Your business is in financial trouble. How do you figure out whether bankruptcy is necessary or helpful for your situation? Ask yourself the following questions:
Is the business a corporation, partnership or proprietorship?
Corporations and partnerships are legal entities separate from their shareholders or partners, and can file Chapter 7 or Chapter 11 bankruptcy in their own right.
But be aware that in a partnership’s Chapter 7 bankruptcy, the trustee can sue the general partners of the partnership if the partnership’s assets are insufficient to pay partnership debts. As a result, partners may be facing a suit by a well-funded trustee suing for the benefit of all creditors of the partnership.
Get good advice before contemplating a partnership bankruptcy.
Proprietorships are just an extension of the owner and can’t file bankruptcy alone. The proprietor must file the bankruptcy, as the property and debts of the business are really just one form of assets owned by the proprietor. The individual owner may file a Chapter 7, Chapter 11 or Chapter 13 bankruptcy (if the debt limits are met).
Should the business be reorganized or liquidated?
To answer this question, you have to know what has caused the problems the business now faces and the prospects for change.
Reorganization can’t create a market, increase gross revenue or make up for a poor fit between the skills that are available and the skills that are required to run the business. But reorganization can:
* Free up cash from paying old debt to finance current operations
* Make it easier to reject leases or contracts that are no longer advantageous (like an expensive facility lease or unfortunate equipment purchase)
* Prevent the loss of vital assets or cash to creditor collection actions.
In between Chapter 7 liquidation and reorganization, a Chapter 13 or Chapter 11 bankruptcy could provide breathing space for you to sell the business as a going concern or jettison assets in something other than a fire sale. The resulting profit (called “proceeds”) could pay taxes or unpaid salaries. Selling the business could mean ongoing jobs for your work force under new ownership. The bankruptcy could then be converted to a Chapter 7 bankruptcy, or dismissed if bankruptcy protection is no longer needed. The court will probably make you pay creditors from sale profits in order to get the bankruptcy case dismissed.
How much of the business debt is “secured”?
The division of debt between “secured” and “unsecured” guides what reorganization can do for your business. “Secured debt” is a creditor’s claim that is secured by a lien of some type in your property, either by your agreement or involuntarily, such as with a court judgment or taxes.
Purchase money security interests (a security interest the seller of goods takes at the time the goods are purchased) can be avoided or “stripped down” to the current value of the purchased goods in Chapter 11 and 13 bankruptcies. Creditors with purchase money security interests in goods with lower value almost never file a lawsuit to enforce their interest in the goods.
In bankruptcy planning, it’s important to know if judgment liens have been “perfected” (recorded with the right governmental agency), as secured debts are totaled separately from unsecured debts in calculating your eligibility for Chapter 13 bankruptcy. With a Chapter 13 proceeding, these debts can be “stripped down” to the value of the assets to which the lien attaches.
Recording a tax lien gives a creditor a lien on all of the taxpayer’s real estate and personal property. It can be eliminated in Chapter 13 bankruptcy if there isn’t any equity in the property. But tax liens can even reach retirement savings and 401(k) plans that are beyond the grasp of other creditors.
In most secured bank or SBA loans, the borrower gives the lender a security interest in all the borrower’s personal property. This is called a “blanket security interest” because the lien “blankets” all the borrower’s assets. (“Personal” here means everything but real estate, not “personal” as opposed to “business” assets.) Even things like accounts receivable and intellectual property can be covered by a blanket security interest. The agreement may also give the creditor a lien in assets purchased after the security agreement is signed.
In Chapter 11 or Chapter 13 bankruptcies, the lien may be “stripped down” to the value of the property at the time the bankruptcy is filed. Since a lender has rights in the items themselves and in any profit from their sale, you may not be free to sell the asset and pocket the profits, or even use the profits to pay other business debts. Spending the profits without the lender’s permission may be a form of fraud, creating a debt you can’t rid yourself of in bankruptcy.
Does management have the resources and desire to engage in the reorganization process?
Bankruptcy reorganization in Chapter 11 requires a significant time commitment on the part of owners and managers. The “bankruptcy bargain” is that, in exchange for stopping collection of debts and other bankruptcy protections, you provide full disclosure of your company’s financial condition to creditors and the court, both at the beginning of the case and on a monthly basis thereafter.
While the bankruptcy is ongoing, you owe what’s called a “fiduciary” duty to your creditors, which means you must keep them highly informed and be very honest and protective of their interests before your own interests.
A reorganization can drain an already stressed business, because management personnel must take time to participate in bankruptcy proceedings. And the legal expenses are significant.
Most reorganizations fail, usually for lack of a real plan to solve the underlying business problems.
Is the business one that you could start up again after a liquidation of the current business?
Businesses that require little capital, have few assets, or are really just extensions of the owner’s skills and personality are ones that it may not pay to reorganize. The owners may be better off liquidating the business, in or out of bankruptcy, and starting over in a fresh business entity. This can be a complex task and requires good professional advice to do correctly.
A Chapter 7 may be the best choice when:
* The business has no future
* There are no substantial assets or qualities that cannot be reproduced, or
* The debts are so overwhelming that restructuring them isn’t feasible.
A Chapter 7 bankruptcy can provide a corporation with an orderly liquidation under the direction of the trustee and at no expense to shareholders. Creditors are assured that they will be paid to the extent of the available assets and the priority of their claim.
As former management, you’re assured that the assets that are available go (after the expenses of the bankruptcy) to pay taxes for which you may be individually liable.
Deciding whether bankruptcy is appropriate for your business may be one of the most difficult decisions you’ll ever make. But having information about what could happen to you and your business in the bankruptcy process can help.
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