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Legal Considerations for Business Continuity and Growth in a Down Market

When companies face significant financial and operational challenges, from liquidity concerns to labor and employment issues, several legal considerations are essential to making calculated decisions in an uncertain environment.

Liquidity, Solvency, and Financing Concerns

It is important to review the representations, warranties, and covenants (e.g., collateral, leverage, and cash flow ratios) in your credit or financing agreements to determine if you (or your counterparty) are at risk of a default. If your business (or your counterparty) is at risk of a default, consider taking immediate action, such as amending the covenants under the credit or financing agreement or otherwise seeking lender forbearance. Thus, you should obtain an accurate financial snapshot of your (or your counterparty’s) business and formulate and continuously update an operating budget. Notably, directors and managers of insolvent companies can owe fiduciary duties to the corporation, shareholders, and creditors.

Restructuring

If your business (or your counterparty) is in financial distress, you should consider the immediacy of a liquidity crisis, the complexity of the balance sheet, the number of counterparties involved, and the availability to seek and obtain distressed capital outside of court. Chapter 11 bankruptcy, which typically is a distressed company’s last resort, should be considered if out of court restructuring cannot be achieved. Thus, it is important to weigh the costs of a potential chapter 11 filing against the benefits to the business, which might not otherwise be attainable, and whether any transaction that may generate a long-term solution could be accomplished outside of the chapter 11 process. If an out of court restructuring is not feasible, a chapter 11 filing affords a debtor several protections, thereby enabling a debtor to impact financing agreements and other contracts in ways that may not be possible out of court.

Director and Officer Liability

It is also important to gain an understanding of the fiduciary obligations and duties that managers, officers, and directors owe to the stakeholders of an insolvent business. Accordingly, now is a good opportunity to review corporate charter documents and related business records to ensure they are up to date with respect to, among other things, manager, officer, and director liability and to review and understand the contours of all applicable manager, director, and officer indemnification agreements and insurance policies before it’s too late.

Federal Assistance

Businesses may qualify for certain federal assistance programs passed by Congress, such as the Paycheck Protection Program (PPP) and the Main Street Lending Program. We have counseled many clients on their ability to avail themselves of these benefits. Importantly, accepting or participating in some of these programs can preclude a business from availing itself of certain other federal assistance benefits or programs.

Insurance

It is also a good idea to review your policies regarding coverage for interrupted business, liability claims, event cancellations, inability to deliver, and securities liability. It is important to know what your insurance policies require in terms of the timing of notice, conditions, and exclusions.

Labor and Employment Issues

Before laying off or decreasing your workforce, it is imperative to understand applicable labor and employment laws. An example of this is the federal Worker Adjustment and Retraining Notification Act (WARN) and similar laws in some U.S. states that require a certain number of days’ notice be provided to employees and certain third parties before certain mass layoffs or plant closings occur. There can be severe penalties and consequences for businesses that fail to comply with applicable labor and employment laws. You should also review applicable employment agreements and policies before implementing a reduction in your workforce.

Taxes

The primary tax objectives in any debt restructuring are to minimize taxable cancellation of debt (“COD”) income and preserve valuable tax attributes (such as net operating losses and tax basis of assets) to generate tax benefits after restructuring. COD income can be triggered in a number of ways, including modifications of debt instruments, debt-for-debt exchanges, debt repurchases at a discount, debt-for-equity exchanges, and asset transfers in satisfaction of debt, all of which can occur either “in” or “out” of bankruptcy. There are certain exceptions from recognizing COD income, but it is important to understand how and when they apply, which depends on a myriad of factors. Generally, taking advantage of the exceptions to COD income recognition comes with a price of reducing or eliminating a debtor’s tax attributes, such as net operating losses. It is important to understand the elections available to debtors and certain statutory provisions available in bankruptcy that can preserve and maximize valuable tax attributes available to generate tax benefits post-restructuring. It is also important to understand how changes in the terms of new or restructured debt, or changes in interest rate environments, can result in different tax consequences than prior debt, including the deferral or loss of interest deductions.

Thompson & Knight has the extensive legal experience and expertise needed in times of crisis, and we stand ready to assist and represent our clients’ needs. If you have questions or would like more information about how you can best position your business in this turbulent financial market, please contact the individuals below.

Key Contacts

David M. Bennett

Bankruptcy and Restructuring Practice Leader

Shad E. Sumrow

Finance Practice Leader

Demetra Liggins

Bankruptcy and Restructuring Partner