Top 7 Things Business Owners Should Consider Before Bankruptcy

What do Marvel Studios, GM, Six Flags, Chrysler, Ally Financial, and Apple have in common?  Each of these companies has either filed for bankruptcy or been on the verge of doing so.  As a business owner, considering bankruptcy can be scary. However, it is not something you have to consider alone. 

What should you know now to help you make the best decisions for your organization? 

There is more than one type of bankruptcy.

Businesses can file bankruptcy under chapter 7 or chapter 11.  A chapter 7 bankruptcy is a liquidation, whereas a chapter 11 bankruptcy is a reorganization.  In a liquidation bankruptcy, assets are sold, and creditors are paid with the money recovered through liquidation.  In a reorganization, the business continues to operate for the benefit of creditors and a plan is developed with the business’ creditors to deal with the business’ debts.  

Business owners, on the other hand, can file under chapter 7, 11, or 13. Like business chapter 7s, individual chapter 7 bankruptcy cases involve the liquidation of the debtor’s assets to pay creditors.  In chapters 11 and 13 cases, the individual comes up with a repayment plan to deal with their debts.  In chapter 13, the debtor makes payments to a trustee, who distributes funds to the creditors.  In chapter 11 (business or individual), unless a trustee is appointed, which is rare, the debtor takes on the roles that a trustee would otherwise perform and makes distributions to creditors directly.  An attorney can help you decide which option is best for you and your business.

Having the right team in place is important, and the leadership of the owner/officers is essential.  

Just as a business owner or officer may need to have others fulfill various roles within their organization, from payroll and accounting to human resources, sales, marketing, and IT, they will also need the right people to fulfill certain roles during a reorganization.  Having experienced bankruptcy counsel is a must.  Outside financial advisers for additional direction will also facilitate the process.  Some firms will even appoint a Chief Restructuring Officer.  Regardless of who is on the team, the restructuring will only be successful if the owners or officers can successfully lead the team to accomplish its goals. Often, people from outside your company will have the best perspective to guide you to make the important choices to get out and stay out of bankruptcy. The owner or officer will need to understand the new rules of operating while in bankruptcy and keep the company in compliance.  They will need to communicate with employees, creditors, customers - and potentially media - regarding future employment, payments, order fulfillment, and high-level goals.  They will need to be credible, transparent, and maintain a high level of trust.  A qualified team can help you do this and allow you to focus on what is most important to successfully turning around your business. 

Bankruptcy is a complicated and involved process.

When a business owner or a business files for bankruptcy protection, the business will be under the scrutiny of the case trustee (chapter 7 or 13), the Office of the United States Trustee, the creditors committee (chapter 11), and the Bankruptcy Court itself.  The company or owner – known as “debtor” in the case – will have to disclose detailed information to the court, the U.S. Trustee, and other parties-in-interest.  All chapters of bankruptcy require debtors to supply financial information relating to their financial affairs leading up to the filing, and some chapters (13 and 11) require debtors to report ongoing financials throughout the bankruptcy case on a monthly basis.  It is imperative that a business’ financial information is maintained and updated throughout the bankruptcy process.

Further, in some types of bankruptcy, the court will play an active role in your business. The court will have to approve certain actions, including employing professionals, conducting transactions that are out of the ordinary, obtaining financing (other than accepting ordinary trade credit), and even paying employee compensation earned pre-bankruptcy.

In most cases, you can expect regular hearings and meetings throughout the process.  Although business owners or officers may not need to attend every hearing, the owner or officer may choose to attend specific hearings that are important.  Even if the hearing itself may not require the presence of an owner or officer, deals are typically struck between the parties outside the courtroom before or after hearings, so being available to discuss case issues at regularly scheduled hearings is critical.

Relationships between owners, officers, directors, and shareholders will change.

In a chapter 11 bankruptcy, court approval is necessary for certain actions or transactions.  That means the board of directors may simply yield their authority to the Bankruptcy Court and rely on the officers to manage the reorganization.  Often, however, the board will still expect the officers to obtain board approval before seeking court approval for certain actions or transactions.  

When it comes to shareholders, however, any action that would normally require stockholder approval outside of bankruptcy now only needs court approval.  Although shareholders are last on the distribution list and often receive no distributions in a case, they still have an interest in the case.  Accordingly, shareholders or the U.S. Trustee may seek to have a committee of equity shareholders appointed consisting of the 7 largest shareholders that are willing to participate.  However, this is a rarity and usually only in large, more complex cases.  Even if a committee is appointed, their influence is limited.

Duties shift from shareholders to creditors.

Once a company passes the point where their debts outweigh their assets, the company (its officers and directors) owes a fiduciary duty to its creditors and not just its shareholders.  If the value of the company’s assets is less than the amount of debt owed by the company, then it is the creditors who are most at risk.  Officers are accustomed to maximizing shareholder returns; therefore, shifting to managing the company for the benefit of creditors is a major change.  

Additionally, creditors may have competing interests.  There are secured creditors, unsecured creditors, trade vendors, customers, employees, and others.  Knowing whose interests to serve is challenging and making the wrong move can put officers in jeopardy of claims for breach of fiduciary duties.  The benefit to the owner or officer of taking their company through the chapter 11 process is that the court, with input from the company and its creditors, ultimately makes the big decisions, and the Bankruptcy Code provides a set of priorities for how creditors should be paid, which shifts liability away from the owners and officers and puts the responsibility on the shoulders of the court. 

Personal Guarantees and loans to the business may be tricky to deal with.

Although owners and officers of larger companies may not be called upon to sign a guarantee on behalf of the company, owners and officers of smaller companies may have to guarantee the performance of a business contract.  

The Bankruptcy Code requires that similarly situated creditors all be treated similarly in bankruptcy.  All creditors within a class must be treated the same, meaning, for example, that a company can’t pay one general unsecured creditor 75% of its debt while paying all other general unsecured creditors only 10% of their debts.  

Further, the Bankruptcy Code requires the trustee or debtor to avoid certain preferential payments or payments to “insiders” (relatives, owners, officers, directors, affiliates, etc.).  If the company repays a debt shortly before the bankruptcy, there is a chance the payment may be undone by the court so that the funds can be distributed to all the creditors rather than just one. 

Bonuses and transferring assets years ago may cause problems today.

In addition to recovering the value of preferential payments, the trustee or debtor is also tasked with avoiding any “fraudulent transfers.” A fraudulent transfer is a transfer made while the company is insolvent (debts outweigh assets), or which cause the company to become insolvent and for which the company does not receive equivalent value in return.  Debtors in bankruptcy must disclose all transfers of assets going back two years prior to the bankruptcy filing.  However, the fact that older transfers do not have to be disclosed in the bankruptcy paperwork, does not mean that older transfers can’t also be clawed back.  Individual jurisdictions may have Fraudulent Transfer Acts or other laws in place that allow for the clawing back of “fraudulent transfers” that go back longer than two years.  Arizona’s Fraudulent Transfer Act, for example, allows creditors to recover fraudulent transfers for up to four years.  

In short, if (before filing bankruptcy) an owner or officer causes the company to pay bonuses to themselves or other key employees, or transfers other assets from the company to themselves or others without receiving equivalent value in return, then the asset, its value, or the value of the bonus may be demanded back from them as a “fraudulent transfer”.  

Conclusion 

Bankruptcies are difficult to go through.  They are stressful, time consuming, and filled with unknown pitfalls, but they can also be rewarding as you use the tools available to you to support your business and future growth.  Having a qualified attorney and team around you throughout this process is important to reaching the best possible outcome.  The stress of going through bankruptcy can be eased, pitfalls can be avoided, and a company can emerge on the other end in a better position. 

About Decision Support Solutions LLC: In addition to helping clients find solutions to immediate cash flow, debt, and other financial issues, Decision Support Solutions works closely with companies to create key financial and operational systems, processes, and frameworks to set them up for success into the future.  The four pillars for client success are commercial debt mediation, restructuring advisory, bankruptcy support, and business legal services. https://www.dssrestructuring.com/