common mistakes made by businesses in financial distress

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A Professional Corporation

Common Mistakes Made by Businesses in Financial Distress

by David S. Kupetz*

Businesses in financial distress are often in a state of chaos. The time and attention of management, unable to address the causes of the financial distress facing the company, are consumed with putting out fires. Moving from emergency to emergency, management fails to focus on long-term needs.

Common mistakes made by businesses in financial crisis include:

• Letting go of accounting personnel.

In the most simplistic analysis, the source of financial troubles can generally be found either in a lack of revenue or an excess of expenses or debt. While a business may be a better or worse business depending upon how it is internally structured and situated in the market, cash flow makes the conventional business purr. A lack of revenue can be many times traced to insufficient market share, shortage of inventory, slow paying or insolvent account debtors, obsolete product, marketing failures, etc.

Though efforts may be made to increase revenue when management thinks it has discovered the source of the company’s revenue shortages, an eye is almost invariably turned to the opposite side of the coin, that is, the reduction of expenses. While a focus of attention in this direction is commendable in many instances, one must be careful which expenses to cut. In some but not in every business, payroll plays a significant role in the monthly budget and, in particular where business has slowed to a point where all personnel are not fully subscribed, it is easy to contemplate layoffs or terminations to reduce expenses. Where the mistake is made is when management of a financially troubled company thinks that accounting personnel are expendable.

More so than at any other time in the business life of an operation, accounting personnel are indispensable during a financial crisis. As the restructuring consultant or attorney attempt to analyze the economics of the business proposed to be saved, it is the numbers which tell the story. Most do not have the luxury of having been intricately involved with the business and therefore have no history with the operations or interim financial reporting. Consequently, one must look to the financial statements of the company for a flavor of what there is to reorganize and, of course, those financial statements must be accurate and complete.

While there may be some merit to the conclusion that the accounting personnel contributed to the financial crisis and that their retention will only prolong the agony, hiring new personnel before terminating the old group is generally better. (This assumes that there are no issues of fraud, defalcation, incompetence, intentional or misreporting.) Without some transition from old to new, the new personnel's task may more imitate forensic accounting than regular reporting.

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The failure to retain or appropriately replace accounting personnel leads to a loss of control over financial reporting, and a lack of timely and accurate financial information. Even otherwise well run operations will likely fail under such circumstances.

• Refusing to communicate with or misleading creditors.

Whether a restructuring is to take place as an out-of-court workout or through a bankruptcy plan, maintaining good relationships with the company creditors is a wise practice that could be the glue that makes even a bad case good. Ignoring the telephone calls and inquiries will almost always result in creditors presuming that there is something more to hide than just the fact that they aren't being paid. What is worse than refusing to return that call, however, is communicating incorrect or misleading information, which gives rise to distrust when the truth is discovered. Disseminating accurate and consistent financial information is a key in maintaining rapport with creditors and in maximizing the chance for a successful restructuring.

• Misleading employees.

Employees should be treated with no less respect than creditors and should not be victims of inaccurate or misleading information. Rumors of financial distress within an organization are the fodder upon which resumés are made. While an employee may be one of those whom management desires to terminate for expense reducing purposes, the one that got away may be the one you needed most. Most human beings are self preservationists, and if an employee believes that he or she is to be terminated eventually, our job market has made it clear that it is best to be employed when seeking to secure new employment. Having been trained on clichés like “he who hesitates is lost,” “beat the opponent to the punch,” and “he who laughs last laughs loudest,” the employee may take the absence of information and act upon it. It is best therefore not to treat your employees as strangers who are not concerned with the financial condition of the company.

• Failure to timely identify and eliminate "bleeders."

Depending on the nature of the business and magnitude of its operations, the company should be able to independently analyze selected aspects (i.e., departments, divisions, subsidiaries, locations) of its structure. Separate limbs of the company that drain more from the bottom line than they contribute must be classified as bleeders. And it is important to act promptly to eliminate identified bleeders.

• Failure to cut overhead; keeping the sacred cows.

In addition to cost-cutting measures that take place when management reduces labor expenses, a careful eye should be directed towards reducing overhead or operating expenses (travel, insurance and supplies). Some that can result in significant expense reduction may fall into the category of "sacred cows," such as the prestige of an office in a high-rent district that's more beneficial to employees than finances.

• Failure to build a sufficient war chest.

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To the extent creditors have not already put the company on cash on delivery terms, it is to be expected that such a policy will be implemented upon the public knowledge of financial distress or the filing of a bankruptcy reorganization case. For this reason and others, such as a need for cash for expense items unique to bankruptcy cases (U.S. trustee fees, appraiser fees to defend motions for relief from the automatic stay, etc …), it is important that the prefiling debtor generate cash to be used in the bankruptcy case. Generating cash can be done via liquidating nonessential property, retaining proceeds of accounts that would otherwise be turned over to the secured lender, new borrowing, sale of securities, etc. While the goal of raising the necessary war chest is important, counsel must be careful not to advise the client to engage in cash-raising activities that raise issues more problematic than a lack of cash.

• Using trust funds to operate the business.

Since many companies control the remittance of funds to governmental agencies from payroll withholdings, the temptation in financially troubled times is to treat such agencies as involuntary lenders. While the motivation is generally to ensure a continuous supply of needed goods and services, it may cause problems for management and confirmation of a Chapter 11 plan. Responsible persons may be individually liable. And the unpaid tax makes it more difficult to confirm a plan. Also, the tax claim is a debt that must be paid in full through the plan. Depending on the claim's magnitude, this requirement may affect the company's ability to prove the plan is feasible.

• Giving collateral or additional collateral in exchange for an extension of debt.

Pressures imposed upon a debtor before it elects to file for bankruptcy protection many times result in business decisions which may appear sound at the time but which later prove to have been unwise. One such decision may be the giving of collateral or additional collateral in exchange for an extension of credit or the maturity of existing debt. While the grant of a security interest may be avoided after the case is filed under the preferential transfer provisions of § 547 of the Bankruptcy Code, the short limitations period and the success of one or more defenses available under that statute may preclude such recovery.

Even if a valid cause of action exists, success is never guaranteed and may not be as expedient as the case requires. Where a security interest exists, the debtor may be faced with motions for relief from the automatic stay, disputes regarding the right to use cash collateral, objections to the sale of the collateral free and clear of the lien so granted, and questions as to the proper treatment to be afforded the creditor under a plan. Though there may be valid motivations to give new or additional collateral to secure a debt, the strongest motivation should be the extension of new credit in an amount equal to or greater than the value of the collateral being offered. Anything short of that should be avoided if possible.

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Direct Line: 213.617.5274

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Los Angeles Office

333 South Hope Street, Thirty-Fifth Floor Los Angeles, California 90071-1406

Voice: 213.626.2311 Fax: 213.629.4520

DAVID S. KUPETZ David Kupetz specializes in troubled transactions, crisis avoidance consultation, workouts, restructurings, reorganizations, bankruptcies, receiverships, assignments for the benefit of creditors and other non-bankruptcy insolvency proceedings. He represents debtors (in restructurings and workouts and in chapter 11 reorganization cases), secured creditors, unsecured creditors' committees, assignees for the benefit of creditors, buyers/sellers of businesses/assets in distressed circumstances and other entities in insolvency and bankruptcy situations.

A sampling of clients represented by Mr. Kupetz includes: Care Enterprises, Inc. (debtor in possession); Ocean Pacific Sunwear, Ltd. (debtor in possession); County of Los Angeles (creditor); General Electric Capital Corporation (secured lender); Litton Industries, Inc. (creditor); Boston West, LLC (Boston Markets) (debtor in possession); ExxonMobil Corporation (creditor); Honda Trading Co. (creditor); CKE Restaurants (creditor); San Diego Television, Inc. (debtor in possession); South Bay Pizza, Inc. (debtor in possession); Transgo Corp. (unsecured creditors’ committees); Aura Systems, Inc. (out-of-court unsecured creditors’ committee); Snow Valley, LLC (debtor in possession); Gardenburger, Inc. (debtor in possession); eStyle, Inc. (debtor in possession); American Home (debtor in possession); No Fear Retail Stores, Inc. (debtor in possession); and Ventura Port District (chapter 9 debtor).

His many articles on bankruptcy-related subjects have been published in The Business Lawyer, Commercial Law Journal, IDEA: The Journal of Law and Technology, Journal of Bankruptcy Law and Practice, The Annual Survey of Bankruptcy Law, The Urban Lawyer, The Banking Law Journal, Los Angeles Lawyer, California Lawyer, Commercial Law Bulletin, Los Angeles Daily Journal, The Secured Lender, The Journal of Private Equity, The Journal of Corporate Renewal, Public Law Journal, Federal Lawyer and many other publications. For a list of articles authored by Mr. Kupetz, please see the next page. Mr. Kupetz served as the author of Collier Commercial Bankruptcy Forms for many years and currently is the author of the Collier Handbook for Creditors' Committees.

Mr. Kupetz is a frequent lecturer on reorganization and other insolvency topics.

Mr. Kupetz was admitted to the California bar in 1986. He obtained his legal education at the University of California, Hastings College of the Law (J.D., 1986).

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SELECTED ARTICLES AND OTHER PUBLICATIONS AUTHORED BY DAVID S. KUPETZ

"Bankruptcy Court Chastises Stockton's Capital Market Creditors for Their Opposition to Chapter 9 Relief," Los Angeles Daily Journal (June 2013).

"Assignment for the Benefit of Creditors: Effective Tool for Selling and Winding Up Distressed Businesses," Valley Lawyer (June 2013).

"Chapter 9 for Municipalities," California Lawyer (April 2013).

"Court Rules City Doesn't Need Approval to Settle Claims During Chapter 9," Los Angeles Daily Journal (February 12, 2013).

2013 Collier Handbook for Creditors' Committees, Co-Author (LexisNexis).

"Standards for Confirming a Chapter 9 Plan of Debt Adjustment: Incorporating and Diverging From Chapter 11 Plan Standards," Vol. 32 Cal. Bankr. J. No. 2 (2012).

"Stockton health benefits not protected by the Contracts Clause," Los Angeles Daily Journal (August 9, 2012).


"Chapter 9: Refuge of last resort for municipalities," Los Angeles Daily Journal (December 6, 2011).


"Intercreditor Subordination Agreements and Voting Rights in Chapter 11," Norton Annual Survey of Bankruptcy Law (West, a Thompson Reuters business, 2010 Edition).

"The Supersessionary Effect of Federal Bankruptcy Law on State Statutes of Limitations for Actions Against Receivers," Norton Journal of Bankruptcy Law and Practice (Vol. 19, No. 4, August 2010).


2009 Collier Handbook for Creditors’ Committees, Co-Author (LexisNexis).

“The Venerable Assignment for the Benefit of Creditors Weathers the Ninth Circuit’s Decision in Sherwood v. Lycos and Remains a Valid Alternative to Federal Bankruptcy Proceedings,” Norton Annual Survey of Bankruptcy Law (Thomson/West 2008 Edition).


Norton Bankruptcy Law and Practice, 3d Edition 2008, author of chapters on municipal debt adjustment and assignments for the benefit of creditors (Thomson West).

“Evidentiary Hearings in Bankruptcy Court: Necessary for the Resolution of Disputed Material Facts and Open to the Admission of Evidence Previously

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Introduced in the Case and the Court’s Knowledge of the Case From Prior Proceedings,” Annual Survey of Bankruptcy Law (Thomson/West 2007 Edition).

“Comfort Zone: Creditors’ Committees are More Frequently Seeking Comfort Orders Since Recent Bankruptcy Law Changes Increased Their Disclosure Duties,” Los Angeles Lawyer (April 2007).


“Valuation Experts, Beware the Gatekeeper!: Establishing Enterprise Value in Chapter 11 Reorganization Cases,” The Bankruptcy Strategist, Volume 24, Numbers 2 and 3 (December 2006 and January 2007) (2-parts).

"Independence of Valuation Experts is Crucial in Chapter 11s," Los Angeles Daily Journal (October 13, 2006).

"Unions, Pensions, and Executive Compensation in Chapter 11," Pratt's Journal of Bankruptcy Law, Volume 2, Number 3 (August/September 2006 Edition).

“What is the Cure?: Nonmonetary Defaults Under Executory Contracts,” Annual Survey of Bankruptcy Law (Thomson West 2005 Edition).

”Assignee’s Preference Avoidance Power,” The Bankruptcy Strategist, Volume 22, Numbers 9 and 10 (August and September 2005 (2-parts)).

“Corporate Governance of Chapter 11 Debtors: The Impairment or Suspension of Shareholder ‘Democracy’ Rights Taking Into Account the Economic Realities of the Case,” Norton Bankruptcy Law Adviser (Thomson/West July 2005).

“Defending California Real Estate Foreclosures,” Real Estate Southern California (June 2005).

“Filing Bankruptcy by Solvent Tenants to Cap Landlords’ Claims,” Los Angeles Lawyer (April 2005).

“The Rooker-Feldman Doctrine in Bankruptcy: While a Bankruptcy Court’s Exclusive Jurisdiction Remains Undisturbed, It May Be Subject to Rooker-Feldman and Interjurisdictional Preclusion Constraints In Situations Where It Shares Concurrent Jurisdiction with a Non-Bankruptcy Court,” Annual Survey of Bankruptcy Law (Thomson West 2004 Edition).

“It’s Not Over Until It’s Over: Chapter 11 Plan Confirmation,” Andrews Litigation Reporter, Volume 1, Issue 9 (August 27, 2004).

“Assignment for the Benefit of Creditors: Effective Tool for Selling and Winding Up Distressed Businesses,” Annual Survey of Bankruptcy Law (Thomson West 2003 Edition).

“The Bankruptcy Code is Part of Every Contract,” The Secured Lender (November/December 2003).

“Spendthrift Trusts: The Real (but Not Unlimited) Benefits in Bankruptcy,” American Bankruptcy Institute Journal (October 2003).

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“For Bankruptcy Alternative, Know Your ‘ABCs,’” The Journal of Corporate Renewal (July 2003).

“Adjusting Municipal Debts: Chapter 9,” The Public Law Journal (Summer 2003).

“Assignment for the Benefit of Creditors: Advantageous Vehicle for Selling and Acquiring Distressed Enterprises,” The Journal of Private Equity (Summer 2003).

“Intellectual Property Issues in Chapter 11 Bankruptcy Reorganization Cases,” The Secured Lender (May/June 2003).

“The Fundamentals of Business Bankruptcy (Reorganization and Liquidation),” Business Credit (May 2003).

“Assignment for the Benefit of Creditors: Salvaging Value From a Sinking Ship,” Business Credit (April 2003).

“An Assignment for the Benefit of Creditors is a Useful Vehicle,” Los Angeles Daily Journal, p. 7 (April 16, 2002).

“Assignment for the Benefit of Creditors: Exit Vehicle for Many Troubled Enterprises,” Journal of Internet Law, Volume 5, No. 10 (April 2002).

“Business Bankruptcy: A Primer for Unsecured Creditors,” Commercial Law Bulletin (March/April 2002).

“Real Estate Leases In Bankruptcy: Landlord/Tenant Issues Under the Bankruptcy Code,” Annual Survey of Bankruptcy Law, 2000-2001, 2001-2002 Editions, West Group.

“Assignment for the Benefit of Creditors: Exit Vehicle of Choice for Many Dot.Com, Technology, and Other Troubled Enterprises,” Journal of Bankruptcy Law and Practice, Volume 11, No. 1 (November/December 2001).

"Beware When Your Client is a Debtor in Possession: Getting and Staying Employed in Bankruptcy Cases," Washington State Bar News, Volume 54, No. 10 (October 2000).

“Charging a Secured Creditor’s Collateral,” California Lawyer, p. 28 (August 2000).

“When Your Tenant’s Business Goes Bust: How the Bankruptcy Code Impacts the Landlord’s Rights,” Office & Industrial Properties (June 2000).

“Developments in Bankruptcy Law and How They Affect Landlords,” Apartment Management Magazine (May 2000).

“Hands Off: Per Se Rule Against Surcharging Oversecured Creditor Is Rejected,” California Bankruptcy Court Reporter, Volume 4, No. 5 (May 2000).

“Perfecting Security Interests in Intellectual Property: Lenders Beware,” Bankruptcy Strategist, Volume XVII, No. 6 (April 2000).

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“Bankruptcy Filings and IP Licenses,” Intellectual Property Today, Volume 7, No. 4 (April 2000).

“Per Se Rule Against Surcharging Oversecured Creditor is Rejected,” Commercial Law Bulletin (March/April 2000).

"Cramdown Slamdown," California Law Business (February 28, 2000).

"Intellectual Property Issues in Chapter 11 Bankruptcy Reorganization Cases," Journal of Internet Law, Volume 3, No. 8 (February 2000).

"What Creditors Should Know About Retention of Counsel by Debtors in Possession, and About Payment of Their Fees," The Banking Law Journal, Volume 117, No. 1 (January/February 2000).

"Moves That Firms in Financial Turmoil Must Avoid," Los Angeles Business Journal (January 17-23, 2000).

"Beware When Dealing With Licensors of Intellectual Property: Avoiding Potential Pitfalls Facing Licensees and Lenders When Bankruptcy Intervenes," The Computer Lawyer, Volume 17, No. 1 (January 2000).

"Dealing With Issues in Chapter 11 Cases filed by Licensors of Intellectual Property," e-commerce Law & Strategy, Volume 16, No. 9 (January 2000).

“To Assume or Not to Assume: Real Estate Leases In Bankruptcy,” Journal of Bankruptcy Law and Practice, Volume 8, No. 5 (July/August 1999), and California Bankruptcy Court Reporter (3-part series-May, June, and July, 1999).

"The Bankruptcy Code Is Part of Every Contract: Minimizing the Impact of Chapter 11 on the Non-Debtor’s Bargain," The Business Lawyer, Volume 54, No. 1 (November 1998).

"Resolving Business Financial Crises," California Lawyer (July 1998).

"Common Mistakes Made by Businesses in Financial Crises," National Public Accountant, Volume 43, No. 3 (May 1998).

"Cram Slam," California Law Business (March 23, 1998).

"Seeking Perfection: Federal Grace Period Pre-empts State Law," Los Angeles Daily Journal (February 2, 1998).

"'Old Equity May Retain Priority in Chapter 11 Plan," Los Angeles Daily Journal (September 29, 1997).

"On Executory Contracts, Precedent Carries the Day," Los Angeles Daily Journal (August 18, 1997).

"What Can Go Wrong Before a Bankruptcy Filing," Los Angeles Daily Journal (June 30, 1997).

"Home Rule -- Access to Chapter 9 Relief Remains in the Hands of Local Government Entities," Los Angeles Daily Journal (October 31, 1996).

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"When Dirt and Debt Are Not Indubitably Equivalent," Los Angeles Daily Journal (September 23, 1996).

"Municipal Debt Adjustment Under the Bankruptcy Code," Current Municipal Problems, Volume 22, No. 3, pp. 340-348 (1996).

"City Limits -- Legislature Considers Conditions on Chapter 9 Relief," Los Angeles Daily Journal (September 12, 1995).

"The Deficits of Orange County," Los Angeles Lawyer (July-August 1995).

"Municipal Debt Adjustment Under the Bankruptcy Code," Municipal Attorney, Volume 36, No. 4 (July/August 1995).

"Municipal Debt Adjustment Under the Bankruptcy Code," The Urban Lawyer, Volume 27, No. 3, pp. 531-604 (Summer 1995).

"Municipal Debt Adjustment Under the Bankruptcy Code," Government Finance Review, Volume 11, No. 3, pp. 27-29 (June 1995).

"Municipal Debt Adjustment -- A Look at How Chapter 9 Allowed Orange County to Provide Essential Services While Undergoing Debt Restructuring," The Federal Lawyer, Volume 42, No. 4, pp. 18-24 (May 1995).

"Chapter and Verse -- An Analysis of Municipal Debt Adjustment Under the Bankruptcy Code," Los Angeles Daily Journal, pp. 7-8 (April 13, 1995).

"Intellectual Property Issues in Chapter 11 Bankruptcy Reorganization Cases," IDEA: The Journal of Law and Technology, Volume 35, No. 4, pp. 383-406 (1995).

"Basic Issues and Alternatives Facing Litigators When Bankruptcy Interrupts the Litigation Process," Commercial Law Journal, Volume 99, No. 4, pp. 401-45 (Winter 1994).

"Sales of Substantially All Assets of Chapter 11 Bankruptcy Estates Outside of a Plan," Commercial Law Bulletin, Volume 9, No. 5 (September/October 1994).

"Break-Up Fees in Bankruptcy," Commercial Law Bulletin, Volume 9, No. 4 (July/August 1994).

Note, "Cable's 'Non-Cable Communications Services': Cable Television as a Common Carrier," 8 COMM/ENT 75 (1985).