This post is part of a series of posts entitled First Considerations for the Financially Distressed Business. For a comprehensive list of articles contained in this series, click here.

A. Lacks Sense of Finality

An out-of-court restructuring agreement between a debtor and creditor – whether forgiving, reducing, or allowing for repayment in installments – is only as strong as the document itself and relies heavily on the debtor’s ability to enforce such an agreement. In contrast, a court ordered discharge (like those usually granted in a bankruptcy proceeding) has the full authority of the federal court system and, therefore, an increased sense of finality.

While this problem can be resolved by careful drafting of the agreement and meticulous efforts by the parties involved, it is still a contract, which is a document that is almost always subject to ambiguity, disagreement, and, ultimately, litigation. Therefore, debtors with a less-clear path to solvency may want to consider the assuredness that comes with a bankruptcy filing rather than an out-of-court restructuring.

B. No Automatic Stay

While this problem can be resolved by careful drafting of the agreement and meticulous efforts by the parties involved, it is still a contract, which is a document that is almost always subject to ambiguity, disagreement, and, ultimately, litigation. Therefore, debtors with a less-clear path to solvency may want to consider the assuredness that comes with a bankruptcy filing rather than an out-of-court restructuring.

Without a bankruptcy filing, a debtor relying on out-of-court restructuring may not have this powerful benefit. Instead, the debtor must find a way to convince their creditors to stay their collection efforts on their own accord, avoid filing lawsuits, and listen to the alternative options for payment the debtor presents. This may be a dubious effort, especially if relations with creditors have turned sour, as they often do when payments aren’t being made.

C. Sales Will Not be Free and Clear of Liens

The Bankruptcy Code provides that the debtor (or trustee) may sell property “free and clear of any interest in such property of an entity other than the estate.” The goal of this is to allow debtors to freely dispose of assets to create liquidity, which itself is better suited to reorganization.

An out-of-court restructuring does not have the benefit of this provision. As a result, a debtor with assets that are tied up in multiple liens would have more difficulty in disposing of assets and restructuring quickly, having to convince lienholders to agree to certain actions. While this is by no means impossible—in fact it is a process that such lienholders would already be a part of generally in an out-of-court restructuring—it takes time and may require concessions to be made.

D. Inefficient With Too Many Creditors

Although the need for consensus, or near-consensus, among the creditors is advantageous against needlessly litigious actions by creditors, it can put the debtor at a disadvantage if there are simply too many creditors. Because of the costs that are associated with creating an adequate plan that will convince creditors that an out-of-court agreement is in their best interests, if there are too many creditors with too different of interests, it can become difficult to manage. Businesses with several dozen to hundreds of creditors of varying types may be better off using bankruptcy, which would uniformly treat all creditors, rather than an out-ofcourt agreement, which may require custom tailoring to each kind of creditor.