By: R. J. Shannon, Esq.
The service industry is precarious even in the best of times. Remaining profitable always requires innovation and consistent excellence to remain profitable, especially in a place with tight competition and margins like Austin. These are far from the best of times. Public health authorities have canceled major events like SXSW and closed the dining areas of bars and restaurants. Every business is facing months of drastically reduced or non-existent revenue. For most, this is an existential threat.
There are, however, steps that businesses facing financial distress can take to help their business survive the crisis. This paper provides general guidelines and considerations for owners and managers of service industry businesses. It is focused particularly on bars and restaurants but the principles broadly apply. The guidelines are for general information and not legal advice for your specific situation.
A. DEVELOP A BUSINESS PLAN
The most important considerations are not legal ones. The entire industry will suffer losses but minimizing those losses is key. It can make the difference between being able to work out an arrangement with a landlord or equipment lessors and needing to file for a chapter 11 bankruptcy to save your business.
Over the short term, it is usually best to continue operations—if possible—as long as your revenue exceeds your variable costs. Although this may be impractical for many bars and restaurants, you know your business best. Start planning now.
B. ADDRESSING FINANCIAL DISTRESS
The number one reason that formerly profitable and established businesses are unable to overcome temporary financial distress is that they take steps to address their financial distress too late. In light of the current crisis affecting the entire industry, even businesses with adequate working capital should plan to face future liquidity struggles. Below is an outline of steps that service industry businesses unable to meet their obligations should consider.
- Work with Creditors
Most creditors (lenders, suppliers, employees) will be aware of the distress facing the entire service industry. If there is a mitigating factor at play, it is that creditors know that even well-run companies that will be profitable over the medium- and long-term will face short-term liquidity problems and distress.
Many creditors will be willing to work with businesses. For instance, a landlord, knowing that re-letting the space to another tenant right now would only be possible, if at all, at a very steep discount may agree to temporarily reduce rent and spread the shortfall over the remaining term of the lease. A lender may be willing to forbear payments in exchange for extending repayment out over an additional six-months to avoid forcing your business into bankruptcy. A manager may be willing to take a temporarily-reduced salary. No matter the current financial condition of your business, you should act now to determine which creditors are willing to work with you so that available funds are used efficiently.
Creditors face their own pressures. Although they have an incentive to come to arrangements with individual businesses that have positive medium- and long-term prospects, they may not be able to do so with everyone facing distress. And while coming to an arrangement with a company may be in their best interest to ensure that the business continues as a going concern, a creditor might want to know that others are sharing in the risk or agreeing to similar reductions. A lender will want a clear understanding of the business’s financial condition and other key creditors to make similar concessions before agreeing to modify terms. A multiparty agreement can often be reached that is better than could be negotiated with individual creditors.
To the extent possible, payments to creditors should be delayed while negotiations are ongoing.
- Prioritize Payments
Some creditors will inevitably insist on prompt payment. While you are negotiating with creditors, or if you cannot work out an agreement with enough of creditors to avoid liquidity problems—i.e., revenue is insufficient to pay all obligations—it will be necessary to prioritize which creditors are paid are paid timely. Failing to pay certain creditors is will cause more problems than others. Although the relative importance depends on the particular facts and circumstances, the categories below reflect the general importance for most service industry businesses.
- High Priority: Critical Vendors, Secured Lenders, and Lessors
Critical vendors, secured lenders, and lessors have the most power to interfere with a businesses’ operations and therefore have the highest priority. Critical vendors are those without which a business would not be able to operate. There is no adequate replacement and operations would suffer if the vendor stopped providing goods or services. Secured lenders are the lenders with liens against the real estate, equipment, accounts, or other property of the business. These parties could foreclose or repossess the property securing the loans. Lessors are the parties who lease property used in the business. They could lock you out of your location or repossess equipment.
These creditors are not of equal importance. A lender who provided a secured loan for your kitchen equipment would have a difficult time profitably foreclosing on those assets. A merchant cash advance lender, however, could capture all of your credit card payments and immediately shut down your revenue stream. The relative importance of a creditor depends on what actions it can take if its not paid timely.
- Medium Priority: Employees and Non-Critical Vendors
The second most important group consists of employees and non-critical vendors. Employees are usually more sensitive to delays than vendors who could be replaced. A competent waiter or bartender could easily find another job under normal circumstances. Failure to pay employees timely results in entire kitchen staffs quitting without notice and other disruptions. But these are not normal circumstances.
Although businesses have some flexibility to delay payment to employees and vendors in the short run, doing so may reduce the business’s long-term credibility and goodwill. You could find a competent cook easily at the moment but failing to pay them now may limit opportunities in the future. This applies to a lesser extent to vendors who could be replaced. These parties should be paid if possible.
As a business consideration, companies should likely reduce their staff if they have not already done so. This helps employees by allowing them to seek unemployment and other public benefits while compensating the people who continue to work. Employees will be entitled to unemployment benefits whether their hours are reduced or they are laid off. You should consider the expenses for furloughed employees against the good-will that may accrue for keeping them on staff.
- Low Priority: Unsecured Lenders and other Creditors
Unsecured lenders should generally be willing to defer payments. For an unsecured creditor to obtain a recovery, it would need to engage in a months-long legal process to obtain a judgment that could be halted at any point by a chapter 11 bankruptcy reorganization. Businesses should therefore strongly consider not paying unsecured debt pending an arrangement with creditors that provides a clear path through this crisis.
Lines of credit and credit cards with available balances are exceptions. It will often be beneficial for companies to make at least the minimum payments in order to maintain access to the credit line that can be used to satisfy higher priority creditors if necessary. Although minimum payments may result in accrued interest, that is better than a lockout or eviction.
- No Priority: Distributions to Equity
Companies should not be making any distributions to equity. If distributions are required under a company’s organizational documents, management should seek an exception. Although some business may have experienced profitable a profitable first quarter, the second quarter will show losses across the industry. Businesses should maintain their cash reserves as much as possible.
Additionally, if a bankruptcy is required, distributions to equity will be avoidable preferences under 11 U.S.C. § 547. Owners would likely be required to pay these amounts back and also need to hire a personal attorney for the privilege. It is a lose-lose.
- Access Existing Unsecured Credit
After prioritizing the payments above, companies should generally use existing unsecured credit facilities to pay creditors until the crisis is over. Cash held by the company and assets held by ownership will help more than unsecured credit in obtaining a restructuring or reorganization.
Companies will often use all of their cash reserves and their owners will make numerous capital injections prior to seeking restructuring or bankruptcy as a last resort to avoid closing their doors At that point, the business has little dry powder left to negotiate with creditors. Businesses facing a liquidity crisis are often better off using their unsecured credit facilities first and using cash or the owner’s assets once they have a path forward.
There are two key exceptions to this general rule. The first is if the business is hopelessly insolvent—i.e., the borrowing only delays the inevitable and there is no realistic chance that the borrowing helps. Taking additional debt in that situation just dilutes recovery for creditors and opens management up to potential liability. The second is if the business’s debts are less than $2,725,625. If so, the company may qualify as a small business debtor under the Small Business Reorganization Act of 2019 (the “SBA”). This provides a number of benefits if bankruptcy becomes necessary and gives companies leverage in negotiations with their creditors. Companies should discuss their options with an attorney before accessing this credit in those situations.
Drawing on secured credit facilities is less of a winning proposition. Secured creditors can foreclose on their collateral if they are not paid and have special rights in a reorganization proceeding. That said, it may still be the right solution depending on the particular circumstances.
- Access New Credit
New credit for the service industry may be more expensive than existing credit facilities. However, the Federal Reserve has endeavored to push down interest rates and politicians have suggested various ways to help industries affected by the COVID-19 pandemic, including making government guaranteed loans available. Lower-cost credit may become available. Whichever is less expensive should be utilized first.
- Consider Bankruptcy before Equity Capital Infusions
Some businesses will have creditors who are unwilling or unable to work with them to avoid a liquidity crisis and will not have sufficient access to credit. Owners should strongly consider whether injecting new capital into the business is in their individual interest and the interest of their companies. There are other options to consider.
Chapter 11 of the U.S. Bankruptcy Code allows a company to reorganize its business while continuing operations. Creditors are prohibited by the “automatic stay” from taking actions to collect debts or take control of estate property. So a landlord will be prohibited from changing the locks and vendors will not be able to sue for collection. Meanwhile, the business continues, and new obligations have first priority, providing vendors and employees assurance that they will be paid.
The goal of a chapter 11 bankruptcy is confirmation of a plan of reorganization. The plan will modify the rights and obligations of the business and its obligations. Depending on the situation, creditors may be paid less than 100% and payments may be spread out over several years. One way to think of it is that a plan forces creditors to take a deal that they should have been willing to make consensually.
For the existing ownership to retain their ownership in the company, however, the plan must provide full payment to all creditors or ownership must provide substantial new value that can be used to at least partially satisfy the company’s obligations, unless the company qualifies as a small business debtor under the SBA. Owners will unfortunately often pour all of their personal assets into a company before ultimately having to file bankruptcy. The owners will then have no choice but to accept liquidation or a buyout that results in little to nothing for them. If they had retained their assets, however, ownership would have been able to keep the company in exchange for the funds.
That said, equity infusions make sense where it provides a clear path through the crisis. If an equity infusion would provide sufficient liquidity for the foreseeable future and ownership has additional capital is available to address unforeseen circumstances, it might be the best options. Creditors may also require equity infusions as part of a consensual payment arrangement or for a new loan. An equity infusion could make sense in those situations as well.
Most businesses in the service industry will probably not need to file bankruptcy despite the distress they should expect to face. But it is an important option to consider and keep open. If nothing else, the credible threat of filing bankruptcy can be used in negotiations with creditors.
C. WHEN SHOULD I TALK TO A LAWYER?
A lawyer could help at any stage, including the legal aspects of your business plan. However, the return on investment is highest after you have assessed the situation and have an idea of how your business would be affected under different possible outcomes of the COVID-19 pandemic over the next several months. Hiring an attorney at that point could help you come up with contingency plans in each event and begin planning negotiations with creditors. Your lawyer may be able to help avoid a liquidity crisis requiring additional intervention.
Consulting an attorney with restructuring and bankruptcy experience becomes urgent once a liquidity crisis is eminent or a creditor initiates legal action. Even though the goal should be a consensual workout among parties if possible, an attorney with knowledge of bankruptcy will be able to use it as leverage against a recalcitrant creditor.
Often, companies wait until their options have become severely limited before contacting an attorney. Many lawyers provide free or reduced-cost consultations in which they could speak to the specific details of your situation and advise when action will become urgent.
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Attorneys at Barron & Newburger, P.C. have extensive experience representing service industry clients and would be happy to address the general guidelines above or discuss the specifics of your situation. If you have any questions or comments, please reach out to R. J. Shannon at (512) 569-9106 or [email protected]
 R. J. Shannon is an attorney with the Bankruptcy and Reorganization practice group in Barron & Newburger, P.C.’s Austin office. He has represented restaurants, bars, and their creditors in out-of-court restructurings and bankruptcy proceedings and is a founding investor in a restaurant in New York. He can be reached by telephone at (512) 660-4574 or email at [email protected]