Bankruptcy can be expensive, often too expensive. The cost of a Chapter 11 reorganization proceeding for a small company, one with $10 million in annual revenue for example, is nearly as much as a larger company with 10 times the amount of revenue. Many companies facing financial difficulties these days simply cannot afford a bankruptcy reorganization, and they end up liquidating – either in a Chapter 7 bankruptcy or by turning over the keys to the secured lender.
Due to the expense of Chapter 11, some bankruptcy professionals are dusting off an old tool which lost its decades-old popularity in the 1990s. That tool is a “composition.” A composition can extend the maturity date of debts (an “extension”) or reduce them (a “compromise”) or both (an “extension and compromise composition”). In the right circumstances, a composition can increase the chances of saving a business as a going concern and put more dollars in the pockets of creditors, mainly through significantly decreased expenses as compared to a Chapter 11 proceeding.
A composition is merely a written contract among a company and its creditors to modify the company’s debts. It can allow a company to overcome a particular financial or operational problem or survive a general economic downturn. A composition is one potential outcome of a “workout” between a company and its creditors. Another outcome is a bankruptcy filing, including a prepackaged or prenegotiated bankruptcy if creditors are cooperative or an involuntary one if creditors are antagonistic.
Since compositions are creatures of contract and governed by common law (judge-made decisional law), and not statutes like the Bankruptcy Code, they offer tremendous flexibility. A composition agreement can contain any creative provision that business people or their lawyers can dream up to solve a problem. Compositions do have limitations, however, because they often require agreement among the creditors. Without this, statutory tools of the Bankruptcy Code may be required to solve the problem (and bind all creditors).
A typical composition agreement contains provisions on the timing and amount of payments to creditors, the conditions under which the agreement becomes effective (usually a sign-on by a certain percentage of creditors – often 90 percent), defaults, creditor remedies upon default and limitations on payments to the company’s principals. More complex situations may call for payments to be made to an escrow agent, the establishment of reserves for disputed claims, oversight by an informal committee of creditors and the payment of counsel for such committee by the company. But by and large, even complex compositions are more streamlined and cost-effective than the simplest Chapter 11 bankruptcy cases.
Compositions have the best chance of working with middle market or smaller companies, which generally have simpler capital structures and a more limited creditor body (in amount and type). The chances of success improve the more that the company’s creditors know and trust management and desire to maintain the company as a customer. Many compositions were done when small domestic manufacturers, particularly in the textile industry, experienced problems from overseas competition or from U.S. competitors moving plants overseas to bring down labor costs. Their suppliers were willing to be flexible as their own customer base was dwindling.
Clearly, there are times when bankruptcy is the better option. For example, if a company needs to shed space by rejecting one of its real estate leases, under state law the landlord may have a daunting claim due to accelerated future rent. In bankruptcy, such termination damages are capped at a manageable level. A bankruptcy may also be needed if a “renegade” creditor is so far along in the legal process that he is demanding full or immediate payment to refrain from having the sheriff seize assets. Only the bankruptcy “automatic stay” will put the brakes on such a creditor.
Although compositions are still ideal for restructuring trade debt for middle-market manufacturing and service concerns, they can and should be more widely used. One was used recently by creditors of a real estate finance company whose business was to purchase mortgages, pool them and sell interests in them as securities. Bankruptcy was not an option due to relatively new aspects of the Bankruptcy Code exempting certain creditor actions in such securitizations from the automatic stay. As a result, a bankruptcy fling would have been chaotic. Instead, the parties were able to resolve the matter using a complex form of a composition agreement.
For middle market or larger companies, or simple or complex situations, a composition can be an effective, low-cost alternative to a Chapter 11 reorganization.
Thomas R. Slome is a Member of Meyer, Suozzi, English & Klein. He works in the firm’s bankruptcy and business reorganization law practice.