Chapter 11 Bankruptcy and Alternatives for Business Owners
Table of Contents
- Threshold Decisions
- Option #1: Dissolution and Winding Down
- Option #2: Chapter 7 Business Liquidation
- Option #3: Reorganizing Under a "Conventional" Chapter 11 Bankruptcy
- Option #4: The Small Business Chapter 11 Case
- Option #5: Chapter 11 Bankruptcy For Individuals
- Option #6: Subchapter v For Small Businesses
- Related Articles
Small business reorganizations require dedication and commitment. Early consideration should be given to the costs and benefits (potentially, many) of chapter 11 bankruptcy. When we consult we will first discuss whether the business is worth saving?
If the answer is 'yes', then chapter 11 is a powerful tool to restructure and eliminate debt.
If a graceful exit seems better, then dissolving, winding down or liquidating under chapter 7 are alternative options.
Here's an overview of the spectrum of possibilities....
Option #1: Dissolution and Winding Down
This option is sometimes favored by owners wishing to preserve some goodwill with an eye toward starting a new enterprise, who anticipate a surplus after all debts are paid, or want to maintain control over the liquidation of company assets and payment of obligations.
As with all choices, a cost/benefit analysis is important. Whether the value of the assets warrants the cost of winding down, in time and money, should be considered. Goodwill is intangible and unpredictable, and the difficulty of collecting receivables should be realistically evaluated.
A majority of members or owners usually must authorize dissolution, although the company’s operating agreement may have other requirements. Upon authorization, "articles of dissolution" are filed with the secretary of state. Upon filing the company is officially “dissolved”, and its business is limited to those activities necessary for winding down. All creditors are notified, either by mail or publication. A creditor with actual notice must submit its claim within 120 days from the later of the effective date of the notice or the date of the filing of the articles of dissolution, or be barred according to statute. If a creditor’s whereabouts are unknown, notice by publication, usually in the form of a newspaper advertisement, is given. Such creditors have until three years after the publication date to enforce their claims.
Throughout the winding down process the company has a fiduciary obligation to and holds its assets in trust for its creditors. Operational aspects of winding down include making sure all tax returns (including sales and use tax) are filed and up to date, that employees receive appropriate termination notices, and that accounts receivable are reviewed and, if possible, collected. A dissolved company may prosecute and defend lawsuits, dispose of its property, settle and close its business, discharge liabilities, and then distribute remaining assets to its members or owners.
Option #2: Chapter 7 Business Liquidation
A limited liability company or a corporation can file a chapter 7 bankruptcy, just as a natural person can. Although business entities do not receive a discharge, an automatic stay goes into effect upon filing which prohibits the bringing or prosecution of lawsuits against the company (but not against principals who have guaranteed corporate debt). A trustee is appointed to collect the assets of the business, net of secured debts, and distribute any surplus to unsecured creditors. Often there is nothing for creditors. A business chapter 7 can still be a good option where there is a desire to move on rather than engage a winding down process.
Option #3: Reorganizing Under a "Conventional" Chapter 11 Bankruptcy
Upon filing, your business becomes a new legal entity, the “debtor in possession”, with a fiduciary obligation to treat its creditors as required by the Bankruptcy Code. Most prepetition debts cannot be paid outright, they are paid later through the plan of reorganization. So, it may be necessary to find new vendors, or use the leverage provided by bankruptcy to negotiate arrangements with existing creditors. Old bank accounts and insurance policies must be closed and new "debtor in possession" accounts or policies obtained. As with all other bankruptcies the automatic stay goes into effect upon filing. Lawsuits and all other creditor actions stop. This allows time to develop a confirmable plan of reorganization.
While tax collections are stayed with all the rest and pre-petition tax debt paid through the plan, taxes coming due after the filing (including personal property and sales and use taxes) must be paid as they come due. Secured creditors are not entitled to receive contractual installments, only to be “adequately protected” so that their security interests do not lose value while the business is reorganizing. If any creditor has a security interest in “cash collateral” (e.g., operating cash and cash equivalents, which are typically included in blanket security interests) then the company's operating budget must be periodically reviewed and approved by the bankruptcy court.
The Office of the United States Trustee is a division of the Department of Justice which oversees the entire bankruptcy system. The U.S. Trustee is routinely involved in chapter 11 cases, and can be helpful in developing the case. Early on there will be an “initial debtor interview” with their staff, in which they will gather information about your business and make sure you are acquainted with its responsibilities as a debtor in possession. The UST also conducts the meeting of creditors in chapter 11 bankruptcy cases and, later, will take a position as to whether your proposed plan of reorganization is confirmable. Working through and resolving these issues is an important part of the process of reorganizing your business.
While developing a confirmable plan of reorganization is somewhat technical and complex, there is much room for variation and creativity.
Equipment may be sold free and clear of liens. Unnecessary equipment may be surrendered to secured creditors in full or partial satisfaction of their debts. Secured debt can be “bifurcated” into secured and unsecured components corresponding to the present value of the collateral. The unsecured component of bifurcated claims is treated as general unsecured debt, which is the least favored priority in bankruptcy. Loans can effectively be re-written on more favorable terms. The principal balance and interest rate on equipment the business needs to continue operating can be reduced, and the term of the loan can be stretched out. While general trade debt must receive at least the amount it would derive from a liquidation that amount is often only a fraction of the original claim, “cents on the dollar”, which may be paid over an extended period.
The chapter 11 process allows all creditors to file “proofs of claim”. After these are thoroughly vetted the proposed chapter 11 plan is ready to proceed to “confirmation”. This is the hearing at which the bankruptcy court makes a determination that your plan conforms to the requirements of the Bankruptcy Code and is “fair and equitable” to all creditors. Once the court makes those findings and enters an order confirming the plan, the plan becomes a new and enforceable contract between the reorganized business and its creditors. This is the ultimate goal of any chapter 11 case.
What constitutes “fair and equitable” treatment depends upon the type of creditor. Plan treatment of pre-petition tax debt offers the least flexibility. Unless a different agreement is reached with the IRS or DRS, it must be paid in full within five years of the filing date at the applicable statutory rate of interest. Each secured claim is a class unto itself, so the plan treatment of each is usually negotiated separately.
Some classes of creditors have a right to vote to approve or reject the plan. As a preliminary to confirmation a proposed disclosure statement must be approved by the court. The disclosure statement must contain sufficient information about the debtor’s situation, the bankruptcy case, and the proposed reorganization plan to allow creditors to make an informed decision about their vote, similar to a prospectus. Creditors who are “unimpaired” (those creditors whose contractual or statutory rights are unaltered by the plan) are conclusively presumed to have accepted the plan and are not entitled to vote. This would ordinarily include all tax debt, and creditors that are being paid according to their original contract. “Impaired” creditors (all others) are entitled to cast ballots accepting or rejecting the plan. The voting scheme itself is somewhat complex. For example, a class of unsecured creditors must accept the plan by at least two-thirds in amount and one-half in number of the total allowed claims. But approval is a very realistic outcome. The alternative of receiving little or nothing if the case fails tends to be a reality check on otherwise intransigent creditors.
To be confirmed, the bankruptcy court must also find, in most cases, that the plan complies with the “rule of absolute priority”. One effect of this rule, considered in isolation, is that holders of equity interests cannot retain their interests in the company unless all higher-ranking claims are paid in full. Superficially, this would make most plans unconfirmable, because principals would not be able to retain their ownership interests. Fortunately, the statute which sets forth the requirements for confirmation provides exceptions to the rule, so in practice it is rarely an insurmountable hurdle.
Option #4: The Small Business Chapter 11 Case
If your business has total debt not exceeding $2,725,625 it must file as a small business case. A “conventional” chapter 11 case has a 120 day “exclusivity period” within which only the debtor can file a plan. After that, any creditor may file a plan. In a small business case, the exclusivity period is 180 days. The extra two months may be an advantage if there is an aggressive creditor with the motivation and resources to file and prosecute a viable plan of their own, but that is somewhat unusual. A conventional chapter 11 has no specific deadline within which to obtain confirmation of a plan, although the case is always subject to dismissal if it appears that a successful reorganization is not possible. In a small business case, there is a somewhat rigid 300-day deadline within which to obtain confirmation of a plan. Bottom line, a small business case is subject to more restrictive deadlines, although I have found that it affords plenty of time to get the job done. There are some other distinctions, but overall, a small business case is not markedly different from a traditional chapter 7 case.
Option #5: Chapter 11 Bankruptcy For Individuals
Historically, reorganizations were assumed to be for businesses, not people. But individuals very commonly own unincorporated businesses, including partnerships and sole proprietorships which can benefit from a bankruptcy reorganization. And individuals with only consumer debt can benefit too. There was a controversy whether natural persons are eligible to file under chapter 11, but that has long been resolved. If you are an individual, chapter 11 is one of your bankruptcy options. The relative complexity of chapter 11, in comparison with other available bankruptcy chapters should be considered, however. Generally, all the requirements of chapter 11 apply to individuals. On the other hand, a chapter 11 filing creates opportunities that a chapter 13 does not offer. Chapter 11 for individuals can be most useful in situations where you exceed the debt limitations of chapter 13, or if there is a home mortgage arrearage which cannot be cured within the five-year term limitation of chapter 13. It is possible in a chapter 11 to obtain a more extended time period to cure.
Option #6: Subchapter v For Small Businesses
Subchapter v of chapter 11 was brand-new in early 2020, and it is a significant departure. Although unique, subchapter v combines features of the “classic” business chapter 11 and chapter 13. Although the debtor retains the responsibilities of a debtor in possession, including the responsibility to continue operating the business, a trustee is appointed, and serves until the case is “substantially consummated” (i.e., usually until plan payments have begun). What is unusual, and helpful, is that a subchapter v trustee performs a hybrid role, which includes facilitating development of a consensual plan of reorganization and distributing any payments until the plan is confirmed. To keep the facilitative aspect of subchapter v moving along, the court must schedule a status conference not later than sixty days after the petition is filed. Fourteen days prior, the debtor must file a report that details efforts to achieve a consensual plan. Perhaps the biggest innovation here….It is possible under subchapter v to modify the rights of a creditor whose claim is secured only by the debtor’s principal residence, if the loan was not used primarily to acquire the residence and was used primarily in connection with the debtor’s business. For example, the balance of a such a line of credit could be reduced to true equity value and payment terms altered. Subchapter v also contains significant restrictions. Although only the debtor can propose a plan, that must occur with ninety days of filing. Similar to chapter 13, all projected disposable income within a three-to-five year period must be devoted to the plan.
In many situations, the still-new subchapter v may be the best fit for a small business.