Adjustments and Workouts

• Author: David J. Cook
• Pages: 149-165

Adjustments and Workouts

The Short Story

Synopsis

As an alternative to bankruptcy or other formal proceedings, some

commercial debtors offer to settle the claims of their creditors. The offers

consist of (1) a payment program of a fixed amount over months, quarters,

or years, with pro rata payment to each creditor providing for partial or

full payment of debt; (2) a composition or pot plan that offers a percentage

of the pot or percentage on the dollar to creditors in lieu of bankruptcy;

(3) payments from percentage of gross or net profits over time from the

debtor or debtor’s successor; (4) payment of a one-time discounted amount.

The debtor, the debtor’s attorney (or sometimes a third party, such as

a credit manager’s association) makes these offers and manages these

programs.

The machinery here is worth explaining. The debtor owes money to the

creditor. This is a contractual obligation, which consists of an immediately

enforceable obligation with a fixed amount. The debtor might have agreed,

for example, to pay interest at 18% (a usual contract rate), to pay attorney’s

fees in the event of suit, and to issue a personal guaranty. These are all

standard terms of commercial credit, bank loans, matured lines of credit, or

just about any other commercial obligation. If the debtor and the creditor

enter into a “workout agreement,” in which the debtor agrees to pay these

obligations according to some type of formula, the agreement might not

specify whether the creditor has “swapped out the original obligation” or

initiated a “new obligation” under the workout. This is called substitution

and novation.

This workout might be a total disaster for the creditor should the

debtor default. If there is a default, the creditor perceives that the creditor

can immediately file suit on the original obligation. In response, the debtor

might claim that the original obligation was “swapped out” and in its place

is the “new obligation” under the workout. A creditor must carefully read

the workout and specifically reject the “swap out.” Any workout, from

the viewpoint of the creditor, should preserve the creditor’s right to sue.

Moreover, in the event of a workout, the creditor is probably obligated to

get the guarantor to consent, less the guaranty claim exoneration under the

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INSOLVENCY EXPLAINED

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guaranty and discharge from any liability the guarantor might owe to the

creditor.

Workout agreements are legal landmines with lots of unpleasant

surprises. A workout requires enormous diligence to insure that the

creditor, in the event of a default, escapes unharmed and uninjured. As

they say in all spy movies, trust no one, including the person handing you

the check to sign your name to some dense contract in tiny print—single

spaced, two sided, and full of legalese.

Here the typical treats and tricks: The payments under the plan are a

substitute for the original creditor’s claim. The debtor conditions payments

on the creditors waiving their personal guaranty and signing a general

release that would waive any rights against corporate insiders for other

claims, such as fraud, “alter ego,” insider dealings, theft of company assets,

or any other basis of personal liability. Some arrangements compel the

creditors to waive security interest. This is a “read the fine print” moment.

Legal Basis

A debtor is free to make a deal. This is basic law of contracting. A creditor

can accept a discount or agree to accept payment over time. The creditor,

absent its own obligations (i.e., its other creditors), can waive a claim, waive

security, or waive a personal guaranty. Here the law of common sense digs

in its heels. Business people succeed when they sell to customers who

pay their bills on time. Business people succeed because they follow their

accounts receivable. If there is a default, the business person as a vendor

will dunn the customer and, absent payment, will file suit or hire a collection

agency. If the customer collapses, for whatever reason, instead of filing

bankruptcy, the customer might offer a “workout.”

The offer of a workout does not preclude the creditor from immediately

filing suit and seeking an pre-judgment writ of attachment. Provisional

remedies, like an attachment, enable a creditor to lien the debtor’s assets

and gain priority. Depending upon the state, an attachment enables the

creditor to seize inventory; encumber equipment, real property, or rolling

stock; seize bank accounts, money market accounts, and stocks; and levy

the accounts receivable. The writ of attachment is the core remedy here.

From the viewpoint of the debtor, “a debtor may pay one creditor in

preference to another, or may give to one creditor security for the payment

of his demand in preference to another” is the first touchstone. The debtor,

absent fraud, does not have to treat creditors fairly. The second touchstone

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