Small Businesses

YOUR BUSINESS IS IN TROUBLE!

How do you determine if bankruptcy is necessary or helpful for your situation?

First, is the business a corporation, a partnership, or a proprietorship?

Corporations, limited liability companies and partnerships are legal entities separate from their shareholders or partners.  They can file Chapter 7 or Chapter 11 bankruptcy in their own right.  In a partnership’s Chapter 7 case and in some limited liability companies, the trustee can sue the general partners of the partnership if the partnership’s assets are insufficient to pay all claims for the amount by which the partnership assets fall short of partnership debts.   11 U.S.C.  723.

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:  they can’t file bankruptcy alone: the proprietor must file bankruptcy, since the assets and the liabilities of the business are really just one form of assets of the proprietor.  The individual owner may file Chapter 7, Chapter 11 or Chapter 13 (if the debt limits are met). See  Chapter 13
  • 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 what are the prospects for change:

  • Reorganization can’t create a market; increase gross revenue, or make up for a poor fit between the skills available and the skills required to run the business.
  • Reorganization could free up cash from servicing the old debt to permit current operations;  permit rejection of leases or contracts that are no longer advantageous (an expensive facility lease or improvident equipment purchase); or prevent the loss of vital assets or cash to creditor collection actions.

In between Chapter 7 liquidation and reorganization, a  liquidating Chapter 13 or Chapter 11 could provide a breathing space for the owners to sell the business  as a going concern or or its assets in something other than a fire sale.

The resulting proceeds could pay taxes or unpaid salaries; sale of the business could provide ongoing jobs for the work force under new ownership.  The bankruptcy could then be converted to Chapter 7 or dismissed if bankruptcy protection is no longer needed.  The court will probably condition dismissal of the case on payment to creditors of the sale proceeds.

  • Does management have the resources and desire to engage in the reorganization process?

Bankruptcy reorganization in Chapter 11 requires significant time on the part of the owners and managers to comply with the requirements of the bankruptcy system, interface with counsel, and negotiate with creditors.  It is usually expensive as well.

The “bankruptcy bargain” is that, in exchange for the protection of the automatic stay and other bankruptcy protections, the debtor provides full disclosure of its financial condition to creditors and the court, both at the beginning of the case and on a monthly basis thereafter,  and operates as a fiduciary for its creditors while the bankruptcy is ongoing.

A reorganization can drain an already stressed organization of management’s time to participate in bankruptcy proceedings and money since the legal expenses are significant.

Most reorganizations fail, usually for lack of a real plan to solve the problems.

  • Is the business one that the owners 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 entity.

This can be a complex issue and requires good professional advice to do correctly.

  • When Chapter 7 is best

A Chapter 7, whether for the individual or a corporation, may be the best choice when

  • the business has no future,
  • it has no substantial assets or qualities that cannot be reproduced after bankruptcy,  or
  • the debts are so overwhelming that restructuring them is not feasible.

Individuals can get a discharge of the dischargeable debts and a chance to start over.

Corporations don’t get discharges, so a corporation won’t get a fresh start in a Chapter 7, the way an individual does. Nonetheless, a Chapter 7 can provide an orderly liquidation under the direction of the trustee and at no expense to the shareholders.  Creditors are assured that they will be paid to the extent of the assets available and the priority of their claim.  Former management is assured that the assets that are available go (after the expenses of the Chapter 7) to pay taxes for which the individuals may be liable.

Possible pitfalls for management of distressed businesses

If a business is in financial trouble and may be looking at a bankruptcy, It may be important for the owners and officers of the business to consult with a bankruptcy attorney, well before a bankruptcy has been decided on.  Activities of the business prior to the filing of the bankruptcy can result in significant liability for the owners and officers.

What  owners and officers need to know

When business isn’t going well and management is evaluating survival strategies and contingencies for closing, consider the the following:

The division of debt between secured and unsecured guides what reorganization can do for the business.

Missuse of the the proceeds of a secured creditor’s collateral can create a non dischargeable debt for the individuals involved.

When an employer deducts taxes and social security contributions from employee wages, the employer becomes a fiduciary for that money which belongs to the employee.  “Loaning” the business the money due Uncle Sam from employees’ paychecks makes the responsible corporate officers personally liable for the trust fund taxes not paid to the taxing authority.

Sales taxes are trust fund taxes in some jurisdictions, as well.

No longer liable to ownership, corporate officers owe duties to creditors when a corporation becomes insolvent.

Repayments to relatives and business decision-makers on their claims against the debtor can be recovered by the bankruptcy trustee under certain circumstances as preferences.

This page was last updated: March 29, 2011