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, even with the many benefits of a reorganization, the business is worth saving? If the answer is 'yes', then chapter 11 is a powerful tool which can enable a business to restructure and eliminate debt.
If a graceful exit makes more sense, then dissolving, winding down or liquidating under chapter 7 may be better alternatives. Here, we'll consider these options first, then explain how different chapter 11 options work:
Dissolving and winding down a business does not involve a bankruptcy filing, so it is sometimes favored by principals who wish to preserve some corporate “goodwill”, with an eye toward starting a new enterprise, who anticipate a surplus after all the debts of the business are paid, or who deem it advantageous to maintain control over the liquidation of company assets and payment of obligations.
These goals can be illusory. Whether the value of the assets salvaged is worth the cost of winding down, both in time and money, should be carefully considered. Goodwill is intangible and unpredictable, and the degree of difficulty required to collect any 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. If there is a dispute a judge can decide, but usually a consensus can be reached.
Usually, the next step is filing articles of dissolution with the secretary of state. Upon filing the company is officially “dissolved”, and its business is limited to those activities necessary for winding down. This is only the beginning of the winding down process, though. Throughout the 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 returns, are filed and up to date, that employees receive appropriate termination notices, and that accounts receivable are reviewed and, if possible, collected.
Connecticut’s statutes authorize a dissolving company to prosecute and defend lawsuits, dispose of its property, settle and close its business, discharge liabilities, and distribute any remaining assets to its members or owners. Again, the company’s operating agreement may impose additional requirements.
The company can still be sued while the winding down process is going on.
As soon as possible following the filing of the articles of dissolution, all creditors are sent a notice, 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.
Generally, the company’s assets are distributed first to the allowed claims of its creditors, then to its members or owners. Any claim not barred through this process may be enforced by the creditor against the company’s assets, or, if the assets have been distributed, against the members in proportion to their pro rata share of the distribution.
A corporate entity such as a limited liability company or a corporation can file a chapter 7 bankruptcy, just as a natural person can.
There are similarities. Although corporate 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, if there are any over and above secured debts, and distribute any surplus to unsecured creditors.
A business chapter 7 can be a good option where a reorganization under chapter 11 bankruptcy would be unrealistic and the owner would like to move on rather than taking on the responsibilities that come with winding down the company.
Upon filing, your business becomes a new legal entity, the “debtor in possession”. Old bank accounts and insurance policies close and new ones are opened. With limited exceptions prepetition debts cannot be paid outright. It may be necessary to find new vendors. And the company has a fiduciary obligation to its creditors to treat them in accordance with the requirements of the Bankruptcy Code.
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 plan of reorganization that can be confirmed by the bankruptcy court.
Generally, a chapter 11 debtor cannot pay prepetition obligations while restructuring. There are some important exceptions, though.
While tax collection activity is stayed with all the rest, taxes coming due after the filing (including personal property and sales and use taxes) must be paid as they come due. There must be sufficient revenue projected so that taxes do not go further into arrears while the business is reorganizing.
Likewise, secured creditors (for example, a creditor with a motor vehicle lien) do not receive contractual installments.
However, if the value of the collateral is not significantly more than the balance of the secured loan and is depreciating the creditor will be entitled to “adequate protection” payments to ensure that the creditor’s security interest does not lose value while the business is reorganizing.
If the security includes “cash collateral” (operating cash and cash equivalents, typical of blanket security interests with recorded UCC-1s) then your operating budget must be approved by the bankruptcy court. Such arrangements are usually routinely negotiated, but they do require you to demonstrate that it is feasible to continue operating with these minimal obligations while developing your plan.
The Office of the United States Trustee is a division of the Department of Justice which oversees the entire bankruptcy system to prevent abuse. The U.S. Trustee is routinely involved in chapter 11 cases. Early in your case there will be an “initial debtor interview” with their staff, in which they will gather preliminary information about your business and make sure you are acquainted with its responsibilities as a debtor in possession. The U.S. Trustee 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.
Developing a confirmable plan of reorganization is a process which permits many options. While the plan itself is technical and somewhat complex, there is much room for creativity. The following is merely an overview of some common features.
A “sale plan” allows the business to sell some or all its assets free from creditor pressure, free and clear of liens, while maintaining control over the sale.
The company can also be reorganized as an ongoing business. To accomplish this, a plan can provide for the following.
Secured debt (for example, a loan secured by a piece of equipment) can be “bifurcated” into secured and unsecured components. The secured component of the debt is equal to the value of the collateral (which has usually depreciated since the loan was made) on the petition date. The original loan contract, including the interest rate and the term for repayment, is no longer binding. The plan provides for the true secured value of the loan to be paid on modified terms that are commercially reasonable. Essentially, the loan is 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. Equipment the business will no longer need can be surrendered to the lender in full satisfaction of its secured debt.
The unsecured component of such claims is treated as general unsecured debt, which is the least favored priority in bankruptcy. In many cases, most of the unsecured debt will be trade debt. While unsecured creditors must receive at least the amount they would get in a liquidation (the “liquidation value” of their claim) they usually receive only a fractional portion, “cents on the dollar”, over an extended period.
The development of a confirmable plan proceeds through a process that allows creditors to file “proofs of claim”. These are vetted by allowing you to object where appropriate. Valuing the allowed amounts of secured claims is done by motion. The chapter 11 plan is then 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.
The requirements for confirmation are technical and do not lend themselves to being easily summarized. However, the following basics apply.
It is a basic principle in bankruptcy that similarly situated claims must be treated alike. The most common classes of claims are priority claims (including most tax debt), secured claims (for example, liens on equipment), and general unsecured claims (trade debt). To confirm the plan the bankruptcy court must make a finding that the plan is “fair and equitable” to all classes of creditors. In turn, exactly what constitutes “fair and equitable” treatment depends on the class of creditor.
Payment of pre-petition tax debt is probably the most restrictive requirement, in that to be confirmed the plan must provide that it be paid in full within five years from the date you filed for bankruptcy at the applicable statutory rate of interest.
Each secured claim is a class unto itself, so the plan treatment of each can be negotiated separately. Effectively, this can entail re-writing the loan itself to include reduction of the principal balance to the value of the collateral, reducing the interest rate to a commercially reasonable rate and extending the repayment term, or providing for the surrender of unneeded collateral in satisfaction of the secured claim.
Unsecured claims, which include most trade debt, are the least favored. There is no requirement that such claims be paid in full, and a relatively small fractional payout is typical.
To be confirmed, the bankruptcy court must find that the plan has received sufficient votes from creditors. 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. 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. “Impaired” creditors (everyone else) are entitled to receive and cast ballots accepting or rejecting the plan. Ballots which set a deadline for voting are sent to impaired creditors. The weight of each creditor’s ballot depends on the class to which it belongs, and the amount of its claim in relation to other creditors of the same class. 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. This is usually 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.
Once the court finds that your proposed plan meets the requirements set forth in the Bankruptcy Code and enters an order confirming the plan, it becomes, essentially, a new and enforceable contract between your business and its creditors. This is your goal.
The basic, “traditional” chapter 11 bankruptcy process is summarized above. It is available to businesses large and small, from the biggest corporation to the smallest mom and pop grocery store. There are two variations, however, both of which contain potential advantages and disadvantages, depending on your situation.
If your business has total debt not exceeding $2,725,625 (because of the pandemic, this figure was temporarily increased to $7,500,000 earlier in the pandemic and may be subject to revision again) 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.
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.
There are some other distinctions, but overall, a small business case is not markedly different from a traditional chapter 7 case.
Reorganizations were assumed to be for businesses. 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 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.
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.
Notwithstanding, the still-new subchapter v may be the best fit for a small business.