2018 CHL

Question 1

You are Jamie Kelly, a new Licensed Insolvency Trustee (“LIT”) at Jones Inc. As you are preparing to leave for the day you receive the following email from Sue Hilton, a partner in the audit practice of Hilton and Associates, a full service professional services firm that offers insolvency services through Jones Inc.
Highlight the initial engagement issues that must be addressed prior to Jones Inc. accepting an engagement as financial advisor to CHL.

Answer 1

• Conflict check on D&O of CHL and all lenders (GBI, EBC, Venture).
• There’s no conflict as external accountant is MacLeod CPAs. Jones Inc. does not have an existing professional relationship that would impair independence.
• Consider if I have the skillset and resources (staff) to take on this engagement, whether I have the knowledge about this retail industry.
• Obtain an engagement letter from CHL.
• Engagement letter must outline scope of service, reporting requirements/frequency, acknowledgements. SIRFT
• Obtain indemnity from any liabilities that arise from the engagement.
• Get a retainer for your fees.
• Role of Jones Inc. may change from financial advisor to CHL to Court Officer at some point.
• Risk: Be prepared to deal with reactions of lenders of CHL like EBC, GBI and Venture.

Question 2

What if Hilton was the accountant? They offer insolvency services through Jones.

Answer 2

• There would be a perceived conflict of interest because Hilton and Associates is a related firm to Jones Inc. As a result, a third party could conclude that Jones Inc. is not independent of CHL, even if no actual bias exists.
• RPC rule says a member shall not let any influence, relationship, interest affect their judgement and objectivity.

Question 3

Assess the extent to which the company meets its financial covenants to the banks.
(a) Total debt to tangible net worth ratio of 3.5x

Answer 3

(1025+1000)/425= 4.76; this ratio is in breach of covenant. The equity isn’t enough to cover total debt.

Question 4

(b)current ratio of 1.10x

Answer 4

950/1025=0.93; this ratio is in breach of covenant. There aren’t enough current assets to cover current liabilities. This suggests weak liquidity.
If ratio is close, we expect candidate to suggest a discussion with the bank on how it should be waived.

Question 5

(c)interest coverage ratio of 1.25x

Answer 5

Net income/interest expense=-150/(50+25)=-2
We are in breach of this covenant as well. There aren’t enough earnings to cover interest expense.
Or EBITDA/interest.
Conclude that there isn’t enough EBITDA to cover interest.
*If you have two different years given then: Candidate identifies a significant deterioration in the balance sheet and ratios compared to prior year

Question 6

Based on the case facts and your covenants analysis, evaluate the opportunities (Balance Sheet oppt competency H) and challenges for CHL to restructure its affairs on an informal basis.

Answer 6

Overall conclusion: there’s pressure from all stakeholders (lenders, suppliers, landlord) which may make informal restructuring options challenging.
Covenant breaches mean banks can enforce on their security, working capital and real estate, making it hard for CHL to continue to be a going concern.
Informal options
1. Discuss a forbearance agreement with EBC to grant CHL time to perform an IBR (independent business review).
2. By reviewing CF, I conclude busy season is coming up and CHL needs more cash in excess of what is currently available from EBC. CF shows they need 1M$. EBC only offers them 500K
3. By reviewing CF, I recommend renegotiating payment terms with inventory suppliers to reduce cash outflows during the holiday period.
4. Approaching EBC to secure a temporary increase in the operating facility for the first half of the cash flow projection period.
5. It operates from leased premises. We may be able to negotiate lower rent with landlord to alleviate the cash constraint.
6. The location that is significantly underperforming, has the highest rent and highest operating expenses can be shut down, that would reduce rent expense, thereby alleviating the cash constraint. Sell inventory in store 3 as busy season is approaching, this will help dispose of it and raise working capital.
7. Let Venture convert debt to equity instead of repaying them due to the cash constraint and due to the fact the debt is coming due very soon. CHL would be giving up control to Venture which is a negative consequence.
8. Or if CHL doesn’t want to give up control then they can offer second charge to Venture on real estate or capital assets instead of converting debt to equity.
9. It could try to find a new lender and let them get a second ranking charge on it’s real estate if there’s any equity in the real estate. There’s equity of 1000K-400K=600K so they can easily pay of Venture with that.
10. There may not be enough time to access the real estate equity due to lender pressure.
11. It could issue shares to raise working capital. May be difficult to attract investors given covenant breaches and cash flow issues. Offer existing shareholders to buy shares, typically passive investors unlike venture capitalists.
12. There may be some equity cushion in the capital assets, it could use that to get more financing. 500-300=200K equity
13. It could do a sale lease-back to sell its real estate, raise working capital and then lease its real estate to run the business. Takes time to negotiate and may not align with immediate liquidity needs.

Forbearance & IBR → Cash flow shortfall → Supplier term renegotiation → Temporary facility increase → Rent reduction → Close underperforming store → Venture debt-to-equity conversion → Second charge to Venture → New lender (second charge) → Timing constraint → Equity issuance → Capital asset financing → Sale-leaseback.

Question 7

What is necessary for a successful proposal? Operational requirements.

Answer 7

General NOI
* Filing NOI will stay all creditors
* Effect of stay is that pre-filing debts won’t need to be paid by CHL until proposal is approved by court.
* Filing NOI under BIA is best option for CHL given stakeholder pressure and need for a stay.
Charges
* CHL will likely need access to capital during the proceeding, NOI will provide for interim financing charge through court.
* Interim Financier will prime existing lenders’ collateral and may cause issues with existing lenders.
* CHL can also seek other charges through court like Administrative charge, D&O charge.
Lease Disclaimer
* NOI would allow CHL to disclaim store 3 lease. It will have time to prepare lease disclaimer before filing of proposal.

Question 8

What is necessary for a successful proposal? Quality of financial info provided. (J)

Answer 8

• We need monthly cash flow projections with assumptions up to court approval. There are no assumptions currently provided.
• Accountant is external so financial statements can be relied upon.
• Financial info is relatively recent.
• Past financial results cannot be used to predict future financial results. Use current trends to develop financial projections.

Question 9

What is necessary for a successful proposal? How stakeholders will be treated.

Answer 9

Landlord
* Landlord can challenge the disclaimer. Put the landlord will all other unsecured creditors so they’re not in their own class as they could vote against causing proposal to fail.
Suppliers
* Future success of CHL will be assisted by compromise of unsecured debts (to suppliers).
Secured Lenders
* Proposal need not be made to secured classes.
Venture
* Put proposal term to ensure Venture will convert its debt to equity as part of proposal thereby improving balance sheet and reducing interest expense. Proposal could outline any corporate steps to convert debt to equity. If Venture converts debt to equity it will wipe out the existing SH equity.

Question 10

What is necessary for a successful proposal? Tax implications

Answer 10

• Outstanding GST is a director’s liability.
• CRA’s acceptance of proposal is full and final acceptance of GST claims against directors. They cannot go after directors for any shortfall in Gst. Section 86(1).
  ((Only source deduction DT survives but generally it’s paid in full within 6 months of court approval. Sometimes we can put a clause in the proposal or CCAA for the compromise of directors liability to compel them to stay and facilitate the restructuring.)) see Les email. Directors are liable for source deductions, reduced by recovery from DT so CRA can go after them for the shortfall. Unlike GST, source cannot be compromised unless you put a clause in the proposal.
• GST can be compromised in a proposal. Priority is inverted, it ranks as unsecured.
• Debt forgiveness first grinds down on tax losses. If there’s leftover then it becomes taxable income.