Bankruptcy: when is it good news?

Many companies are struggling financially due to the uncertain economic climate. CPAs who have dealt with clients in financial trauma or with those experiencing cash flow shortfalls know the word such clients often fear most is "bankruptcy." Obviously, because of cost and other considerations, reorganization outside bankruptcy is the preferred route. However, modern bankruptcy law is geared, in large part, in favor of the debtor, so this option should not be summarily dismissed. Today many businesses see bankruptcy as a positive situation--an opportunity to infuse new cash and restructure operations and debt.

The growing number of troubled companies using bankruptcy means this strategy no longer carries the stigma it did in the past. Bankruptcy provides obvious relief through its automatic stay against creditors. Depending on the client's circumstances, bankruptcy may be a legitimate and logical option for the CPA to suggest. After presenting a revenue and expense analysis and assisting the client to prepare reasonable and attainable cash flow forecasts, what other information is necessary when considering bankruptcy proceedings? This article discusses four questions that help in the decision-making process.

WHAT IS THE COMPANY'S

TRUE WORTH?

Virtually every business has value, and that value can be used to the debtor's advantage. The value may be obvious or hidden, but its identification can reassure a client that bankruptcy is a legitimate option to be explored, not a defensive move of last resort.

For example, Midway Airlines used assets with no other liens against them to obtain $40 million debtor-in-possession financing at the onset of its chapter 11 filing. (Despite tighter credit standards in many situations, many banks are showing a greater willingness to offer financing to companies in reorganization because they can receive first priority liens as well as fees.) The collateral value of hard assets is important when the client wants new financing. If some of the client's assets are unencumbered by debt, the client clearly will have more levarage in dealing with creditors once it's in bankruptcy.

One entity with hidden value that filed for bankruptcy is the Chicago South Shore and South Bend Railroad. The railroad, although a relatively small entity, was a high-profile railroad with name recognition. Thousands of commuters ride it into downtown Chicago daily. In addition, the railroad had a long-standing and profitable freight business that generated a steady income from a stable group of customers. These examples of hidden value contributed significantly to the notion that the railroad could and should be reorganized when it ultimately faced economic difficulty.

Uniqueness is another consideration when evaluating a company's true worth. Does the client's name have value? Is there goodwill? Has the client established its own niche in the marketplace? If so, are there any competitors that would use price cutting to take advantage of the client's bankruptcy? If not, bankruptcy may allow the client to make repairs and salvage the company with a minimum of risk.

Another hidden asset is the client's top management. In the airline world and in Chicago, David Hinson, the chairman of Midway Airlines, is well known and respected by his middle management, the airline industry and the Chicago business community. Charismatic leaders instill confidence and are important assets in bankruptcy.

WHAT'S THE LIKELY CAUSE--AND

OUTCOME--OF THE

FINANCIAL TRAUMA?

Determining cause means deciding whether the financial trauma was avoidable or unavoidable. Projecting outcome involves calculating how long the causes will remain. Together, these answers give a clearer indication of whether bankruptcy will be a short-term, long-term or bad solution for a client.

What economic factors have contributed to the client's financial trauma? CPAs should list specifics and categorize them as follows:

* Unavoidable circumstances occur when the client has no control over a situation. Causes can occur locally, nationally or worldwide. Traditional cycles in the company's or industry's earnings, national economic factors (such as recession or inflation) or a sudden military conflict (such as the Persian Gulf War) are examples of these three categories.

* Avoidable circumstances are usually in-house, such as poor quality control or an inadequate distribution system. These causes are most apparent when some or all of a client's financial woes can be traced to poor management decisions.

Next, ask how long these circumstances will last. If the company suffers primarily from unavoidable circumstances that are only temporary, bankruptcy protection can be used as a short-term respite that allowes the client to regroup.

Midway filed for bankruptcy, for example, just as the Persian Gulf War ended, oil prices fell, fears of a recession began to subside and the industry's peak travel season began.

In the railroad's case, its primary government-backed funding agency was able to obtain additional funding and beefed up its management team just before the railroad's filing, becoming the logical buyer for its passenger segment. Previously, Department of Transportation regulations had forced the railroad to keep the passenger business running at the expense of its profitable freight business.

Bankruptcy can be good news in these situations. Thus, a client (as well as lenders, investors and employees) can see how quickly the company will begin to recover. When clients see this type of data, bankruptcy becomes a much less threatening prospect.

CPAs may, however, confront clients who have adopted passive, wait-and-see attitudes toward their companies' situations. Although a CPA's primary role may be to analyze and present important financial data, clients in financial trouble may need advisers who can motivate them to take positive action. Bankruptcy isn't always the right answer, but surely passivity is the wrong one. CPAs may need to encourage clients to cut all unnecessary costs. They may find it necessary to help clients choose competent reorganization counsel or a turnaround or crisis manager.

During bankruptcy discussions, the CPA should be able to inform clients of the options discreetly and honestly. Clients willing to take a proactive role in solving the financial trauma are most likely to fare the best after a bankruptcy.

HOW IS BANKRUPTCY

PERCEIVED?

The biggest argument a CPA can face when presenting bankruptcy information is apprehension over the impression it may create, not just in the client's mind but also in the minds of employees, investors, customers and suppliers. This is a legitimate concern for clients.

However, it is possible to use resources to create a positive perception of this decision. Public support is a powerful resource that will have a significant impact on the bankruptcy court. It can demonstrate to creditors and bankruptcy judges that everybody's best interests lie in the company's survival.

Company attitude is crucial. Employees committed to and enthusiastic about their company's recovery are an invaluable asset. I have found, in smaller companies, at least one person from the middle ranks comes forward to perform beyond his or her perceived level of competence during troubled times. In larger organizations, several usually emerge. Prime examples are middle managers who have valuable insights that have never before been given a hearing. CPAs can help clients seek out internal support and use it to carry the company through bankruptcy.

Clients can enhance a positive attitude through clear communication to employees. Employees who understand and believe bankruptcy is necessary and the best choice will overcome many of the negative aspects.

A second valuable resource can be the opinion of local government officials, such as the mayor or city council members. CPAs can help clients show this group the effect in job loss and diminished tax revenue if the company isn't supported in its recovery. Government officials' support for the company in the media can have far-reaching effects. For example, bankruptcy courts and lending institutions often respond to the attitude of public opinion leaders.

Other groups, such as union leaders or community organizations, also are potential sources of support. CPAs should consider the likely responses from each and present results to clients to consider as part of their bankruptcy decision.

WHAT'S THE DOWNSIDE?

It would be inappropriate for the CPA to omit two important considerations in a bankruptcy. The first and obvious consideration is cost. The CPA familiar with a client's financial situation can help evaluate the costs and benefits of a bankruptcy filing. One way to mitigate costs is a process called prepackaged chapter 11 reorganization plans. Reversing the usual steps, companies first negotiate the essential components of their reorganization with creditors, then declare bankruptcy for the added protection this step offers.

The second important consideration is control. Clients should realize that during bankruptcy certain key decisions normally made by management in the ordinary course of business are under the purview of the various creditor groups and, ultimately, the bankruptcy court. Moreover, the end of a bankruptcy may find some management team members filing roles different from those held before the filing.

AN IMPORTANT OPTION

This article has described some basic questions for the CPA who believes a bankruptcy might be in a client's best interest; there will be other questions for each unique case. CPAs should remember, too, in advising clients, that bankruptcy will take away resources from the core business--often ones the client cannot afford to lose. This means that qualified turnaround experts may be necessary to help a company through the process.

Bankruptcy is now seen in a much different light than it was 10 years ago. The questions in this article provide a starting point for CPAs as they consider this step for clients.