Trout Fishing South of the 49th Parallel

<p>Once upon a time, I was a chartered accountant working in the insolvency department at Price Waterhouse
in Canada.

</p><p>In Canada, insolvent and bankrupt companies were treated for what they were: economic failures. Until
the more recent advent of bankruptcies by large Canadian companies, the process was relatively simple:
Receivers or trustees were appointed to supervise financially troubled companies, typically resulting in an
expeditious liquidation of assets. Immediate cash, not restructuring business assets, was the focus of
receivers and trustees, and financial professionals usually held these positions.<small>^{<a href="#2" name="2a">2</a>}</small>

</p><p>Foregoing the anticipated growth in Canadian bankruptcies, I headed south, eventually landing on Wall
Street and, as fate would have it, working in the restructuring department of an investment bank.
Interestingly and very surprisingly, bankruptcy in the United States was not about liquidation or the rapid
sale of a secured lender's collateral. It was about rehabilitation, resuscitation and restructuring companies
and their business assets. It was a system that worked to balance the competing interests of creditors and
debtors, often with the added social benefit of enabling a debtor to reorganize its assets and capitalization.

</p><p>As I observed the new system, the same question always came to mind. Was this process the best for
maximizing overall social utility? Did the benefits exceed the costs, even for parties that would ultimately
suffer the greatest economic damage? Was value preserved and its allocation reasonable among the various
competing interests?

</p><p>The key economic underpinning of any bankruptcy proceeding is the analysis and allocation of value,
whether that value derives from reorganizing, liquidating or selling a business enterprise. The key measures
of bankruptcy lawyers' effectiveness is how well they protect value belonging or potentially available to their
clients and whether the legal strategies ultimately pursued improve the client's position.

</p><p>Many clients make too much of their position and engage counsel in pursuit of outcomes ranging from
the pragmatic to the quixotic. The latter may be found more often among equity holders of private
companies where the equity and the management are the same. It is also found among secured lenders
whose aggressive efforts to liquefy a loan (for which they are likely to be repaid in full anyway) may
deplete troubled businesses of cash and capital when they are most needed and when they often can do the
most to preserve collateral and enterprise values.

</p><p>Therefore, it is important for bankruptcy counsel to accomplish two things. The first is to protect the
client's interests. The second is to fully understand and be comfortable with the client's assertions regarding
value and the process for its realization, if for no other reason than to handicap the client's potential for
"success" and to counsel accordingly.

</p><h3>Debtors</h3>

<p>With the exception of litigation-driven defensive filings, chapter 11 inevitably arises from some failure
of company management and its board of directors to effectively guide the business operations and assets
under their control. Events leading to economic failure are generally well understood and often seem
obvious, particularly in hindsight. They all involve some inability to recognize and respond to one of the
following factors frequently compounded by the amount of existing debt:

</p><ul>
<li>changing market conditions, including (i) changing customer tastes, (ii) consolidation among customers
and (iii) changing distribution channels

</li><li>new technology and/or new competitive products

</li><li>new and/or lower-cost competitors

</li><li>poor product performance

</li><li>failure to react to new information, particularly negative financial information

</li><li>overly optimistic views of current or future business and competitive conditions

</li><li>inadequate financial control and information systems

</li><li>inadequate understanding of the financial resources needed to support the business.</li></ul>

<p>All of the warning signs above typically manifest themselves in lower sales, lower operating margins,
past-due and increasing levels of trade payables, and diminishing liquidity. Each requires prompt attention.
Bankruptcy counsel needs to ensure that the client focuses on these signs, as many debtors do not recognize
these or other indications of existing or impending trouble. Their perceptual maps tend to be too optimistic,
and debtors frequently fail to appreciate the depth of their problems.<small>^{<a href="#3" name="3a">3</a>}</small>

</p><p>Bankruptcy counsel can supplement their efforts by encouraging the client to seek independent advice
or analysis from an experienced financial professional who can help work through internal and external
financial issues. Depending on the size and sophistication of the business, this may take the form of hiring
a qualified financial executive, such as a controller or chief financial officer, to hiring turnaround
consultants or an investment banker. Internal issues to address include evaluating core performance,
profitability and the availability and allocation of resources. External issues should focus on competitive
positioning, financing sources and what third-party transaction values are available assuming
going-concern, sale and/or liquidation scenarios. Counsel can help the client recognize that turnarounds
require unique and separate skills and may even call for replacing senior management until completed.

</p><h3>Secured Lenders</h3>

<p>Secured lenders often face perceptual issues as well. The desire to monetize troubled loans may be so
great that secured lenders can push borrowers into taking actions that are not in the borrower's best interests
and their eventual ability to repay loans. Pressure may be exerted by reducing advance rates on
working-capital assets, increasing interest rates and levying forbearance fees—all of which serve to extend
the amount and timing of payments due to trade creditors. This, in turn, may further threaten the likelihood
of a successful restructuring and may delay or reduce the lender's recovery.

</p><p>The key issue a secured lender must resolve early is whether it is likely to be fully repaid or absorb a
loss. In the case of the former, the lender should view the credit as a continued profit opportunity but should
structure (at least a portion of) its compensation so it is aligned with the interests of the other parties. This
should increase what the lender can earn and improve the likelihood of the successful reorganization of the
debtor. If a loss is possible or likely, the lenders' actions should not worsen the situation or potentially
increase the amount of its own loss.

</p><p>Secured lenders should consider a more dynamic approach to restructuring. They should objectively
evaluate the situation and make one of three determinations: (1) whether the troubled business should
be reorganized as a going concern, sold or liquidated; (2) what the secured lender's likely realization is
under each scenario; and (3) what actions the secured lender should take. If the likelihood is for a
complete recovery, the secured lender should do everything, including reducing the cash burden imposed
on borrowers, to encourage and facilitate that outcome. If the likelihood is liquidation, the secured lender
should accelerate any actions that recover the liquidation amount to reduce the overall administrative
burden and expense. However, in a liquidation recovery scenario where there is an ongoing business, the
secured lender should consider taking a minority position in the equity of the reorganized business. This
could serve as a source of future value and provide appropriate incentives for all participants to complete
the transaction as quickly as possible. Ideally, the secured lender should try to use a fresh approach for
facilitating the borrower's prospects and should consider employing external financial advisors to help
accomplish this objective.

</p><p>Lenders should also be mindful of the potential to sell troubled loans and regularly weigh the benefits
of various courses of action against the potential sale of a loan. A sale to an investor that views the
situation differently may form the basis of a more favorable outcome for both lenders and debtors.

</p><h3>Conclusions</h3>

<p>It is clear that bankruptcy requires the integration of at least two skill sets—one legal, the other financial.
The interplay of these two skills should ideally make the process efficient (and therefore socially useful).
But that assumes hard facts agreed upon by all parties without any underlying emotional or psychological
(a.k.a. theatrical) issues. Failing to account for the psychological dynamic may frustrate outsiders' efforts
to understand whether the process is really efficient or not, or whether it should be dominated by lawyers
or financial professionals. For it is the interplay among the three elements—law, finance and
psychology—and the willingness of the various parties in interest to accept one view or another regarding
sources of value that guides the efficiency of the restructuring process.

</p><hr>
<h3>Footnotes</h3>

<p>^{<small><a name="1">1</a></small>} Thanks to my colleague and ABI member Ron Winters for his assistance. <a href="#1a">Return to article</a>

</p><p>^{<small><a name="2">2</a></small>} In part, this was (and is) due to the unique stratification of the Canadian economy with relatively few large national or multinational
companies compared to numerous smaller enterprises. Typically, it was smaller companies that got into trouble, and with relatively few third-party
sources of financing, the options for successfully restructuring these companies was relatively limited. While the nature of the Canadian economy
remains stratified, the broader use of the Companies Creditors Arrangement Act has allowed substantially more companies to reorganize. <a href="#2a">Return to article</a>

</p><p>^{<small><a name="3">3</a></small>} First and foremost, your client needs to have an accounting system that generates monthly financial reports on a timely basis. <a href="#3a">Return to article</a>