Hidden Costs in Bankruptcy

By Jennifer Dowdell, CFA

Bankruptcy is an umbrella term usually applied to a number of different formalized, court-mandated procedures and protections.  Before discussing the costs imbedded in these processes, it is important to note the differences in purpose between Chapter 11 and Chapter 7 (Chapter 12 and 13 filings are only available to individuals and family farmers, respectively, and so need not be discussed).

Chapter 11 proceedings are Reorganizations. Their intent is to provide viable businesses, whose operation is threatened by the magnitude or timing of certain current obligations, the opportunity to restructure those obligations so that the business may continue as a going concern. The resolution of a Chapter 11 filing is the court-confirmed Plan of Reorganization under which the company will go forward.  By contrast, Chapter 7 is a framework to liquidate the assets of a troubled business under the supervision of the Court.  The resolution of a Chapter 7 case is the distribution of receipts to creditors.

When properly employed, both Chapter 11 and Chapter 7 bankruptcy provisions can offer excellent opportunities for all parties –creditors, equity and management— to recover the value of troubled firms either through continued cash-generating operations or by selling the assets.  Chapter filings by their nature, however, involve specific protocols and standardized government oversight, which do not come without substantial costs in time and administration.  These costs may not be readily apparent at the outset, but a failure to understand them will erode company value rather than enhance it.

Should you file for bankruptcy?  Here are some thoughts on opportunity, costs, and alternatives:

• False steps kill value:  Typically, about one third of companies who initially seek to reorganize under Chapter 11 will undergo further financial restructuring within a few years.
• This is because many were not good reorganization candidates in the first place, an unfortunate illustration of the importance of candidly assessing the viability of your businesses.   Successful Chapter 11 filings create the highest value for all parties—creditors, shareholders and management.  But Chapter 11 only makes sense when it is a stop on the way to a strong and viable business—not a detour on the path to ultimate liquidation. 
• According to The US Department of Justice Trustee Program, debtors who end up in Chapter 7 liquidation have burned up on average 4-5% of their total receipts in administrative costs from previous Chapter filings before they get there.  Companies that begin in reorganization, only to subsequently decide on liquidation, waste valuable resources and time. 

False steps kill value relative to a timely and well-planned sale or liquidation of assets.  Any troubled company should seek a realistic assessment of its prospects of emerging from Chapter 11 as a going concern, with a truly workable Plan of Reorganization.  Doherty & Associates can help management navigate the financing process and evaluate alternatives to bankruptcy.

• The “race to collect” hurts everyone:  At the early signs of potential insolvency, unsecured creditors typically race to declare their loans in default.  When under-collateralized creditors sue the firm to collect, they can force assets to be liquidated piecemeal, rather than an orderly fashion.  
• The “race to collect” damages the estate.  Creditor suits that typically precede any Chapter 7, liquidation filing, create administrative costs, reducing cash or further increasing the number of unsecured creditors in a future liquidation.  The fire drill of multiple litigations distracts management from the crucial business decisions that must be made in a timely fashion in order to maximize asset values.  And assets sold piecemeal to satisfy these separate claims, in nearly all cases, bring a lower value than in an orderly liquidation, such as a bankruptcy proceeding or general assignment. 

Doherty & Associates can help prevent the creditor’s “race to collect” even if the ultimate decision will be liquidation of the company.  An experienced, strategic partner to facilitate debtor-lender communication, preemptive negotiations, new fundings, restructurings and workouts can maximize the company’s asset value.  Experienced advisors can give management the time it needs to make the best decisions—for creditors, equity, and employees.

1. Bankruptcy administrative costs add up:  Even when a company makes an appropriate initial assessment of itself as a Chapter 7 liquidation candidate, administrative costs, including Trustee, attorney and professional fees typically consume between 30% and 40% of total receipts.
2. Surprisingly, only 7%-8% of receipts generally go to the cost of the Chapter 7 debtor’s attorneys .  In addition to the debtor’s counsel, bankruptcy involves a paid US Trustee, attorneys for the trustee, accountants, and claims and litigation support professionals that consume the lion’s share of administrative fees charged in bankruptcy liquidation. 
3. By contrast, the fees associated with liquidations performed under assignments for the benefit of creditors (ABCs) are entirely negotiable, and these costs generally range between 10%-15% of assets (exclusive of the cost of debtor’s counsel).

Bankruptcy costs can add up; and even Chapter 7 bankruptcy is an expensive process.  Where the goal is efficient liquidation or sale of assets, Doherty & Associates can structure general assignments that provided a cost-effective alternative to Chapter filings.

• Time is money: Chapter 7 liquidation cases are typically closed between one and four years after filing, but asset size, and business complexity will significantly affect this timetable. 
• Although the vast majority of Chapter 7 filings are resolved in less than four years, some cases may take significantly longer.  In 2000, for example, the US Department of Justice Trustee Program reports 50 Chapter 7 cases filed before 1991 with assets in excess of $1 million (e.g. Delorean Motor Co., with $59 MM in total receipts filed in 1982) were finally closed after more than ten years.
• When the number of creditors is small, general assignments may take as little as 30 days.  For larger more complicated cases disposition typically requires no longer than 180 days, roughly half the time of the shortest likely bankruptcy process

Time is money; and liquidation in bankruptcy takes time.  General assignments by Doherty & Associates offer a cost-effective alternative requiring, in most cases, less than half the time of an uneventful Chapter 7 filing.

In conclusion, though Chapter filings are often the most familiar options for troubled company,  Reorganization or liquidation under the bankruptcy laws may require unnecessary costs and time investment. False steps, such as filing Chapter 11 Reorganization, when liquidation would be most appropriate, burns time and money.  Management indecision can open the door for creditors to race for assets, reducing the ultimate value of the estate.  Even when the decision to liquidate is expeditiously made, administrative costs in Chapter 7 liquidation typically divert as much as 40% of the firm’s asset value from unsecured creditors and equity; and in the usual course, bankruptcy liquidation may take as long as four years.

Where efficient liquidation or sale of assets is the goal, alternatives may exist that can maximize the recovery of the debtor’s assets in less time, and with lower administrative costs, than Chapter 7 liquidation.  Carefully evaluating all options is always the best way to maximize the value of a company’s assets and resources.

Disclaimer:  The foregoing is intended only as a perspective that may be useful in the initial evaluation of various business options. This information is not offered, or intended as legal advice. It is, in no way, a replacement for consultation with experienced bankruptcy counsel.

About the author:  Jennifer Kelley Dowdell is a Chartered Financial Analyst, who holds an MBA in Economics from The University of Chicago, Graduate School of Business, and a BS in Mechanical Engineering from Purdue University.   Ms. Dowdell has more than 16 years of experience with leading companies in Strategic Planning, Financial Analysis, and Business Operations.  She consults with Doherty & Associates, among other clients, on bankruptcy and litigation process management, regulatory filings, and financial modeling.

Preliminary Report on Chapter 7 Asset Cases, 1994-2000, US Dept of Justice, US Trustee Program, June 2001, Bankruptcy Filings, pg. 15

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