Spring 2005 • Issue 17, page 3

Receivership to the Rescue: Reviving Failing Companies with A Consensual Receivership

By Mosier, Robert*

(Part one of this feature addressed why a company would go into receivership voluntarily. This concluding portion outlines the steps a consensual receiver will take after appointment to maximize the chances for a successful revival.)

The number and variety of options available to a receiver in an attempted consensual turnaround rapidly diminish as the company slides toward liquidation. The following chart shows insolvency on a 1-10 scale along the bottom of the chart (the “x” axis).

During the early stages of financial difficulty, management usually remains in charge and exercises typical options, such as replacing a president, vice president or selling a division. If this doesn’t work, the bank or banks holding the secured debt generally recommend association of a traditional turnaround firm to aid management (or to replace it). Assuming that this doesn’t reverse the company’s declining performance, the next step (generally around five on the above scale) is the commencement of collection litigation by the secured or unsecured creditors, or both. At this point management is embattled and has generally lost all credibility. As the company’s financial woes force it into the judicial system, one of the remedies available to secured creditors is to seek the appointment of a receiver. This usually occurs around points six or seven on the bottom axis. If management is intent on maintaining complete control of the company, a next step often is filing a petition under Chapter 11 of the Bankruptcy Code (where a receiver, if already appointed, may or may not be kept in place by the court). The last step on the decline into oblivion (number 10) is shut down and liquidation.

Note that this progressive (regressive?) scale shows a full range of rehabilitative options available in the early stages of financial trouble. However, as time passes and the company’s situation worsens, the number of options available drops off rapidly. By the time of judicial intervention, step five or so, the hypothetical scale suggests that the options available to management to turn around the company’s fortunes (and probability of success) are only one fifth of what they were during the early stages of the insolvency. And note how quickly they approach zero.

In evaluating future options, and where the company is likely to end up in this process, it is helpful to consider the nature of the business and or its economic sector. If the industry sector in which the troubled company participates is healthy and growing, the potential for a successful turnaround is far greater (for example, a troubled cable installation company operating in an environment where the entire nation has to be re-wired with two-way cable). If the industry sector is shrinking or headed for extinction (many high-tech companies in 2001, for example), the prospect for a successful turnaround is diminished. Key concerns include the underlying reasons for the business’s financial woes and existing management’s ability (and willingness) to take direction from a receiver.

The skeptic may ask: “Since existing management caused the problem, why is it advisable for a receiver to leave management in place (while taking control of the finances)? Isn’t this leaving the proverbial fox in the hen house?” Not really. It must be remembered that the goal of the receivership is to improve creditors’ recovery by turning around the business. The appointment of a receiver is a temporary remedy.

An allied question is “Why can’t the receiver operate the business alone?” The answer is that the receiver usually can, but seldom with the level of expertise and knowledge possessed by existing management. A receiver can bring in substitute management, but the concomitant learning curve requires time and consumes money — time and money the company no longer possesses.

The consensual turnaround receiver’s first agenda item is to build a cash reserve. The receiver must impose/obtain an informal hiatus on payment of the pre-receivership bills of both secured and unsecured creditors. Though this may force the company to a cash-on-delivery operating basis, creating a cash reserve is essential for a company to operate.

Next, the receiver has to impose cost reductions – cutting all but essential expenses. This will likely include layoffs, reductions in salary, closing nonessential unprofitable operations, and eliminating all perks – including those boats, planes and fancy cars the company CEO thought essential.

The time to develop a secured creditor repayment plan comes after (1) the company has accumulated a one-month’s supply of cash (to handle short-term emergencies), (2) revenues begin improving, and (3) the cost reduction plan is stabilized.

This must be a sensible payment plan that can be met while alternative financing for the now-stabilized business is sought. How quickly this can be achieved will generally depend upon the strength of the balance sheet and the ability of management to grow revenues. Once the secured creditor repayment plan is in place it is time to focus on the accumulated unsecured debt. The payment concept is the same as for secured debt, except that a cents-on-the dollar payment plan is an option. The key to success is showing creditors that they will ultimately recover more under such a plan (and retain a paying client) than they would if the company failed and was liquidated. Once these payment plans are in place, initial payments are made, the business is stabilized and, perhaps, new long-term financing has been obtained, the receiver may seek to return control of the business to existing management.

Here is a quick real-life illustration. Bank grants Company a $3 million working credit line, secured by its rolling stock, inventory, accounts receivable, and general intangibles. Company, which sells aftermarket large-frame computers – used IBM computers and those of other manufacturers, is doing well. Its founders are three former IBM executives – two “techies” who were in technical support and a third who was in sales. Initially it was a match made in heaven. Sales soared, and the Company had a very bright future.

The two techies became overwhelmed with their success, however, and wanted to start a new business that emphasized providing contract services, rather than sales. After an extended negotiation, the two techies agreed to sell their share of the Company to the salesman for $5 million – $1 million in cash and a secured note (subordinated to the Bank’s secured credit line) for $4 million. The Company could afford the projected payments over time at its then current operating levels.

With the former partner techies out the door (and with them the checks and balances on company operations they had provided), the salesman finally was able to implement creative programs that he had long dreamed of. Even more important from his perspective, he gave the sales force raises, increased bonuses while decreasing performance requirements, and implemented a more liberal expense policy. Predictably, profits began to sag, and the salesman (who was not a finance guy) soon lost financial control of the Company. The Bank’s line of credit was consumed, and soon moved into default. The alarmed salesman’s attempts to undo the liberalized compensation packages failed: all his experienced salesmen and saleswomen walked out the door, leaving the company in even more precarious straits.

The Bank filed suit for possession of its collateral – the inventory and A/R – and sought imposition of a receiver to protect it. After two meetings with the Company’s principal – the former salesman – a consensual receiver was appointed. The president/salesman was delighted to turn over financial control (of the sinking ship) to the receiver and refocus his energies on selling used computers – his specialty. Both the Bank’s counsel and the Company’s counsel agreed on the plan.

A quick assessment of the Company’s prior successes compared with the current dismal financial outlook told the story and suggested the solution. The principal difference was the absence of the two techies, and the strategy they had contributed to the company’s prior operations. After a couple of phone calls and a few in-person meetings (with and without counsel present), the consensual receiver’s pitch to the group was easy: either the techies returned and resumed their place in management (the trio again managing the company), or the techies would lose their $4 million subordinated note, the salesman would lose the Company, and the trade creditors would likely be shut out by the Bank, leaving them with the sole option of bringing suit on personal guarantees.

As you might guess, after a brief negotiation the deal was put together. Both the Bank and the trade creditors were thrilled with the prospect of a return to profitability. The deal worked. Within one year the company moved back into the black, became current on the Bank debt, and paid unsecured debt. The consensual receiver was discharged and the Bank gave the Company its “Borrower of the Year” award at the end of the first 12 months of the successful turnaround.

This case illustrates the difficulties and rewards of a consensual receivership. The challenges of convincing the Bank to hold off on its collection efforts and of convincing current management to surrender financial (and operational) control were difficult to achieve. There are other illustrative cases, some more difficult, some less. But all underscore the point that the consensual appointment of a receiver and corresponding retention of manage-ment while the receiver controls the purse strings can pay a big dividend – one that is generally much greater than that achieved by automatically dismissing current management and slugging it out with other creditors in a dark room.

*ROBERT P. MOSIER is a Southern California trustee and receiver and principal of Mosier and Company, Inc., a firm that has specialized in managing and turning around troubled companies for more than 25 years.