Professionals on the front lines of a developing insolvency matter are often not insolvency experts. They may be a troubled company’s inside counsel, outside general counsel, accountant, trusted mergers and acquisitions advisor, or even their outside labor or real estate lawyer, becoming privy to one or more insolvency-related problems the company may be experiencing. Given the impacts of the COVID pandemic, labor shortages, supply-chain disruptions, and other market headwinds, these professionals may have run across a disproportionate share of insolvency-related situations over the last few years.

For the non-expert professional, advising clients in an insolvency environment will feel like working in the proverbial Twilight Zone and there is no ready source for guidance as there may be with other unfamiliar legal problems. This column tries to point practitioners in the direction of that much-needed guidance and, hopefully, identifies some general orienting principles and best practices that all professionals should be aware of when counseling a potentially insolvent company.

CONFLICTS OF INTEREST AND FIDUCIARY DUTIES

Insolvency has a way of bringing to light issues that normally stay below the surface such as conflicts of interest and fiduciary duty. Especially for closely held family companies, the potential problems arising from the blurred lines between individual and business interests often go untested. However, as business (and sometimes personal) relationships unravel in an insolvency, many companies and individuals are not prepared for the test.

Lawyers must determine the scope of their representation and adjust if necessary. For example, a lawyer may need to advise the owner of a company, as well as its members and/or partners, to obtain separate counsel because their respective individual interests create potential — and perhaps unwaivable — conflicts of interest. A helpful reference point in this regard is the extremely strict requirement that an attorney for the debtor in a bankruptcy case be a “disinterested person,” which, most importantly, prohibits an attorney from having “an interest materially adverse to the interest of the estate or any class of creditors or equity interest holders, by reason of any direct or indirect relationship to, connection with, or interest in, the debtor, or for any other reason.”¹ The bankruptcy standard, which is unwaivable, is far more rigorous than state ethical requirements for an attorney, which generally prohibit attorneys from representing a client if the client is directly adverse to another client (unless each client consents after consultation) or if the representation of the client may be materially limited by the attorney’s responsibilities to another client or a third party (again, unless the client consents after consultation.)² However, in an ideal scenario, an attorney who has identified a probable need for a bankruptcy filing would be well served to ensure from the outset that the company has insolvency counsel that will be “disinterested” and qualified to represent it in a future bankruptcy proceeding.

On a completely different note, a company’s directors and officers also owe fiduciary duties to the shareholders of the company (i.e., the duties of care and loyalty.) Like the need for attorneys to ensure that their representation complies with applicable ethical standards, individual corporate principals, officers, and directors also need to understand and comply with their fiduciary duties at the outset to prevent incurring potential additional liability for mishandling the situation. Among many examples, restructuring transactions that would benefit an individual director at the expense of the company or constitute a fraudulent conveyance (i.e., a transfer for less than fair value) should not be approved. The fiduciary duty analysis also becomes more complex with the introduction of an actual or potential insolvency.³

GOAL SETTING

Now that everyone understands the various hats they wear and are wearing them properly, counsel can work with company leadership to understand the client’s goals. The goal-setting process can take minutes, months, or years, and is dictated by the urgency of the situation. The insolvency may be a full-blown crisis involving the inability to fund basic operational expenses like payroll and utilities, requiring immediate action and decision-making. The insolvency may also be a gradual decline in performance that has resulted in an actual or looming loan covenant default and a possible need for refinancing or additional investments, allowing more time for analysis and deliberation before a path is chosen.

Clients at any level of insolvency need help identifying options and sorting out realistic goals from the unachievable. For example, the goal of recouping one’s entire investment in the company may not be achievable because the company may not have the value to support even its current debts, putting the equity interests “out of the money.” A lengthy, boot strap-style reorganization may not be possible because the company may lack the cash or financing absent an additional (and possibility significant) investment from existing ownership or an outside white knight to achieve it. An expedited sale to a strategic competitor may not be possible because strategic competitors, who may be the only interested parties, often prefer to let the company fail and opportunistically pick up the choice pieces. It usually takes many discussions to tease out all the relevant factors necessary for this analysis. As difficult as these conversations can be, however, they can ultimately lead to identifying and preserving one or more viable goals.

Sometimes, the list of possible options is dictated to a company by its senior secured lender in the context of a loan workout.⁴ The alternatives given to borrowers by many lenders (appearing in either a forbearance agreement or loan agreement amendment) strike a balance between preserving as much of the ownership’s equity as possible while also preserving the value of the collateral.

In my experience, the four typical options given are:

• Recapitalization: bringing in new money as equity, not debt;
• Refinancing: finding a new lender to pay off the existing lender;
• A going concern sale: finding a buyer who will hopefully pay off the existing lender or make the existing lender as close to whole as possible; or
• An orderly winddown and liquidation: selling the hard and other marketable assets of the company piecemeal but in an organized and controlled fashion to maximize the value of the lender’s collateral.

The solutions that preserve the most equity possible usually take the longest to arrange and achieve. The time that the borrower has to achieve one of the milestones is dictated by the cash that is available. The more available cash, the more time the borrower has. This explains why one of the first questions to ask a troubled company is, “When do you run out of cash?”

STRATEGY AND IMPLEMENTATION

Once the goal is identified, developing a successful strategy for achieving that goal requires, among other things, an understanding of the respective rights of all parties involved. Insolvency matters typically involve a variety of constituents including a troubled company’s equity ownership, the corporate entity itself, and the company’s senior secured creditors and institutional investors. Even within the broad categories of constituents, there is variation of significance and sophistication. For example, the senior secured lender could be a local credit union or global financial institution and the unsecured creditor pool could consist of a handful of relatively current trade vendors or a horde of angry past-due creditors owed tens of millions of dollars. Assessing the landscape in this way is critical to understanding which implementation tools may be required (e.g., a Chapter 11 bankruptcy filing or a state law insolvency proceeding or statutory process.)

Assembling the right team is essential to successfully implementing the strategy. At this stage, it is critical to work with an experienced insolvency attorney. In most matters above a certain size, an experienced financial advisor — sometimes called a turnaround advisor or generically a consultant — is also a critical part of the team.⁵ Most companies have managers and employees that are very good at doing their jobs but have no competency in managing a complex insolvency situation. Moreover, distractions from their day-to-day roles can lead to further problems including decreased performance, poor morale, and jeopardizing the success of the mission. Having a dedicated team of experienced, specialized professionals gives the company the best chance for success.

CONCLUSION

Handling a troubled company is usually extremely difficult for all parties involved — not only for the owners and employees, but also for the company’s professionals. By using a few basic orienting principles and assembling the right team, company counsel can help their client successfully manage the situation they face.