Managing Through Tough Times in Ethanol Production

By Todd Taylor and Ryan Murphy | February 05, 2008
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It's no secret: high corn and energy prices coupled with low ethanol prices are squeezing ethanol plant's margins and making it hard to not only make a profit and pay dividends, but also to buy corn and chemicals, pay wages and make debt payments. Even with the Energy Independence and Security Act signed Dec. 19, 2007, by President George W. Bush, the ethanol industry faces challenges. Newer plants with significant debt loads face these problems more than older plants that paid off debt before the current market tightening.

For management at these plants, having a plan to deal with dwindling cash flows and reserves is critical to avoid shutting down and surviving until better times.

A plant's ebbing cash flow will impact its relationships with creditors such as vendors, banks and employees. It can also test the equity owners, as the financial strains will impose greater burdens on them and may expose divergent goals. This is particularly true where owners wear other hats such as that of a supplier. The specific nature and scope of the financial difficulty will determine which creditor or creditors will be the focus of the plant's operational renewal. The process of realigning reasonable expectations, however, remains fundamentally the same.

Declining cash flows may prevent the plant from meeting all of its contractual obligations in a timely fashion. To work through these issues, the plant must convince creditors that a realignment of these obligations is in everyone's best interests. The primary line of reasoning is that a termination of the creditor's relationship with the plant or commencement of a collection action will result in a far smaller return. As a result, it is in the best interest of all those involved, including the creditor, to receive payment according to a more relaxed timetable or in an amount less than originally expected.

The most critical factor determining whether a plant can weather the current economic climate is early recognition of the challenges and putting a comprehensive plan in place. The plant's resources may be needlessly wasted attempting to impose last-minute solutions. The plant may obtain short-term concessions from creditors. This may provide the plant immediate relief. However, it will typically fail to address the fundamental issues driving the dwindling revenues. It may even exacerbate such problems by causing the plant to incur additional obligations such as interest and attorneys' fees. The current environment calls for resolutions that are broader in scope, more farsighted and permit the plant to continue operations rather than shut down. Such resolutions may include the implementation of a uniform plan to extend contractual commitments to conserve operating capital with a wider array of the plant's creditors.

One critical class of creditors is vendors. Those who supply the goods and services essential to the plant's continued operations often are the first to feel the impact. In a time of financial distress, payments to these suppliers may be untimely and infrequent. This is a product of necessity as it is a way to informally fund operations. If the financial problem is quickly resolved, such vendor financing may be sufficient. The current and near-term economic conditions, namely high-priced inputs and oversupply caused by infrastructure problems, counsel that such a resolution will be rare or only temporary.

If delaying payment of obligations to vendors fails to trigger the operational renewal, banks are often the next class of creditors to be addressed. The deteriorating condition may trigger a default under the loan documents such as a missed payment or very often a breach of financial covenants. Indeed, banks draft the default provisions broadly to enable quick action on their own financial interests. Diligent banks will learn of the operational concerns before a payment default occurs through financial reporting required under the loan documents. The recent publicity surrounding the difficult issues facing the ethanol industry will condition banks to have their antennas tuned for such distress.

Once aware of potential problems, banks usually proceed with a two-pronged approach. First, they will conduct a review of the plant's assets securing the loan. The analysis will assume that the assets will be sold at an orderly liquidation value, significantly less than fair market value. The bank uses this picture of the asset values to establish the available approaches to ensure payment of the loan or otherwise maximize its recovery. Second, the bank will demand that the plant provide it with a plan and supporting financial information, such as projections, to resolve the operational issues. Provided an arrangement can be reached with the bank, it will permit the plant to continue to operate under close monitoring. If the bank perceives that the continued operations will further deteriorate its financial position, the bank will likely act quickly to attempt to enforce its rights, particularly against the assets.

Employees are the final category of creditors affected by declining cash flow. They are one of the plant's critical assets. With continued technological advancement, each employee has added importance. The value of a business will suffer if employees lose confidence. To ensure their continued confidence, management must keep them reasonably informed of the difficulties and the renewal plan. It is also absolutely critical that the wages and other benefits of the employees be paid on a timely basis. Rest assured, the critical nature of these payments will be acknowledged by almost all creditors, including banks.

The negotiations with vendors, banks, employees and other necessary parties culminate with a "workout plan," which captures the renegotiated agreements with the plant's creditors. This plan may be a formal or informal arrangement and may consist of a number of individual agreements. The important aspect of the plan is that it addresses the interests of all the applicable parties, including those of the plant. A successful plan is one that allows the plant to return to financial stability and meets the creditors' readjusted expectations.

If a workout plan cannot be finalized, creditors, in particular banks and vendors, will pursue available rights and remedies in an attempt to maximize their return or force their desired resolution upon the plant. The rights and remedies of banks and vendors differ in material ways; accordingly, so does the plant's response.

A bank's primary remedy is to seize and sell personal property such as plant equipment or real estate. While always cognizant of any substantive defenses, the most pragmatic defenses are those rights provided by the process. To foreclose on personal property or real estate, the bank must meet established procedures for notice, obtaining possession and sale. This process is time-consuming and expensive. In addition, these remedies fail to maximize the return on the assets to be sold. Only with the cooperation of the plant can the bank realize the full value of the plant's assets. Thus, even after the bank begins to exercise its rights and remedies, sufficient time exists to discuss reasonable arrangements or pursue alternatives such as replacement financing or a sale.

While less expansive, vendors also possess significant rights. Vendors always have the right to stop supplying goods or services. This can make a financial renewal difficult as replacement agreements will need to be arranged, and often the plant's alternative vendors are limited due to location, logistics and other restrictions. Suppliers of goods can also demand the return of recently shipped goods, a process called reclamation. A number of substantive defenses exist to reclamation claims; however, vendors further increase their leverage by pursing the claims.

Despite the plant's efforts, creditors may persist in pursuing their claims in the face of continued negotiations. The plant, however, is not without additional options. One is the commencement of a bankruptcy case. Generally speaking, there are two types of chapters available for business debtors: 1) a chapter 11 reorganization and 2) a chapter 7 liquidation. The commencement of a bankruptcy case stays the action of all creditors against the plant or its assets, including attempts by the bank to seize assets, vendors seeking to reclaim goods, and collection actions. More fundamentally, it implements a specific process with the intent of maximizing the value of the plant's business and assets for the benefit of its creditors and owners.

A chapter 11 filing allows the plant to continue to operate with the owners still in control, preserving business value. The filing provides the debtor with additional rights such as the ability to impose a payment arrangement on banks and terminate uneconomical contracts or leases. These rights come with certain obligations, including the requirement to obtain court approval for financing and use of property outside of the ordinary course of business, such as a sale. The chapter 11 process typically concludes with either a plan of reorganization or a sale. A "plan of reorganization" is substantially similar to a workout plan, albeit more formal and detailed. With increasing frequency, the chapter 11 process has been employed to facilitate a sale. A sale in bankruptcy can occur free and clear of all liabilities including liens, making it attractive to prospective purchasers. This heightened interest allows the plant to maximize the value of assets for the benefit of creditors and owners.

In contrast to a chapter 11 reorganization case, chapter 7 liquidation halts business operations. Upon the filing of the chapter 7 case, a "trustee," typically a local attorney, is appointed and controls the plant's assets. The trustee is charged with disposing of those assets and then making a pro-rata payment of those funds after expenses to creditors. A chapter 7 case often fails to capture the full value of the plant and its assets. As a result, it is best utilized to formally conclude the affairs of a company, as most state laws do not permit a company whose liabilities exceeds its assets to dissolve.

At the end of the day, no one in the ethanol industry has a great deal of interest in closing plants. Banks and vendors lose money in foreclosures and bankruptcies. Investors lose their equity investment, and employees lose jobs. However, management and boards need to be realistic about dealing with difficult economic conditions and their own financial situation. Failing to address real problems because of a hope for better times is a recipe for failure. Plants that have a plan and follow it are far more likely to survive and thrive.

Todd Taylor is an officer in Fredrikson & Byron's corporate, renewable energy, securities and emerging business groups. Reach him at or (612) 492-7355. Ryan Murphy is a senior associate in Fredrikson & Byron's bankruptcy and reorganization, and litigation groups. Reach him at or (612) 492-7310.