder might be willing to buy at a premium price?
5. How will the total amount of reorganized debts compare to the total value of debtor’s reorganized assets?
6. How much are insiders willing and able pay to purchase the ownership interests?

Observations:

My experience is that the purchase price an insider must pay at the auction isn’t all that much. Here’s why: because the amount of debt a reorganized debtor must pay to achieve confirmation is already a premium amount—there is no bargain here for outsiders.

By further explanation, consider this:

• Confirmation standards require that total reorganized debt must equal the total value of assets retained—that’s already a 100% debt-to-value ratio;
• So, if debtor’s lienholders have all assets fully encumbered, then reorganized debts will substantially exceed the value of reorganized assets, because administrative and priority claims must also be paid; and
• In other words, whoever wins the auction for ownership of the reorganized debtor will be paying a premium price—at whatever the successful bid amount might be.

Here are circumstances where this strategy might not work:

• When debtor owns a bunch of real estate, or other unique assets, that are in high demand;
• When debtor has one or more competitors that would pay dearly to put debtor out of business; or
• When all debtor’s bridges with its primary lien holder are already burnt to the ground, and the lienholder will do anything to get debtor liquidated.

In most other circumstances, however, this strategy can work. The process will be nerve-wracking because, as the old adage says: “It ain’t over ‘til it’s over.”  But the nervousness is commonly, in my experience, overblown.

I’d be happy to help you customize a plan!

If you have a mid-size client in financial straits who wants to stay in business, these proven strategies work.  A customized reorganization plan implemented at the right time is essential.  Give me a call at 402.343.3276.  I’d be happy to help!