90 Second Lesson: What Is a Composition Agreement?

QUESTION:

We recently received a question from John B asking “What is a composition agreement?”

ANSWER:

A composition agreement is an out-of-court contract between a debtor and multiple creditors providing for the reduction or delay in payment of amounts owed by the debtor to the creditors entering into the composition. Entering into a composition is an alternative to filing chapter 11 that can provide some, but not all, of the benefits of chapter 11.

How a Composition Agreement Can Be an Alternative to Chapter 11

A composition agreement can be a good option for debtors that have a small amount of creditors and good relationships with those creditors. Additionally, successfully negotiating a composition agreement is much more likely when a debtor’s creditors have an interest in the debtor’s ongoing survival. A debtor with a large number of dispersed creditors that have no interest in the continued survival of the debtor’s business will likely be unable to successfully negotiate a composition agreement.

Potential Drawbacks

One of the drawbacks to a composition is that it only binds the consenting creditors, thus creating the potential for “holdouts” and related issues. The possibility of holdouts can also dissuade otherwise agreeable creditors from consenting to a composition because holdout creditors continue to retain their full claims, creating financial risk and uncertainty for the agreeable creditors. The relief available through a composition can be further limited by the need for unanimous approval.

Moreover, a composition does not provide any of the procedural or substantive advantages of the Bankruptcy Code, such as the protection of the automatic stay or the ability to reject burdensome executory contracts.

In contrast to a composition, a court-approved restructuring under the Bankruptcy Code binds holdouts and provides a debtor with certain procedural and substantive benefits (e.g., the assumption of beneficial, or rejection of burdensome, executory contracts or leases).

Under the Bankruptcy Code’s class-based voting scheme, a class is deemed to accept a plan if two-thirds in amount and more than one-half in number of the voting class members vote to accept the plan. Further, in certain circumstances, a plan can be confirmed via “cramdown” to bind rejecting classes. In addition, the Bankruptcy Code provides a debtor with the tools to implement a more substantial restructuring of its capital structure and operations. Bankruptcy, however, is typically slower and more expensive than a composition. Bankruptcy proceedings tend to attract public attention, while composition agreements typically remain private.

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1. Dealing with Corporate Distress 05: The Lifecycle of a Chapter 11 Case
2. Dealing with Corporate Distress 07: Chapter 11 is Not Always the Answer: Strategic Alternatives For and Against Distressed Businesses

[Editors’ Note: This 90 Second Lesson is part of our irregular series in which we answer readers’ questions. If you have a question, submit it to [email protected] and we will try to answer it. This lesson is based, in substantial part, in material reprinted from Commercial Bankruptcy Litigation 2d and/or Strategic Alternatives for and Against Distressed Businesses, with permission of Thomson Reuters.

To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can watch at your leisure, and each includes a comprehensive customer PowerPoint about the topic):

1. ADR & Settlement
2. Resolving Shareholder Disputes
3. Preparing for Mediation: From Selection to Presentation of Claims

This is an updated version of an article originally published on April 7, 2020.]

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