World Turned Upside Down

In the "insolvency zone," creditors exert a strong pull that often throws CFOs off balance.

Whether creditors will allow a company to continue borrowing when it is already bleeding capital is another matter. Banks are clamping down on the growth plans of cash-strapped firms, especially if covenant violations loom. Casino operator MGM Mirage got a reprieve from its banks last March, but it came with a $300 million cut in borrowing capacity, a prohibition against incurring a material amount of debt, and a dollar limit on new investments in CityCenter, MGM’s unfinished luxury residential complex in Las Vegas.

When confronted with major decisions on assets — the sale of a division, for example — management of a near-insolvent company needs solvency and fairness opinions from a third party, says Tim Cummins, a managing director at Stout Risius Ross. Creditors could accuse management of not obtaining a market-clearing price, and an opinion provides some defense. In a bankruptcy court, a below-market price could translate into a fraudulent conveyance — a transfer done with the intent of moving the asset outside creditors’ reach.

Delicate Decisions

Once firmly in the zone of insolvency, finance officers should be open and up-front with creditors to best maintain the relationship, says Jacen Dinoff, CEO of KCP Advisory Group. Dinoff has two rules for dealing with creditors: one, don’t promise that you’re going to pay them when your cash flow will not provide for payment; two, don’t tell them your business won’t file for bankruptcy. “You can say, ‘Our intention is not to file,’” says Dinoff. “But you’re going to need credibility in your dealings.” If executives misrepresent the reality of the business’s position, they may pay for it later in a forum like bankruptcy court, he says. “You may find key creditors whose losses have financed the bankruptcy demonstrating to the court that ‘these guys can’t run the business, they never meet the plan.’”

Adhering to a deliberate and meticulously documented decision-making process puts management on stronger footing. The documentation should include board minutes, as well as a record of what information and analysis were examined to arrive at a decision, says Alberts of White & Case. The documentation advice goes double for any transaction that affects an insider — bonuses, dividends, loans, asset sales. “Plaintiffs see that as fair game,” says Alberts.

Overprotecting against future second-guessing by plaintiffs has a drawback: it slows decision-making dramatically. Ironically, creditor lawsuits often arise when a CFO acts with too much deliberation — delaying a layoff, for example, when cash levels demand it be done immediately. The answer is to lay an adequate paper trail, not the longest one possible. As long as a decision is examined from both the equity holders’ and the creditors’ perspectives, CFOs need not be fearful, says Lindenmuth.

Even so, the zone of insolvency is a realm into which CFOs would rather not venture. But they can’t ignore it. A management team that is monitoring insolvency measures and keeping creditors’ interests in mind gives itself more options in a restructuring. And it grasps problems earlier. Says BDO’s Lenhart: “Managements that don’t acknowledge cash-flow problems and plow ahead as if it were the status quo, those are the ones that are walking into trouble — and getting sued.”

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