Restructuring and insolvency issues that family enterprises face in the tumultuous 2023 economy

Speaker A: Foreign. This is family Office Intel. Uh, I'm your host, Edward Marshall, global head of family office here at the firm. Our guest today is Bob Richards. Bob is the chair of our firm's global restructuring, insolvency and bankruptcy practice and leads a number of different, um, efforts in the bankruptcy insolvency, uh, transactions and litigation. His Practice includes Chapter 11 Representations, Distress Asset acquisitions, distress loans, distressed loan purchases and foreclosure sales, as well as out of court transactions and transaction structuring. So Bob, thanks for, thanks for joining today.

Speaker B: Thanks for having me.

Speaker A: Excellent. Well listen, I think this is the beginning of 2023. We're all trying to think about what um, what are, what the economy could be bringing to bear. Where do you see some weakness in the uh, in the US Economy in different parts of the global economy that would have you concerned, especially given what you focus on with the companies that you represent.

Speaker B: Sure. So as we've seen, uh, Both for the U.S. federal Reserve and other central banks, they've really been increasing interest rates to get inflation under control at a pretty much unprecedented speed. And that hasn't fully hit yet, but it will definitely be hitting throughout the rest of 2023 and into 2024. So uh, it'll hit some industries quicker than others. But almost everyone borrows money. So ultimately it will hit uh, virtually all sectors of the economy.

Speaker A: Anything in particular that you see coming out of 2022, coming into 2023 of a sector uh, that could be particularly affected? Based on what you just mentioned, there's

Speaker B: a number of them. So let me talk about some of the ones that we're already seeing and are most likely to um, you know, to be significant areas of workout or bankruptcies coming up. Uh, one is real estate and hotels and in particular in that sector, uh, you know, commercial, office. You know, are people really going to return to office? Uh, malls have already been troubled. Um, hotels, especially business oriented hotels in a place that's not a place that people also want to vacation, are struggling. We're seeing some struggles now in multi family, especially in areas where you're seeing tech layoffs. So you know, Northern California, those kind of places. Uh, definitely some construction projects are being put on hold and then in certain markets there's also things that have been overbuilt like warehousing. And some of the major users of warehouse are cutting back on their warehouse demand. Bricks, uh, and mortar retail has been in trouble uh, for a while and we expect that to continue short, uh term and certainly long term. Automotive's uh, gonna struggle Some and in particular anything that's um, combustion engine focused. So if you're a carburetor manufacturer, uh, you know, you don't have a long term horizon. And that also relates to support businesses. For instance, gas stations. You know, over time, uh, you know, gas stations are going to, are going to decline as there's more charging stations and less gas stations. Health care, you know, continues to struggle, particularly in the U.S. um, and in particular segments within that would be nursing homes and um, safety net. Rural hospitals in particular are struggling. And one of the things that are really hurting nursing homes and hospitals right now is these temporary staffing costs for agency nurses and agency personnel. And that's not a problem that's likely to go away quickly. Um, we're seeing already consumer finance and related support businesses struggling. For instance, um, residential mortgage originators and servicers. And then finally there's just, you know, some very highly leveraged sectors. Uh, like a lot of tech deals were done at 9, 10, 11 multiples. Uh, so we expect uh, some struggles there. And any company that's got an upcoming maturity date, especially if it has low fixed interest rate debt now, uh, is going to either have trouble finding refinancing or have to refinance a much more expensive term. So there's going to be other problems. You've seen crypto obviously have uh, some problems already, but those are some of the main areas. We're expecting to see particular distress coming up.

Speaker A: So if you're a family enterprise business owner or a family office and you've got some work, uh, that you've done with direct direct investments, what's one of the things that you should be thinking about if you see one of those direct investments that's struggling?

Speaker B: You know, a lot of times we see people put off uh, something that's uh, a likely problem and hope things will turn around. And usually that doesn't lead to good results. Usually, uh, if you're proactive, uh, and have some lead time, you uh, can have better results. You know, generally in any kind of bankruptcy case, uh, you know, assets tend to get sold, existing investors tend to get wiped out. So you know, if you can deal with the problems with enough Runway that you don't have to file for bankruptcy, it's much more likely that uh, existing equity is going to survive in some form. Um, having realistic projections and realistic value current valuations, uh, you know, can be key to making sure that you know, you know, how deep or not deep uh, the problems are going to be. Uh, you're going to want to assess, uh, is it a temporary problem that you can get through with maybe a little extra liquidity or is it really a long term problem, uh, where you need some more serious fixes? Anytime you have, you know, an immediate crisis, you know you've got, you know you're not going to make the next payroll, uh, there's somebody that's about to get a judgment against you, uh, you know that, that, that can alter, uh, you know, the mechanics. So you definitely want to think about those in advance rather than uh, when they're about to hit. Uh, and you know, there's many different ways to address them. Um, there's, you know, business ways to address them and legal mechanisms to address them. But as a general rule, the more upfront you are, uh, the better off you're going to come on your ultimate recovery.

Speaker A: So if you are um, looking at these areas, um, with your, with your direct investments, if what are, what are some of the issues around debt holders and equity holders, uh, that they should be considering in terms of their rights if they're, if, if they're one of their investments, uh, or a company that they're involved with is approaching insolvency.

Speaker B: I mean there's different levels both in out of court deals and in bankruptcy deals. Let me kind of walk through the hierarchy of claims in general. Uh, and different family offices may be at different levels or sometimes multiple levels on these hierarchies. So generally you have senior uh, secured debt. Sometimes that's a single lender, sometimes it's a syndicate, uh, with an agent. Sometimes you have junior secured debt on the actual assets, uh, behind that. Uh, and then sometimes you have mezzanine loans, especially in real estate. But the thing to keep in mind with mezzanine loans is they don't have liens on the real estate itself. They only have liens on um, the equity in the real estate. So essentially they're structurally subordinated to all of the project level debt. Um, the costs of any insolvency process generally uh, get paid. And even if there's no value above the secured debt, you know, the professionals aren't going to do the insolvency process unless the secured debt agrees they're going to get paid. Then the next priority typically is certain employee claims. It's not always every employee dollar, but employees generally uh, get paid at least know current wages and current uh, vacation. Uh, most tax claims tend uh, to be priority claims. And then after that you tend to get down to critical vendors or uh, people whose contracts or leases are assumed in the bankruptcy case, uh, and then finally you get general unsecured creditors, which can be trade creditors, it can be tort claimants, uh, if they're not fully insured, uh, and, you know, can be a wide range of people, and sometimes people have unsecured bond or other debt. After you get through all the, you know, the debt levels, then you have, uh, any recoveries for stock. You know, some companies have some sort of preferred stock or quasi preferred equity. Uh, and if there's multiple levels of that, um, you know, it goes in that priority. And then the lowest, um, is common stock. One other thing I wanted to mention is it's very important to understand if you have a shareholders agreement or you have an intercreditor or subordination agreement, uh, you know, what your rights and obligations are under that because, you know, people will enforce those in an insolvency context.

Speaker A: If a family is more of a passive investor, whether they're through a fund, um, or they're doing it direct, um, how should they be thinking about their strategy if they think that one of their investments in a more passive function ownership type of structure is struggling? What are some of the things that you've seen that families, um, have done to be proactive and not just reactive in situations like that?

Speaker B: Well, part of it depends on the kind of investment you have. So if it's, you know, something that, you know, there's a public market for, you're otherwise free to sell, then you have to decide how much confidence you have in the fund turning things around versus how much you want to just get out and take whatever lumps, uh, you've got. Uh, some of these funds obviously are pretty liquidity restricted and you can only get out in certain times, in certain windows. So there you have less flexibility as, uh, to whether, you know, you can sell out. Uh, you certainly can talk to whoever the fund is or whoever's managing the investment, understand how much distressed experience they have, uh, you know, ask questions about how they intend to deal with the particular things that are causing them trouble, uh, and at least let them know that you're actively monitoring it, even if you don't have the ability to direct them to do something, uh, so that they know that there's a washful eye on it, that you and perhaps other investors you're aligned with M are really looking at what their plan is to deal with the troubles and hopefully get, uh, you something back on your investment, whether it's equity or whether it's debt.

Speaker A: What about being more opportunistic right so if you see that there are issues, uh, in businesses that are uh, struggling, you know, how should families be thinking about the potential to buy out different investors or parties that are uh, uh, in that investment, or buying up loans, uh, that are associated with some of these investments being a little more strategic, uh, for people that may be thinking about uh, how to exit something like that, but somebody that's committed, more committed, or has a different opinion on that particular investment, are there ways that they can be proactive, uh, in those areas that you've seen that uh, has worked out for folks that you, that you've worked with?

Speaker B: Often you see the senior lender has fatigue. Maybe it's traditional bank or some sort of someone that doesn't want uh, a distressed credit long term and uh, it may well be in the interest of equity or junior creditors, uh, to buy them out or to buy their position at a discount, um, and they may well be uh, willing to do that. And in fact if they don't end up selling to you, they may go to the distressed market and sell to someone else, um, and you may not like who that buyer is. So you know, it's, it's in your interest to uh, you know, control the senior debt, especially if it's secured. Uh, you make sure you've got as much rights, uh, as they have. Sometimes you'll see, uh, you know, holdouts like, you know, you need unanimous shareholder transaction approval for a sale and one or two squeaky wheels won't go along with it. Uh, and it may be you buy them out. Sometimes you have the right to do that under your shareholders agreement. Other times, uh, it's just a negotiated transaction. And sometimes even if someone isn't a squeaky wheel, you know, if you really believe you can turn around the company and someone else has less confidence, you know, you can go around and buy a, other positions, maybe even trade debt. And if you uh, are able to turn around the company, you're able to do so at a significant profit versus the people who just want their liquidity and to get out of the transaction.

Speaker A: Bob, can you put that in context of debtor and possession financing? What is that? Can you talk about that concept?

Speaker B: Sure. Um, debtor and possession financing is a concept that in the bankruptcy case, under section 364 of the Bankruptcy code, uh, the bankruptcy court can approve new financing and in fact, you know, in some circumstances can approve new financing. That's Perry passu or even senior, uh, to some of the existing financing. There's certain legal standards that need to be met as to whether you can prime someone's position. But where we particularly see debtor and possession being uh, important is if you um, you know, let's say you're an equity holder and you're willing to put in more liquidity, but you don't want to put it in as more equity. Uh, you know, you could consider for instance providing a debtor in possession financing facility or on an out of court basis. Sometimes we see the insiders buy a junior participation and the existing senior, uh, loan to get the senior to provide them with more liquidity and more breaks. Um, but you know, there's a way for you to kind of improve your new money's position so at least you're more likely to get uh, your new money out and can better protect whatever existing debt or equity you have in the company as well. If you believe in the company and others don't believe in it so much.

Speaker A: So if you've gotten to that point where um, you're working through or one of your investments are working through an insolvency, uh, issue, what are the different kinds of insolvency proceedings, uh, that people should be thinking about or know about at least, um, at a strategic level.

Speaker B: Sure. I'm in the US So I'll mainly talk about us uh type of proceedings. But many other jurisdictions in the world have similar concepts, um, in their jurisdictions. Certainly Canada has very similar concepts to us. So you know, the classic thing that people think about is a Chapter 11 case. In a Chapter 11, at least initially, management's in control. Uh, you can try to reorganize the business, you can try to sell it as a going concern. Uh, you can try to do an orderly liquidation. Often you see retailers, uh, you know, try to do an orderly liquidation to sell the inventory at higher prices and uh, uh, try to market and sell below market, uh, lease holds. Uh, so you can do many things in a chapter 11. But you know, that's what most businesses that are trying to do, some sort of going concern value will pursue. Uh, there's also a chapter seven, which is um, really a fire sale, a liquidation under the control of a trustee appointed off a panel. Typically those trustees won't operate the business. They'll just uh, shut the doors day one, let go all the employees and try to collect the accounts receivable and sell the assets quickly for whatever they can, um, pursue them for. And then there's some other state court remedies that are somewhat like um, you know, bankruptcies. So you know, there's receivership Often receivership sought at the uh, request of the secured lender. Especially if the secured lender, for instance, wants to have better control over its collateral, but doesn't necessarily want to own its collateral yet. Uh, for instance, you may not want to own a shopping mall. And in some places like Illinois, you know, it may take two or four years to foreclose in foreclosure court. So they want to be in control of their collateral until uh, they can complete the foreclosure process. And then in some states in the United States they have something called an assignment for the benefit of creditors, which is somewhat akin to a chapter seven, except you, you pick your own sne who acts as a fiduciary under state law. Uh, and often that SME has some limited ability to operate or some limited ability to sell assets on something like a more going concern basis. And like I mentioned, you know, there's comparable concepts certainly in most, uh, developed nations, uh, to these kind of insolvency proceedings we have in the U.S. uh,

Speaker A: when you're looking at a chapter 11 ah scenario, what does the timeline look like that, um, uh, for typically for a company that's going through chapter 11,

Speaker B: you know, I've been practicing 35 years and it's changed over time. Um, the most common type of Chapter 11 case now is a quick sale or quick liquidation. Often they have the buyer in the wings and the buyer wants to buy through a bankruptcy. So I can get a free and clear order. It can take the contracts and leases it wants and jettison the ones uh, that it doesn't want. Um, and so that phase of the case typically goes, you know, pretty quickly. It can go anywhere from, you know, as little as something like 30 days to, you know, 120 days, uh, depending on especially how much marketing of the asset occurred pre petition. Then you know, there's other phases of the case after the assets are turned to cash. You know, claims processing, litigation, that can take years. But you know, the actual getting the business through a bankruptcy often is quick. Uh, there are still some cases that do the traditional plan of reorganization. The big difference with the plan of reorganization is that, uh, creditors get to vote on that plan. And there's a disclosure statement that's somewhat like a proxy statement that describes the plan and there's a whole bunch of, you know, standards that need to be met for the plan to be confirmable. So it's a more complex and more, uh, time consuming way to get the bankruptcy administered. Uh, but there can be some advantages. For instance, uh, with real Property. If you do it through a Chapter 11 plan, you may be able to get an exemption from transfer taxes or certain mortgage recording taxes, which can be sizable in some jurisdictions. Uh, you may be able to preserve, uh, net operating loss carryforwards, which will be very valuable if the business is able to be profitable in the future. And it may be possible to get, uh, third party releases or exculpations. So there's some things, if you have the time and the inclination, you can get in a plan that you can't get in a quick, uh, section 363, uh, sale. But it is more complex

Speaker A: when families are looking at these situations. How do they maintain their rights, um, and be thinking about that as they're going through a procedure like this with, with either the company that they're uh, passively or very actively involved with.

Speaker B: And I'll focus, you know, on, on more active because in passive, often you're relying on an agent or a lead, uh, to protect your rights. For you, uh, though you want to make sure that they're paying attention. Uh, and some of these things come up very, very quickly. So uh, generally you want to monitor the case if it's any kind of material investment from day one. The good news is all bankruptcy court dockets are online now and everything's electronic. So it's not nearly as expensive to watch what's happening in a case than when you had to go down and actually attend the hearing in the olden days. Uh, some of the things that you particularly want to pay attention to so often, day one or very early in the case, someone will propose debtor in possession financing. You have that debtor in possession financing is proposing to, for instance, prime secured liens. You want to know about that. If you're a secured creditor, they may have hefty exit fees, hefty upfront fees. Uh, so you're going to want to understand how much they're diluting you. And if it's too unattractive, uh, you may want to say, give me time. I want to propose a rival dip financing facility, uh, that's on more favorable terms, uh, than the one that's being proposed. Uh, another thing that can come up pretty quickly in a lot of cases is these free and clear, uh, sale motions. And often they're quite aggressive about what they're trying to sell free and clear from and seek, uh, other findings. So you know, you want to have those watched very carefully. Sometimes if there's been, you know, significant, uh, you know, fraud, you've got an enron you've got your most currently like an FTX or Celsius, uh, there'll be a request for an examiner or a trustee. Uh and if one's appointed, you know, you know they look out for the interests of uh, of many people including uh, a number of the retail uh, type investors and look into some of the uh, diversions and bad acts that are um, at least alleged to have occurred. Uh, there's often a claims bar date and you know you need to file uh, your claim even if it's still a contingent claim. Let's say for instance you're a director and officer and you have an indemnification claim, you know, you would need to file that by the bar date. Sometimes if you have an executory contract or lease, say a long term supply agreement, a real estate lease where your tenants in bankruptcy, the entity in bankruptcy can do one of three things. It can assume the contract and say I'm going to keep the contract going forward. It can assume and assign it to a third party, let's say it's selling the business to someone else. Or it can reject the contract and say, you know, I don't want the space anymore, I don't want your supply agreement anymore. Uh, I want to get out of this. It's, I think it's burdensome. Uh, and in all those instances, you know, usually you either have to say, you know, I, you know, I have a cure claim for instance in an assumption and you need to pay me this much to assume. And if you're going to sign it to someone else, you need to show that they're able to perform. If it's a rejection, you know, you're typically going to have uh, some sort of claim for your future loss, damages for the duration of the contract or at least one year of the lease. So you know, it's important to pay attention to those and file your claim in time. Uh, we talked a little bit about chapter 11 plans. Um, you know you're going to uh, want to typically vote on that plan. Uh, that plan may include some objectionable provisions. Let's say that you have uh, litigation rights against officers or directors and they're proposing a release of those officers and directors. You're going to want to object to those releases. And then finally towards the end of the case, um, people tend to think about litigation. So you know, you might get a preference demand letter saying you know, you receive these kind of payments within 90 days of the bankruptcy, pay it back. Uh, you might get an actual, you know, lawsuit filed in the bankruptcy case. Uh, so, you know, you need to be on the lookout for those kind of exposures and defend that. And then in some larger cases especially, you'll see something that's not yet a suit, but called a bankruptcy rule 2004 investigation. So you'll get a subpoena asking for documents and a subpoena asking to, you know, take your deposition. If you were an officer and director, uh, in the first instance, those are kind of fishing expeditions. But ultimately, depending on what they find, it can turn into lawsuits afterwards. So, you know, it's important to take those seriously and you know, assume that, you know, they're trying to find money somewhere and you don't want it to be yourself.

Speaker A: So in that aspect of trying to make sure you have all of your ducks in a row there, what should family members or members of a family, office staff or individuals, ah, connected, uh, to that be thinking about when it comes to personal liability? I mean, should they be thinking about how to, how to protect themselves in advance with the right kinds of insurance, you know, kind of representation? Should they be resigning from organizations that are struggling like this? What, what, what are some of those things that you've seen that are important to, to make sure that you consider. To make. To, you know, know, put, put the family in a good position. Um, because these are often, as you mentioned, contentious types of um, situations. And, and uh. And you know, the family can be a, uh. If, if it's a very significantly wealthy family, it could be an area where a, a debtor or somebody like that could be looking, um, for um, a. A place to uh, to. To. To help on the money side.

Speaker B: Sure. So it's, it's particularly a risk for someone who's serving as an officer or director of the entity. Um, it can also sometimes be a, uh, a risk if you're a majority or controlling shareholder. Uh, there's certain kinds of liabilities that are statutory. Ah, one of the primary ones is trust fund taxes. So that would be payroll taxes, sales and use taxes, and more often than you would think, uh, businesses struggling for liquidity don't, uh, pay those current. And if they don't get paid, uh, the state will come after not only the company, but after, but all officers and directors, uh, trying to collect those taxes. So if you're an officer, director of business that's struggling, uh, you're going to want to talk to your CFO and say, show me that all the trust fund taxes have been paid current and will be paid current going forward. Uh, likewise, any Money that the business collects for employees. So let's say 401 contributions or self funded medical or the like, you're going to want to make sure that that gets to the actual plan and isn't being used for working capital. Uh, you know, in some states there can be liability for wages and paid time off. Uh, so, you know, generally you want to make sure that those kinds of things have gotten paid. And then we're increasingly seeing, um, you know, different class actions and insolvency situations. And we see wage an hour class actions, we see um, Warren class actions saying, you know, you didn't give a war notice or you didn't give enough warrant notice and therefore, uh, you know, you're, you should be liable for a large claim there. Uh, for publicly held companies, sometimes you see a securities class action, uh, brought and there can also be uh, claims. If for instance, you're on the board and you offer authorized the dividend or distribution six months ago, 12 months ago. Was the business really solvent when you authorized that? And what was your business basis, uh, for authorizing that? Uh, also if the business is insolvent, uh, you may owe a fiduciary duty to creditors and not to shareholders. So there's a lot, a lot of potential landmines here, including potential just general D and O suits. Uh, one thing that I always advise directors and officers while they're on the board is make sure you're acting on a well informed basis with solid minutes, solid board books so that you can say, hey, I satisfied the business judgment role. Certainly on some kinds of action that helps. On others that are statutory, like, you know, you didn't remit your trust fund taxes, uh, it doesn't matter whether uh, you have a good board book or not. Uh, you're just statutory liable because it's the state's money and it didn't get remitted to the state. In terms of whether, uh, you know, you want to resign, uh, certainly your resigning can help in terms of anything going forward that you know, you know, you're not approving it, you're not involved with it. If something happened, uh, before then, let's say, you know, someone was embezzling money and you didn't capture it or you know, something else happened. You know, generally resigning won't uh, protect you necessarily from claims related to things that happened. You know, why you were a director, uh, why you were an officer, uh, there are some downsides to resigning. You know, obviously you have less ability to uh, influence how the uh, workout or how the Bankruptcy goes going forward. And you know, sometimes, especially if they're going to file bankruptcy, there's not as much risk in being a director and officer going forward. Because in bankruptcy, anything out of the ordinary course of business, you know, a sale, a financing, another material decision needs to be proved by the bankruptcy court. So, you know, there's often less risk in doing that because the uh, you know, the bankruptcy court is the ultimate decision maker, not the board. The board more recommends than, uh, actually

Speaker A: implements in terms of insurance policies. I think DNO people are very familiar with DNO insurance, whether they're on a nonprofit or a for profit type of entity or business, uh, that they're dealing with. What about DNO tail policies? What do those look like and what are they and how should be people? How should people be thinking about them?

Speaker B: Yeah, I mean, anytime you're involved in a distress situation, you know, early on, you want to understand, you know, what is the policy. Sometimes there's multiple layers of coverage. Um, is it a claims made policy? Is it a claims incurred policy? Uh, is it about to come up for renewal? If so, you know, is the company, uh, renewing it? Uh, you know, those are things you want to understand immediately. And then almost all policies have what's called a tail, right? Or an extended reporting period. And that says that if you pay an extra premium of X dollars, you can get an extended reporting period for a year. If you pay X plus Y, you can get it for three years. You, sometimes they go as long as six years. And you know, the reason you might want longer is, you know, to outlive any statute of limitations. What's important to understand about um, you know, tail policies is, uh, you know, it, it would cover any suit, you know, brought in that extra year or extra three years, but only for things that happen generally before the policy ended. So, you know, it doesn't cover going forward. It would only cover, you know, uh, times when the policy lapsed and essentially cover your defense costs and maybe cover your liability, uh, going forward. You know, you're going to want to understand, uh, exclusions under the policies because DNO doesn't cover, you know, everything. Uh, so, you know, you're going to want to understand if there are pending claims, are they likely to be covered or not. Um, do you know, uh, tail policies, uh, you know, can have some hefty premiums. Um, ideally, you know, you would want the company or the company's lender to fund those premiums perhaps for cooperation to wind down. Sometimes they'll do that, sometimes they won't if you, if they don't, then you have to decide, you know, collectively with the other directors. Am I nervous enough that we want to fund the tail or do I uh, just want to go without the tail? Uh, and also there's time windows to, you know, do the tail option. So you want to make sure, especially if their policies expiring that you, you know, exercise the tail, uh, timely so that it's there to protect you going forward from suits and at least defense costs.

Speaker A: So reflecting on everything that you've been working on in this space, what's the one lesson learned in your practice?

Speaker B: Yeah, I would say, you know, being proactive and being realistic. I mean, you know, we see so many times where people, you know, hope for the best. You know, they know that things aren't great but you know, maybe they've been through bad periods before and you know, something's worked out and they just don't want to face reality until uh, you know, it's pretty dire. And that, that usually is not a good situation for directors, officers, investors, uh, you know, those kind of people. Those situations tend, tend to end up in liquidation, sale to competitors, uh, litigation. So I would say being proactive and being realistic is a key.

Speaker A: Great. Well thank you, thank uh, you Bob for joining uh today. Really appreciate the background and the advice uh, on this and if people want to get in touch with you, what's the best way to find uh, to find you?

Speaker B: Yeah, on the Dentons website, my uh, you know, email is uh, robert.richardsettens.com uh and you know, happy to answer any follow up questions. I will mention that, you know, in the US we're over 45 restructuring lawyers and worldwide, including in Canada, you know, we're over 400. So you know, we can cover your needs anywhere that they may arise.

Speaker A: Excellent. Well, thank you Bob and uh, thanks everybody. Well, that's it. Bye everyone.