John Ventola and Douglas Gooding Published in ACC Quarterly Newsletter
| May 20, 2008
| John Ventola and Douglas Gooding
Chief Restructuring Officer: Coming to a Company Near You?
The use of financial advisors or “crisis managers” is becoming a more routine feature of loan workouts and bankruptcy proceedings and the number of appointments by boards of directors of crisis managers as “Chief Restructuring Officers” is likely to accelerate. As a company’s business encounters financial, liquidity and/or operational difficulties, the company’s lenders often will demand the retention of outside professionals as a condition of forbearance or other accommodations. The company’s owners or other stakeholders also may recognize that the company’s problems require the specialized expertise of outside consultants to help engineer a turnaround.
Traditionally, turnaround consultants are retained by their corporate clients as financial advisors through standard consulting agreements. The consulting agreements often spell out relatively narrow scopes of duties, often for a fixed period of time. Recently, however, it has become increasingly common for outside professionals to be hired by troubled corporations – particularly those in the middle market – as “chief restructuring officers.” CRO retentions are characterized by broad scopes of duty comparable to those held by a chief financial officer or even chief executive officer, and CROs may be charged with implementing sweeping changes to the corporation’s business and operations. Further, the retention period for a CRO can be much longer than customary for a financial advisor.
There can be clear benefits to the retention of a CRO compared to a financial advisor, as discussed below. But the installation of a CRO has legal implications both for the corporation and its board as well as the outside professional who accepts such a role. It also may raise some legal risks for the company’s lenders. Some important considerations for all parties to such a decision are discussed below.
The increased utilization of chief restructuring officers seems to have been driven primarily by the dramatic increase of middle market companies owned by professional investors, such as private equity firms. The move away from family owned middle market companies has resulted in increased amounts of leverage maintained by middle market companies and an increased willingness of equity owners to make substantial (and sometimes permanent) changes in management. Consequently, the primary decision makers in a troubled company in today’s climate may be far more willing to install a CRO as compared to a family owned middle market company from years past.
The availability of a CRO can be extremely beneficial to a troubled company and its stakeholders. Experienced turnaround professionals are used to dealing with unhappy creditors and managing crises while maximizing available value. From the standpoint of lenders contending with a troubled borrower, the appointment of a CRO can be exceedingly important. The occurrence of a significant event of default quite often strains communication and jeopardizes the relationship between existing management and the company’s lenders, and lenders may view a fresh set of eyes as a precondition to any further accommodations to their borrower.
A well regarded CRO will open the lines of communication, bring credibility and can implement strategic changes rather than simply making recommendations to management that often is entrenched. Other times, a CRO will serve to verify management’s strategic direction and projections, and thus break impasses between the company and its lenders. A CRO also can serve to insulate management to a certain extent in a difficult turnaround by implementing the changes and doing the “dirty work” necessarily accompanying the restructuring process, so that management is not tainted in the eyes of employees. CROs also can play a critical role as a facilitator or mediator between competing stakeholders in a manner that existing management simply cannot.
At the same time, the use of CROs has enjoyed growing acceptance by bankruptcy courts after initial periods of skepticism toward the concept. Whereas in the past the United States Trustee or the court itself often would reject the installation of a CRO as an unacceptable alternative to the appointment of a trustee, in many important districts the appointment of a CRO has become routine. See, e.g., In re: The 1031 Tax Group, LLC, 374 BR 78, (Bankr SDNY 2007). The bankruptcy courts in the District of Delaware essentially have endorsed the retention of CROs through the adoption of a Protocol for Engagement of CROs.
The ramifications of installing a CRO during an out of court workout phase are legally significant. As the name implies, a CRO is just that; an officer of the company subject to personal liability in many states for unpaid payroll, trust fund taxes and possibly other unpaid liabilities of the corporation. One of the first matters to be investigated is whether the company’s directors and officers insurance, if any, and indemnification provisions of its charter documents will extend to such a newly appointed party. The CRO will then have to make professional determinations of the company’s prospects and his or her ability to help effect a turnaround.
From the board of directors’ standpoint, issues of comparable magnitude also have to be considered. A company contemplating the appointment of a CRO in most circumstances will either be in or near the amorphous “zone of insolvency”, at which time the board of directors at least arguably assumes fiduciary duties to the company’s creditors. Nonetheless, it seems indisputable that even a board in the zone of insolvency enjoys the expansive protections of the business judgment rule. Further, in many instances the selection of the CRO clearly will be consistent with a board properly discharging its duties to creditors and other stakeholders, as the party selected for CRO likely will have professional experience and skills not held by other members of management. That is particularly the case when existing management may not be disinterested or may have its own agenda.
An important legal issue from the lender’s standpoint, of course, is the danger of exerting undue control over the borrower. While lender liability cases have been few and far between in recent years, lenders must remain cautious lest they find themselves subject of an affirmative action or the target of a recharacterization or equitable subordination claims in bankruptcy. Consequently, lenders must balance the reasonable wish for information and an independent party with the risk of being accused of directing a borrower’s operations.
Once a decision is made to retain a CRO, the two most critical items likely will be the scope of the CRO’s duties and the compensation to be paid. The delineation of the CRO’s duties is vitally important. The engagement of a CRO whose duties are uncertain likely will be doomed to failure or at best substantial inefficiency, as territorial squabbles break out between the CRO and existing management. It is therefore critical that the board define the CRO’s duties either through the engagement letter signed with the CRO or through a specific board resolution creating the CRO position and defining the officer’s duties.
The parties next will of course need to agree on the compensation to be paid to the CRO and, in many circumstances, the CRO’s consulting firm. Compensation arrangements vary widely, but some conventions have been established. Often the CRO will charge a fixed amount per month, but members of the CRO’s firm working on the engagement will bill by the hour. Incentive compensation such as “success” or “deal fees” are not uncommon, and increasingly CROs will request compensation for improved performance by the company. CROs generally should not be paid through equity stakes in the company, as such compensation will prevent the CRO from being “disinterested” if the company must file bankruptcy, and thus require the termination of the CRO’s service.
In light of the apparent recession and economic pressures facing all companies and tightening liquidity, corporate restructuring and bankruptcies are on the rise. For the reasons set forth above, Chief Restructuring Officers are likely to be a central feature of many restructurings.