Common Mistakes Made by Businesses in Financial Crisis
Businesses in financial crisis are often in a state of chaos. The time and attention of management, unable to address the causes of the financial distress facing the company, are consumed with putting out fires. Moving from emergency to emergency, management fails to focus on long-term needs.
In consulting with business clients to prepare for a financial restructuring, whether that restructuring takes place outside of bankruptcy or under the jurisdiction of the Bankruptcy Court, it is important that counsel (and/or other professionals involved) guide the client so that important legal, practical considerations are not left unattended.
Common mistakes made by businesses experiencing financial distress include:
Letting Go Of Accounting Personnel
Management of financially troubled companies frequently focuses attention on cutting expenses. This is commendable in many instances. However, the mistake is made when management thinks that accounting personnel are expendable. More so than at any other time in the business life of an operation, accounting personnel are indispensable during a financial crisis. As the restructuring consultant or attorney attempt; to analyze the economics of the business proposed to be saved, it is the numbers which tell the story. While there may be some merit to the conclusion that the accounting personnel contributed to the financial crisis and that retention of such personnel will only prolong the agony, hiring new accounting personnel before termination of the existing group is generally the better approach. This approach assumes, of course, that there are no issues of fraud, defalcation, complete incompetence, intentional misreporting or other grievous problems. New accounting personnel, no matter how competent, are more often than not going to be hampered by the absence of old personnel to explain the existing systems, location of records, types of reports which may exist, and idiosyncrasies of the bookkeeping process. In the absence of some transition from old to new, the task at hand for the new number crunchers may more imitate forensic accounting than regular reporting. The failure to retain or appropriately replace accounting personnel leads to the same problem: a loss of control over financial reporting and the lack of timely and accurate financial information.
Refusing To Communicate With Or Misleading Creditors
Whether a re- structuring is to take place as an out of court workout or through a reorganization plan in bankruptcy, maintaining good relationships with most if not all of the company creditors is not only a wise practice but could be the glue that makes even a bad case good. Even unfavorable news is better than no news at all. Ignoring the telephone calls and inquiries will almost always result in creditors presuming that there is something more to hide than just the fact that they aren't being paid (that they already know). What is worse than refusing to return that call, however, is communicating incorrect or misleading information. The person who wants to stay in business generally cannot accept the concept that conveying the existence of financial distress can be anything but bad. With that attitude, the options are to convey no information, or to convey inaccurate information with the hope that extensions of credit will not dry up. Again, the lack of information merely leads to speculation, and such speculation is never complimentary. With all of the negative light of silence, though, misleading information can be infinitely worse. Misleading information gives rise to distrust when the truth is discovered. The dissemination of accurate and consistent financial information is a key in maintaining a good working relationship with creditors and in maximizing the opportunity for a successful reorganization.
Misleading Employees
Employees should be treated with no less respect than creditors, and likewise should not be victims of inaccurate or misleading information. Rumors of financial distress within an organization are the fodder upon which resumes are made. While an employee may be one of those whom management desires to terminate for expense reducing purposes, the one that got away may be the one the company needed most.
Failure To Timely Identify And Eliminate Bleeder
Depending on the nature of the business and the magnitude of its operations, the company should be able to independently analyze selected aspects of its structure, whether those aspects be broken down into separate departments, divisions, locales, subsidiaries or otherwise. To do so again requires an ability to study, among other things, the financial reports for that division, department, etc., and brings back the importance of the accounting and bookkeeping personnel. To the extent independent studies of this type are not already a part of management review, an initiation of such studies must be undertaken. There may, however, be reluctance to commence such work if not readily available since the time and effort necessary to properly conduct such a study could put a strain of the accounting personnel and management team. Without such an effort, management will be unable to intelligently analyze distinct aspects of the operations, which, if modified, if not altogether eliminated, could improve chances of survival. Separate limbs of the company, which drain more from the bottom line than they contribute must be classified as bleeders, and the delay or failure to stem such bleeding could result in ultimate failure. It is, therefore, imperative that tasks of this nature be undertaken immediately upon the commencement of a restructuring program. While it is beyond the scope of this article to provide much insight into the detail of such studies, and difficult to establish any general rules in this regard, it is important to act promptly after management through such studies has concluded that some aspect of the operations should be eliminated.
Failure To Cut Overhead; Keeping The Sacred Cows
In addition to cost cutting measures which take place when management elects to reduce labor expenses, a careful eye should be directed towards overhead or operating expenses. Whether the business under consideration is a manufacturer, wholesaler, retailer, service provider or otherwise, each incurs general and administrative expenses. Those expenses include administrative travel, insurance, legal, office and officer salaries, supplies, rent, utilities, taxes, and other similar items. While some of these items are not subject to significant change when seeking to reduce expenses, others which may result in significant expense reduction may fall into the category of sacred cows. For example, the prestige of a particular high rent district, which is of more benefit to employees than to the bottom line, may be an insufficient reason to remain at a particular location.
Failure To Build A Sufficient Warchest
To the extent creditors have not already put the company on cash-on-delivery terms, it is to be expected that such a policy will be implemented upon the public knowledge of financial distress or the filing of a bankruptcy reorganization case. For this reason and others, such as a need for cash for expense items unique to bankruptcy cases, e.g., United States Trustee fees, appraiser fees to defend motions for relief from the automatic stay, deposits to utilities, or because the debtor may be unable to secure postpetition advances, it is important that the prefiling debtor generate cash to be used in the bankruptcy case. Depending on the type of operation, the immediate need for cash, and the likelihood of generating cash from some other source subsequent to filing, the amount of cash desired varies. Generating cash can take a number of forms: liquidating nonessential property, retaining proceeds of accounts which would otherwise be turned over to the secured lender, cash infusions through new borrowing, either secured or unsecured, capital contributions, sale of securities, etc. Some of these methods are of course subject to claims of third parties, for example, retaining proceeds of secured accounts, and others may be fraught with issues of fraud or securities problems, as in the case of a sale of securities. While the goal of raising the necessary warchest is important, counsel must be careful not to advise the client to engage in cash raising activities which give rise to issues more problematic than a lack of cash. Finally, there is not always sufficient time to implement a cash hoarding program when the client comes to you at the last minute such as on the eve of an attachment, judgment, or foreclosure. Under such circumstances, hard decisions must be made as to whether the case can be successful without the luxury of a warchest.
Using Trust Funds To Operate The Business
Since many companies control the remittance of funds to governmental agencies from payroll withholdings, the temptation in financially troubled times is to treat such agencies as involuntary lenders. While the motivation is generally to assure a continuous supply of needed goods and services, it may cause problems for management and confirmation of a chapter 11 reorganization plan. Responsible persons may be subject to individual liability. In addition to the problems created by having the attention of a person indispensable to the reorganization directed towards fending off collection efforts against that individual, the unpaid tax makes it more difficult to confirm a plan. While the tax claim, from the debtor's standpoint may not be paid in full on the effective date of the plan, though the principal who is now a responsible person may insist on it, the tax claim is a debt which must be paid in full through the plan. Depending on the magnitude of the claim, this requirement may affect the company's ability to prove the plan is feasible.
Giving Collateral Or Additional Collateral In Exchange For An Extension Of Debt
Pressures imposed upon a debtor before it elects to file for bankruptcy protection many times result in business decisions which may appear sound at the time but which prove later to have been unwise. One such decision may be the giving of collateral or additional collateral in exchange for an extension of credit or the maturity of existing debt. While the grant of a security interest may be avoided after the case is filed as a preferential transfer, the short limitations period and the success of one or more defenses available under the statute may preclude such recovery. Further, while the security interest exists, the debtor may be faced with motions for relief from the automatic stay, disputes regarding the right use of cash collateral, objections to the sale of the collateral free and clear of the lien so granted, and questions as to the proper treatment to be afforded the creditor under a plan. Though there may be valid motivations to give new or additional collateral to secure a debt, the strongest motivation should be the extension of new credit in an amount equal to or greater than the value of the collateral being offered. Anything short of that should be avoided if possible.
By avoiding common mistakes made by debtors before a bankruptcy filing, businesses may give themselves a fighting chance to avoid that arena, or, if that is not practical, to succeed in chapter 11.