The term "workout" is used to describe a more formal, mutually-negotiated modification of debt that does not involve a bankruptcy filing. Simply stated, a workout is an agreement worked out between the debtor and his or her creditors for payment of the debts between them. The agreement is negotiated without all the bells and whistles (and perhaps the stigma) of the bankruptcy process. In 2005, Congress made major changes to bankruptcy laws making it more difficult for a debtor to have a clean slate through bankruptcy. As a result, non-bankruptcy workouts are now more common.
Compositions and Extensions
Workouts are sometimes called compositions or extensions. A composition is a contract between a debtor and two or more creditors in which the creditors agree to take a partial payment in full satisfaction of their claims. An extension is a contract between the debtor and two or more creditors in which the creditors agree to extend the time for payment of their claims. An agreement may be both a composition and an extension, or an agreement to accept less money over a longer period of time.
The same laws govern both compositions and extensions. Both are subject more to contract law principles than debtor-creditor rules. Thus, compositions and extensions must satisfy all formal requirements of contract formation, which can vary from state to state, but most of the basic principles are constant whichever state you're in. There must be an offer to make a contract, the offer must be accepted, and there must be "consideration" (a legal term meaning something of value exchanged between the parties).
Effect on Creditors
While more than one creditor must enter into the workout agreement, there is no requirement that all of the debtor's creditors agree to its terms. Creditors that do not agree to the workout are not affected by it. In other words, they are entitled to pursue other remedies to collect the debts owed to them and can proceed to recover the full amount, but they are forfeiting the right to automatically benefit from whatever partial payment the composition allowed.
By entering into a voluntary agreement with creditors, the debtor avoids the stigma that attaches to bankruptcy but achieves the same results -- discharge from all or a portion of his or her debts. In fact, the workout discharge is even broader than a bankruptcy discharge. Also, a workout discharge does not affect the debtor's rights to file a future bankruptcy, whereas certain types of bankruptcy discharges do. But the main advantage of a workout is that it is voluntary. In a workout, unlike bankruptcy, all of the participating creditors must agree to the workout's terms.
Like any financial decision, there are downsides associated with non-bankruptcy workouts. As mentioned above, non-bankruptcy workouts are voluntary for both the debtor and creditor. Sometimes, creditors can disagree about the terms of the workout agreement and try to recover their debt in full. Simply stated, debtors are at the mercy of the creditors for non-bankruptcy workouts to be a success. Another potential downside is after a creditor and debtor plan a non-bankruptcy workout, the creditor could always have a change of heart and not abide by the terms of the agreement.