Case Study: SL Furniture Ltd. –Commercial Bankruptcy
This case has been developed and is meant for educational purposes only. All persons, companies, facts and discussions appearing in this case are fictitious. Any resemblance to real persons, living or dead, or companies, existing, or no longer operating, is purely coincidental.
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Learning objectives
- To identify the problems in order of priority and recommend appropriate solutions
- To understand the risks involved in processing a corporate bankruptcy file
- To plan how to proceed and then manage priorities
- To understand all phases of administering a corporate bankruptcy file
Introduction
You are employed by ABC Accounting Ltd., an accountingfirm,as a manager in the restructuring and insolvency practice (“ABC Trustee Ltd.”) and report to the office’s senior partner, Mr. Smith. When you come to work on April15, 20x5, Mr. Smith asks you to come and see him as soon as possible about a call he has received from Bob Brown, a lawyer with Roth & Brownto discuss his client, SL Furniture Ltd. (the “Company” or “SL Furniture”).
Mr. Smith informs you that he had a brief conversation with Mr. Brown who indicated that the past year has been very difficult for SL Furniture, and according to the Company’s semi-annual financial statements as of December 31, 20x4, the Company is headed for an annual loss of more than $1 million.
Mr. Brownadvised that herecently met with Mr. Walter, President of SL Furniture, and he seemed to be totally overwhelmed by the turn of events. Mr. Walter indicated that the Company management has done everything necessary to turn things around, however the situation continues to worsen.Mr. Walter indicates he and his management team are willing to work with the advisors in analyzing various possible solutions.
A meeting with the Company is quickly arranged and Mr. Smith would like you to attend as you will be heavily involved with this file going forward.
Section 1 – Engagement Acceptance and Planning
Objective:
- To make candidates aware of client acceptance and planning issues
Questions:
a)What is the insolvency professional’s first step in deciding whether to assist SL Furniture?
b)Before meeting with the Company, how should the insolvency professional prepare?
c)What should be considered with respect to potential liability to the insolvency professional including payment of its fees and disbursements?
Answer:a)Assessment of Engagement Risks
The professional should conduct his/her own assessment of the potential risks associated with assisting SL Furniture:
- Potential conflicts of interest with SL Furniture;(Perform internal conflict check with firm clients)
- Review of major suppliers, if available
- Potential impact on relationships or firm reputation;
- Collection of fees risk; and
- Level and adequacy of knowledge (with industry, corporate restructuring, etc.).
Sound planning is necessary, even before meeting with the client. Gather as much information about the company as possible. Possible sources include: internet, company website, news articles, public filings, bank files, corporate registry, personal property registryand the land registry.
Insolvency professionals can often make a good first impression on the company’s representatives, when it’s clear that they have attempted to learn as much as possible about the company and its industry prior to the initial meeting.
To protect professional fees and limit the level of file-related risk, insolvency professionals should assess the potential for the major shareholder to provide a guarantee of payment of fees and indemnity in the event of litigation. In some cases, insolvency professionals can also arrange for their fees to be guaranteed by a third party or request a security deposit (retainer) before starting to work on the file. These terms should be included in the engagement letter.
Note: In considering whether an indemnity in the event of litigation is appropriate or available, consideration has to be given to the various codes of ethics, as some provincial CPA orders/institutes’ rules of ethics (in particular the Quebec Order’s code of ethics) may limit the ability to obtain an indemnity.
Meeting Mr. Walter, SL Furniture President
At the initial meeting with the Company, Walter described his company and its current struggles, which issummarized below.
Company history
Incorporated and commencing operations approximately 25 years ago, SL Furniture Ltd. operates as a manufacturer of medium to high end solid wood kitchen and bedroom furniture. The company’s head office and manufacturing plant and are in rented premises located just outsideYourCity, YourProvince.
The current lossesareprimarily due to the company’s recent expansion to the United States, which required substantialinvestment but produced very disappointingresults.The company operated an American subsidiary (SL Furniture (USA) Inc.) in Plattsburgh that made the same types of products as the Canadian plant but solely for the American market.There wereserious delays in setting up the new plant and many quality control problems arose, which had a negative impact on the company’s operations in the US. Because of the company’s serious lack of liquidity and the problem-plagued new plant, senior management decided to close the US plant, pay all creditors and repatriate the assets to its Canadian plant. During the same period, the company’s Canadian sales have also suffered a significant decline, and its gross margins have been severely squeezed.
Senior management and shareholders
SL Furniture Ltd.Organization Chart
Board of Directors
Chair - Mr. Walter
Treasurer - Mr. North
Secretary - Ms. White
Director - Mr. Shaw
Director - Ms. Walton
Mr. Walter, CEO
Mr. Stewart, VP Operations / Mr. Lock, VP Finance / Ms. Reed, VP Marketing
Production Staff / Accounting Staff / Sales Staff
Mr. Walter has been the company’s President and CEO for the last 10 years. He has worked in furniture manufacturing for more than 30 years. He is recognized in the industry for his expertise, and possesses an extensive network of contacts, particularly furniture retailers.
SL Furniture Ltd.Corporate Structure
Mr. Walter / LBR Investment Fund / 5 Shareholders
40% / 35% / Each at 5%
SL Furniture Ltd.
100%
SL Furniture (USA) Inc.
Employees
The company currently employs approximately 20employees, including four managers in the following positions: President, Vice-President (Finance), Vice-President (Marketing/Sales) and Vice-President (Operations). Most of its employees have been with the company for many years, and employee turnover has always been very low. Walter says that he cares about his employees’ welfare and that, despite the drop in business, he has not laid off any employee. However, he has cut their hours slightly, but this initiative has been ineffective with almost no financial impact.
Market
In recent years, the Canadian furniture and overall wood product manufacturing sector have experienced major difficulties, particularly due to higher levels of foreign imports at prices often much lower than Canadian products, and yet of increasingly comparable quality. As a result, many consumers now buy imported furniture rather than made-in-Canada.
Although Mr. Walter says he has no official statistic to substantiate this statement, he feels that the Canadian furniture industry, as well as the entire wood product manufacturing sector, is in crisis, and he expects this trend to continue for a few years.
Competition
Competition is widespread,and foreign competition, particularly from Asia, has intensified greatly in recent years. Initially, the imports’ low prices were counteracted by the higher quality of Canadian products, which helped reduce the impact of foreign competition.
On the other hand, Walter explains that foreign exporters have now significantly improved the quality of their products, while continuing to maintain their substantial price advantage. In fact, their delivery timeframes for their Canadian customers are also improving greatly with the result that their market share has increased considerably. Walter feels that this is a deep-seated trend that will continue for years.
Current Financial Position
Mr. Lock, Vice-President (Finance), who is also at the meeting, hands you the company’s financial statements, as of December31, 20x4(see ExhibitA).Noting that the company’s third fiscal quarter has just passed, he indicates that financial results for the quarter are not yet available because his team’s workload has increased due to management of the company’s serious liquidity crisis, which has stopped them completing the quarter end financial statements.
Customers
The company’s customers are primarily located in Canada, however a small number of customers located in the US remain, despite the closure of the US subsidiary. According to management, Canadian customers currently represent about 85% of the annual sales.
Historically, the company’s customers have been supportive and bad debts have been minimal. However, recent product quality problems have caused a sharp rise in product returns, and some customers are apparently refusing or failing to pay off their account balances.
Section 2 – Research
Objective
- To identify pertinent decision-making factors
Questions:
a)What additional documents should you request during the discussion with management?
b)What questions should be posed to management?
Answer:a)Additional information to assist with further analysis:
- corporate presentation or business plan;
- Inventory listing: break down by:raw materials, work in process,finished goods and location;
- the most current trial balance and internal financial statements;
- themost current detailed aged accounts receivablesub-ledger;
- details on prepaid expenses;
- details on property, plant and equipment, including copies of recent appraisals or valuations;
- details on other assets;
- copy of lease for head office and plant;
- details and copies of any leased assets
- the most current detailed aged accounts payable sub-ledger;
- a listing of priority claims and any other creditors, noting the company is likely not aware of whereclaims may rank and therefore may require some direction on this matter;
- details of employee duties, seniority as well as wage and vacation payamounts owed;
- details of any creditor actions against the company for collection of debts or other claims (including the Canada Revenue Agency);
- copies of the most recent government returns and filings (source deduction, goods and service tax, retail sales tax (or harmonized sales tax) and corporate tax); and
- forward-looking information – example: cash flow or other projections.
- information on sales credit terms, return policy, warranty policy, co-operative advertising/promotional credits, returns and warranty history, etc.
b)Additional questions for management:
- How does management and shareholders view the current situation? Can the company be returned to profitability or should it be liquidated?
- What is being done to improve the quality issues?
- Would potential buyers be interested in purchasing the company as a going concern?
- Are shareholders or other partners interested in, or capable, of injecting additional capital?
- What, in management’s opinion, is the current market value of the company’s assets?
- What is the company’s projected short-term cash flow (13 weeks)? How serious is the liquidity crisis?
- Is any of the debt personally guaranteed? If so, from whom?
Section 3 – Options for Stakeholders
Objective
- To identify the various possible options for the stakeholders
Meeting Mr. Walter, SL Furniture President (Continued)
In response to some of your questions, Mr. Walter indicates:
- He is very pessimistic about the company’s future. He feels that the current market is very difficult and the competition increasingly fierce. The company’s liquidity crisis has also reached record levels, and he is worried there will not be enough money to cover the next payroll and rent in two weeks’ time.
- He feels that the current shareholders do not want to inject any more capital into the company. He is also tired and would like to retire.
- He has just received an assessmentof $92,350 from the Canada Revenue Agency for unremitted payroll deductions.
- He provides a list of potential priority claims (see Exhibit B) as compiled by the company’s controller.
- He also provides a summary of assets, including the estimated liquidation value of the assets based on internal estimates and a recent appraisals requested by the shareholders. (seeExhibit C).
- Mr. Walter did sign a limited personal guarantee to the Oak Shoppe, a major supplier who is owed $500,000. The guarantee has some value.
After your meeting and review of the information, the lawyer asks for your opinion about alternatives available to the Company.
Questions:
a)Given the situation,what do you consider the Company’s primary possible options are?Discuss the pros and cons of each option in light of the information provided by the Company?
b)Which option would you recommend and why?
c)Based on your recommendation, Mr. Smith asks you to prepare an estimate of the recovery to the unsecured creditors. [Note: Operating costs and professional fees after your appointment areestimated at $90,000 and $75,000, respectively. Some of the equipment was acquired and financed through instalment sales contracts. The equipment financingcompanies are prepared to reimburse their share of fees and expenses that you estimate at $65,000
Answer:a) The Company’s 2 possible actions are as follows:
Option 1: Proposal
Under a Proposal, the Company could be re-structured. Management would be in charge with the Trustee monitoring the operations. By filing a Notice of Intention to file a Proposal (“NOI”) the Company would have additional time to review restructuring alternatives and process some of the WIP into finished goods. This assumes that the cost benefit of doing so makes sense.
Prior to executing any proposed strategy, consideration should be given to obtaining an opinion on the validity of the 4 equipment financing companies’contracts to ensure your recommendations are validly based on the equipment financing companies’ actual priority on the Company’s assets.
Under a Proposal, the Company could be also liquidated under control of management. This has the advantage of potentially higher recoveries than a bankruptcy and reduced costs since professionals are just monitoring operations instead of being in control.
Option 2: Bankruptcy
The Company could make an assignment in bankruptcy. WIP could still be completed in bankruptcy if it made sense to do so and with Inspector approval.
Pros, Cons and Other Considerations
Given the facts provided, notably the immediate liquidity crisis, the unavailability of additional equity, and management’s opinion that the Company cannot be returned to profitability, the option of restructuring the Company and continuing operations can be ruled out. For the same reasons, selling the Company as a going concern should be viewed as not realistic, since few buyers would be interested and the transaction timeframes would be too long, given the current state of the Company’s liquidity position.
In a bankruptcy or proposal situation,
A trustee in bankruptcy has strict duties to perform under the Bankruptcy and Insolvency Act that are aligned with its role as an officer of the court acting in the best interests of all creditors;
Consideration should be given to:
- the need for the trustee to obtain approval of the court for certain actions or orders (example: approval of sales process, approval of sale and vesting of assets, etc.).
- the ability of the trustee to give clear title to a purchaser.
- the ability of a trustee to review potential transactions, namely transfers at undervalue and preference payments.
b)Recommendation:
Noting that the options discussed above achieve the same result, the facts suggest that having the Company make an assignment in bankruptcy would be the best option, for the following primary reasons:
Management of the Company wants to cease operations and liquidate. Since Mr. Walter has a personal guarantee with some value, he will want to maximize the net proceeds from the sale of assets to minimize his exposure under his guarantee to the Oak Shoppe. Therefore he should be very co-operative.
c) The estimated recovery to the Unsecured Creditors is shown in Appendix 1 of the answer appendix document.
Section 4 – From Taking on the File to the First Meeting of the Creditors
Mr. Brown tells you that he will contact Mr. Walter directly to discuss the situation. Several days later, Mr. Brownconfirms that he has spoken to Mr. Walter and that they have both come to the conclusion that an assignment in bankruptcy is the best option.
Mr. Walter suggests you speak to the 4 equipment financing companies involved to co-ordinate the sale of assets since he believes it will help increase the value of the other assets. The break-down of values of amounts owed to equipment financing companies and estimated values of assets covered by their security is included in Exhibit C.