Making The Best Of A Bad Situation: Planning For Business Bankruptcy

 

Nobody starts a business planning on going on filing for bankruptcy.  But sometimes, despite our best efforts, businesses do not thrive.  If your business has gotten to the point that you are considering filing for bankruptcy, there are some things you should consider to make the bankruptcy process as easy as possible.  This article assumes that your business has been incorporated.  (You can read more about incorporation and different business entities here.  If you are operating as a sole proprietorship or a partnership, a personal bankruptcy may be a better option.)  Businesses cannot represent themselves in bankruptcy proceedings, so you will need to hire a lawyer who specializes in commercial bankruptcy and restructuring.

Bankruptcy Basics

The bankruptcy process serves dual purposes:  offering debtors relief from their debts and a “fresh start” and providing an orderly process for paying creditors.  The moment your business files a petition for bankruptcy relief, the “automatic stay” is imposed.  The automatic stay prohibits creditors from attempting to collect on their pre-petition debts (debts incurred before the date you filed for bankruptcy) and forces them to look only to the bankruptcy process to be paid.  Similarly, if you are a plaintiff in a lawsuit (e.g., a collection suit against a client), you will need to halt that suit temporarily.  Lawsuits that are pending in state or federal court can either be transferred to the bankruptcy court or the bankruptcy court can grant permission for them to continue where they are (lifting or modifying the automatic stay).

The filing of the petition also triggers the creation of the bankruptcy estate, which is comprised of all the property and property interests owned by the debtor on the date of filing.  This is the pool of assets from which creditors can be paid.  This includes both tangible assets (equipment) and intangible assets (accounts receivable, intellectual property rights).

Along with the Petition, you will be required to file Schedules and Statements of Financial Affairs.  A person authorized to act on behalf of the company (usually the President) will have to sign these under oath.  The Schedules are basically a list of all the company’s assets and liabilities.  The Statements of Financial Affairs ask more detailed questions about how the business’s money was spent.  For example, you will be asked to list all payments to creditors made within the last 90 days before filing and all payments to insiders (generally, officers or shareholders of the corporation or people related to them) within 2 years.  The purpose of the Schedules and Statement of Affairs is to give the Judge and your creditors a clear understanding of your financial picture.  Shortly after filing, you will be required to attend a meeting of creditors (also called a 341 meeting), where the bankruptcy trustee and your creditors will be able to ask you questions about your Schedules and Statement of Financial Affairs, which you must answer under oath.  You can view these and other bankruptcy forms at http://www.uscourts.gov/FormsAndFees/Forms/BankruptcyForms.aspx.

Your creditors may file claims against the bankruptcy estate.  In these documents, the creditor will list the amount of the debt it thinks it is owed, whether it is secured or unsecured, and if the debt is entitled to priority (i.e., whether it should be paid ahead of other debts).  If you think a creditor’s claim is wrong, you may object to it and have the court decide how much the creditor is owed, if anything.

Choosing A Chapter

There are two types of business bankruptcies:  liquidating and reorganization.  Liquidation is governed by Chapter 7 of the Bankruptcy Code (11 U.S.C. § 101 et seq.).  As you may discern from its name, in a Chapter 7 case, a business liquidates its assets and ceases operations.  Reorganization cases are governed by Chapter 11 of the Bankruptcy Code.  In these cases, the debtor restructures its debts, pays its creditors according to a “plan of reorganization,” and can continue operations as a reorganized entity, which is a separate legal entity from the debtor.  The reorganized debtor can carry on the same business, in the same name, with the same employees, but it is not liable for the pre-petition debts of the debtor except as provided in the plan of reorganization (e.g., if creditors are to be paid from future revenue).

Chapter 7 Liquidation

If you file for bankruptcy protection under Chapter 7, a Chapter 7 Trustee will be appointed.  The Chapter 7 Trustee is charged with gathering the business’s assets, liquidating them, and distributing the proceeds to creditors.  The debtor is relieved of responsibility for the liquidation process, which may be less stressful, but also often results in a lower sale price for the asset.

If the Chapter 7 Trustee determines that an asset may be hard to sell or would not result in a meaningful payment to your creditors, he or she may “abandon” the property.  The debtor may keep abandoned property or if it has been pledged as collateral, the creditor may foreclose on it if you are behind on your payments to that creditor.

Because corporations do not receive a discharge at the end of the Chapter 7 bankruptcy, if you were personally liable for the business’s debts (e.g., if you guaranteed a loan), the creditor can look to you to pay any part of the debt that was not satisfied through the bankruptcy.  After liquidation, the business is terminated.

Chapter 11 Reorganization

            If you file for bankruptcy under Chapter 11, no trustee is automatically appointed.  The debtor remains in control of its business and has all the obligations that a trustee would have.  In particular, the debtor-in-possession has a duty to act in the best interest of all its creditors.  Although the same management may remain in control of the business, they are operating it for the creditors, not themselves.

The debtor is much more active in a reorganization than a liquidation.  You will be required to present a plan for restructuring your debts and paying your creditors along with a disclosure statement that explains your plan.  The creditors can then vote whether to accept or reject that plan.  The Bankruptcy Judge will have to approve it.  The plan of reorganization must treat your creditors fairly, meaning that all similarly situated creditors are treated the same. It must also be feasible.  If you are planning to pay your creditors out of future revenue, you will have to convince the creditors and the Bankruptcy Judge that you can bring in enough money to make those payments.  If your plan of reorganization calls for your business to continue operation, the business’s debts may be discharged, allowing the business to move forward with a manageable level of debt.  If your plan calls for your business to be sold to a third party as a going concern, you will not be eligible for a discharge.

Pitfalls To Avoid

Under either Chapter 7 or 11, some pre-petition payments can be “clawed back” into the bankruptcy estate.  In a Chapter 7, the trustee will pursue this money; in a Chapter 11, the debtor does it.  The recoverable payments generally fall into two categories – preferences and fraudulent transfers.

Preferences are payments to creditors made within 90 days of the filing that result in the creditor being paid more than its fair share.  So, if you are contemplating filing for bankruptcy and you have a large line of credit that is personally guaranteed, you don’t want to pay off that lender right before filing in order to avoid being personally liable on the debt.  The creditor will be required to return the preferential payment and will be treated the same as similarly situated creditors.  Payments made in the ordinary course of business are not considered preferential payments.  You can keep paying your rent or mortgage, utilities, and normal trade bills, even as you are contemplating bankruptcy.

Fraudulent transfers include actual fraud (like paying fake invoices) and constructive fraud (payments for which the debtor did not receive reasonably equivalent value made while the debtor was insolvent or likely to become insolvent as a result of the payment).  Payments made to insiders are ripe for claims of fraudulent transfers.  Therefore, if you have insiders (usually relatives) working for your business either as employees or contractors, you need to ensure that their salaries are commensurate with their responsibilities and are reasonable for your market.  If you’ve used business assets to pay for personal expenses, those payments are also likely to be challenged as fraudulent transfers.

Because Schedules and Statements of Financial Affairs are signed under penalty of perjury, it is extremely important that you fill them out carefully and err on the side of disclosing more than is necessary.  Material omissions in these documents can be grounds for dismissing the bankruptcy as being filed in bad faith, or even more seriously, criminal charges for bankruptcy fraud.  Additionally, if you fail to disclose an asset, you may waive any claim to it.  Thus, it is especially important to make sure that your list of accounts receivable is complete and accurate and that you list all pending or potential legal claims that you may have against any party, or you may be prohibited from pursuing those claims.

   Filing for bankruptcy is not an easy decision.  It is often the culmination of many months or even years of incredibly hard work trying to build, sustain, and save your business.  With a little advance planning, you can make the bankruptcy process go as quickly and smoothly as possible.

 

This article is intended to provide only general information, not legal advice.  If you think that you may need to file for bankruptcy protection, you should consult with an attorney.  Your state or local bar association may have an attorney referral service to help you find an attorney licensed in your jurisdiction.