Bay Area Business Lawyers | Primum Law

Workouts and Out of Court Restructuring

Things are changing fast for us all during this COVID-19 pandemic. The coronavirus outbreak is affecting millions of workers and hundreds of thousands businesses. Owners and managers are faced with a scenario most businesses and even senior seasoned businesspeople have not experienced before. From sudden and massive loss of revenues (or even permission to remain open for business), to unfamiliar models of remote work, to retooling to assist the health industry’s treat-and-heal efforts, businesses are being forced to adapt.

How can your business best adapt to this situation of today while remaining viable after the dust settles? In spite of your best-informed efforts to date, you may not want to go the traditional route open to businesses, i.e.: a classic bankruptcy to restructure.

Consider alternatives, one of which is presented by trusted McKinsey group. On March 30, 2020 McKinsey and Company issued their COVID-19 report and call to action. The report guides you to take action through the five stages of resolution of this scenario. According to McKinsey these five stages represent the imperative of our time. The battle against COVID-19 is one that leaders today must win if we are to find an economically and socially viable path to the next normal. I cannot agree more with this view.

From the opening salvo of today’s crisis to the next ‘normal’ that will emerge after the battle against coronavirus has been won, the five stages are1 :

  1. Resolve
  2. Resilience
  3. Return
  4. Reimagination
  5. Reform

Since we are pretty much done with the stage where businesses had to resolve the most immediate challenges – those to its workforce, customers, technology, and business partners. The first stage was done quickly and, we all must admit it, not always that well thought out. It is vital now for businesses to quite consciously move through the next four stages with some forward planning. We can relax a bit and reflect, not only address the near-term cash-management and supply chain challenges defining our broader resiliency solutions, but to also to brainstorm a strategic, executable plan to return our businesses to scale quickly. By sitting and planning according to the remaining four steps in the scenario, companies can be comforted with a real plan that can provide a greater degree of certainty to all actors – staff, vendors, landlords, consumers.

We see that a lot of companies might be tempted to make the decision in favor of debt financing and filing bankruptcy if they are not be able to make it. Many business leaders might assume this is the only or at least the best way to get a fresh start. Bankruptcy proceedings are a traditional solution all businesses have in the back of their minds, no doubt. However, we must caution you and your stakeholders not to be so hasty! We always recommend that companies be more creative, think ahead (to the multi-year consequences of a bankruptcy or refi) and develop alternative and out-of-court strategies.

Here are a few alternatives you may consider when deals or the company as a whole show signs of distress.

Restructuring Outstanding Debt Security

At times a company may seek to refinance its outstanding indebtedness and adjust its capital structure. Debt restructuring can permit a company to take advantage of current market conditions to:

  • Reduce the amount of outstanding debt in order to deleverage
  • Extend maturities of outstanding debt
  • Decrease interest expense, as a result of a reduction in financing costs
  • Increase liquidity
  • Preserve equity
  • Access new or cheaper funding sources

One of the most common ways of debt restructuring for small-mid-sized businesses is an exchange offer. This is an offer by the company to exchange one or more types of its debt or equity securities for another type of security. Companies generally use exchange offers when they want to eliminate one or more specified classes of securities. Typically, exchange offers are used to:

  • Eliminate an approaching maturity date of a debt instrument or mandatorily redeemable preferred stock
  • Cure a default under a debt instrument by taking out that debt instrument
  • Satisfy the financial covenants in other debt instruments
  • Comply with the minimum equity capital requirements of regulators

While exchange offers take many forms so they can adapt to the particular situation at hand, they fall into two broad categories:

  • Debt-for-equity exchanges
  • Debt-for-debt exchanges

Rights Offerings

A rights offering is the general term used to describe an offer to the company’s existing securityholders (common stockholders) to purchase their pro rata portion of a new securities issuance. To assure that the company raises sufficient aggregate funds in the rights offering, the company often seeks to have one or more investors ‘backstop’ the aggregate amount of the offering – agreeing in advance to purchase all of the new securities not purchased by other offerees in the rights offering. If the backstopper is an existing securityholder, they agree to purchase their pro rata share as well.  In return for providing the backstop, the backstopper is allowed to:

  • negotiate the terms of the new securities, including the price, type of security and timing of the offering
  • receive a backstop fee payable at the time of the commencement of the offering equal to 3% to 5% of the aggregate offering amount, payable:
    • in cash
    • in additional shares of the new securities or
    • by a discount on the price to be paid by other offerees in the rights offering

Rights offerings have the desirable feature of reducing the potential issues that arise around the fiduciary duties of directors when approving the offering, since existing stockholders are given an equal and ratable chance to participate in the offering.

Exploding Preferred Stock

‘Exploding’ preferred stock is the term used to describe a series of convertible preferred stock with a liquidation preference ahead of the common stock and which is convertible into common stock of the company. The conversion of the preferred stock is initially limited on an as-converted basis to the maximum amount of voting power allowed by the relevant stock exchange without requiring a stockholder vote to approve the transaction (typically 19.99% of the existing voting power before the issuance).

The preferred stock usually automatically converts to common stock at a higher conversion percentage on further receiving the required stockholder and/or regulatory approvals for the investment transaction. If the approvals are not obtained by a certain date, the preferred stock becomes more favorable to the investor by requiring accrual and/or payment of dividends at a high dividend rate that increases incrementally every few months until the approvals are obtained. Therefore, the preferred stock ‘explodes’ and begins to take value away from the common stockholders if the investment transaction is not approved within a certain date of the investment.

Exploding preferred stock is used when the company’s common stock is listed on a stock exchange and it needs the cash on its balance sheet before the required stockholder approval of the ultimate common stock issuance can be obtained. The relevant stock exchanges all have rules or interpretations that the terms of the preferred stock cannot be coercive or draconian in obtaining stockholder approval, but can be large enough to properly receive stockholder approval.

There is not always a need nor is it always desirable to file for bankruptcy.  Consulting with a team of attorneys well-versed in the alternatives can allow your company to preserve its good reputation and its flexibility in the years after the economic and social dust has settled on the COVID-19 pandemic.


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