Bankruptcy Options for Your Troubled Small Business

A. Thomas DeWoskin

By A. Thomas DeWoskin

Part 4 of a 5-part series: Options for Small Business Owners in Financial Distress

turbulenceIf you’re a small business owner in financial distress, you’re undoubtedly looking for options for your business to have a better chance of surviving the pandemic and other economic surprises of the recent year. In the first three parts of this five-part series, we’ve looked at ideas for improving your business operations, discussed the importance of the availability of cash and improving your cash flow, and reviewed non-bankruptcy options to restructure your debts.

However, you and your attorney may conclude that none of those options meet your needs and it is time to consider a formal bankruptcy filing under the U.S. Bankruptcy Code.

Forms of Bankruptcy Relief

Before getting into details, let me make a suggestion: Don’t be too hard on yourself. It is rare for a business to fail because of only one issue. Even if your actions contributed to the problem, there were most likely other factors beyond your control involved as well. Besides, bankruptcy may provide a chance for you to fix what went wrong.

Another consideration is that the old stigma of filing a bankruptcy case has largely dissipated over the past few decades. Our Founding Fathers realized that the old European use of a debtors’ prison was unworkable and that a structured mechanism to help financially strapped people and businesses navigate a “soft landing” was needed instead. As a result, there actually is a provision in the U.S. Constitution requiring the Congress to make “uniform Laws on the subject of Bankruptcies throughout the United States.”

If you feel embarrassed about filing a bankruptcy, compare it to taking a tax deduction. It’s another example of financial relief provided by statute to individuals and businesses. It’s there for you to use, and there’s no reason to feel guilty for doing so.

The Bankruptcy Code provides for several different types of bankruptcy filings:

  • Chapter 7 – A liquidating bankruptcy case, available to almost all persons.
  • Chapter 9 – Specific provisions for municipalities, or subdivisions thereof.
  • Chapter 11 – A reorganization case, available to almost all persons.
  • Chapter 12 – Special reorganization provisions for family farmers.
  • Chapter 13 – A limited reorganization, available only to natural persons and subject to certain income and debt limitations.

There are two aspects to bankruptcy relief which are common among all the chapters – the automatic stay and the opportunity for a fresh start. The automatic stay stops all creditor action against your business, providing you with a breathing spell during which you can attempt to solve the business’ problems. The fresh start provides your business with the opportunity restructure its debts into terms the business can live with.

Here’s a closer look at Chapters 7 and 11 as options for a small business owner to consider. Chapters 9 and 12 are not frequently used (unless you are a governmental agency or a farmer). A Chapter 13 bankruptcy has its own unique rules and procedures; any experienced Chapter 7 attorney should be able to counsel you on your Chapter 13 options as well.

Chapter 7 Liquidation

When most people hear the word “bankruptcy,” they think generally of a liquidation, which essentially describes a Chapter 7 filing. A trustee is appointed in every case. The trustee’s primary duty is to determine if the debtor has any assets which can be liquidated and to then distribute the liquidation proceeds to creditors pursuant to the priorities set forth in the code.

Contrary to popular misconception, a debtor does not “lose” all assets to the trustee. First, all states, including Missouri, have adopted a statutory list of assets which cannot be reached by a creditor or a bankruptcy trustee. Under Missouri statute, most common household goods are exempt (within certain limits), as are other assets such as cash, cars, and the cash value of a life insurance policy. Other assets simply never become part of the bankruptcy estate. Property owned by wife and husband as “tenants by the entirety” is the primary example of this. With certain exceptions, if a married debtor files bankruptcy and the spouse does not, property held as tenants by the entirety is not available to the trustee for liquidation in Missouri. The tenants by the entirety laws in Illinois are quite different.

Second, the trustee is interested only in assets which have sufficient value to make liquidation worthwhile. For example, the trustee would not liquidate the debtor’s home if it is worth $250,000 but has a $260,000 mortgage against it.

However, if the debtor is not able to continue making the payments on the mortgage, the house could still be lost, but it would be due to foreclosure by the lender and not because of the bankruptcy filing.

Some debtors may not qualify to file a Chapter 7 case based on a “means test” to determine if the debtor’s income exceeds certain limitations.  Such debtors may be able to file under Chapter 11 or 13 instead.

And not all debts can be discharged in a Chapter 7 case. Domestic support obligations, debts incurred by fraud, many taxes, and several other specified types of debts are nondischargeable.

Finally, corporate entities do not receive a discharge, which is why there are very few Chapter 7 business filings. Only natural persons are entitled to receive a discharge of their debts.

Chapter 11 Reorganization

Another option for a small business is a Chapter 11 reorganization. Generally, small businesses shy away from Chapter 11 because it is expensive, risky, time-consuming, and complex. However, Chapter 11 is the only bankruptcy option for a small business seeking to restructure and continue in operation if it is not a sole proprietorship.

Cases filed under Chapter 11 generally seek to reorganize the debts of the debtor, although liquidations in Chapter 11 are not uncommon. In a Chapter 11 case, the debtor generally remains in possession of its pre-petition assets (as “debtor in possession” or “DIP”) and uses them to continue operating its business during its reorganization. Relief under Chapter 11 is available to both natural and statutory entities.

Chapter 11 cases often require a number of issues to be resolved promptly, so the petition commencing the case often is accompanied by a number of “first-day” motions which seek relief on an expedited basis regarding various issues. These issues can be procedural or involve substantive relief. Several commonly filed substantive motions would include the debtor’s motions to use its assets in the ordinary course of business while the case is pending, to seek post-petition financing, and to pay its employees.

The power of the DIP to continue utilizing its assets must be tempered with a recognition of each secured creditor’s interest in those assets. The creditor is entitled to protection of those interests and compensation for any deterioration of its interest in its collateral while the case is pending.

The Bankruptcy Code provides that protection by requiring the debtor to provide “adequate protection” in the form of an “indubitable equivalent” of the creditor’s interest in the collateral, such as cash payments to the creditor and providing a replacement lien on property acquired post-petition. Other forms of adequate protection include maintaining and insuring the collateral and appropriate reporting requirements.

The general rule in a Chapter 11 case is that the debtor may not pay any pre-petition debts while the case is pending. Courts often grant exceptions to pay employees and all related payroll taxes, to honor pre-petition customer deposits, or to pay “Critical Vendors.” Critical vendors are those owed money for pre-petition goods and services necessary to the debtor’s operations and not readily available elsewhere but that will not continue to be supplied without the vendor being paid.

The primary goal of every Chapter 11 debtor is to develop a Plan of Reorganization which allows it to restructure its debts and remain in business. This may or may not include the sale of unprofitable divisions or unnecessary equipment. A debtor may reject burdensome leases of real or personal property and pay the lessor pennies on the dollar.

The debtor can reorganize its obligations to secured creditors in two very important ways.

First, if the creditor is under-secured (i.e., the value of its collateral is less than the debt owed to the creditor), the debtor can split the creditor’s claim into two different claims: the secured portion (i.e., the value of the collateral) and an unsecured portion (the remaining balance due). The unsecured portion is lumped in with all of the other unsecured claims and paid pennies on the dollar.

The debtor can then alter the terms under which the secured debt is repaid, including the interest rate, and the timing, amount, and duration of the payments. It is not uncommon for secured claims to be repaid under these more favorable terms for several years, after which the remaining balance comes due in a balloon payment. Lenders often are more willing to accept a shorter-term arrangement than something which binds them for many years.

There are many statutory requirements for confirmation of a plan, which the judge must rule upon after a hearing to consider confirmation.

Here is the important part: If confirmed, the plan acts as a new contract between the debtor and its creditors, replacing whatever arrangements existed prior to confirmation. Its terms are binding on all creditors, whether they voted for the plan or not.

Special Small Business Provisions

The Coronavirus Aid, Relief and Economic Security Act of 2020 (“CARES Act”), together with the Small Business Reorganization Act of 2019 (the “SBRA”), both of which became effective in 2020, include provisions designed to make a small business debtor’s trip through Chapter 11 less burdensome and therefore more attractive to them.

The term “small business debtor” is defined in the Bankruptcy Code to include persons engaged in business (other than debtors whose primary business is owning or operating real estate). The CARES Act increased the debt ceiling to be considered a small business debtor from the previous $2,725,625 in total debt to $7,500,000 to increase its availability to slightly larger businesses.

As with so many “improvements,” there are costs and benefits to making the election to be treated as a small business debtor.

  • Only the debtor is permitted to file a plan and must do so quickly – within 90 days of filing the case.
  • There will be no creditors’ committee, but a trustee will be appointed to oversee the case. Although the debtor is required to pay the trustee’s fees, a trustee who knows the ins and outs of Chapter 11 can be of great value to the debtor.
  • A Chapter 11 plan can be confirmed without the support of any creditor class if certain other conditions are met.
  • The ability of the debtor to recover preferential transfers has been limited. In addition to venue changes, and the debtor now is required to exercise certain due diligence prior to filing the lawsuit. Clearly, this is an improvement for creditors.

The primary benefit of the new provisions may turn out to be the mandatory appointment of an overseeing trustee. With no creditors’ committee appointed in a small business case, the trustee represents the opportunity to approve the debtor’s progress and its Plan of Reorganization and serve as a reliable source of information for the judge at status conferences or hearings.

In the next and final installment of this series, I’ll discuss the practical issues faced by a business during its trip through Chapter 11.

Here are the other posts in this series:

Introduction: Options for Small Business Owners in Financial Distress: A 5-Part Series

Part 1: Your Small Business: The Economic Turbulence – Analyzing and improving your business operations

Part 2: Accumulating Cash and Improving Your Business’ Cash Flow – Analyzing and improving the business’ flow, as well as obtaining additional financing if necessary

Part 3: Non-Bankruptcy Ideas for Helping Your Troubled Small Business –  Ideas on using non-bankruptcy options in an effort to restructure your debts

Part 4: Bankruptcy Options for Your Troubled Small Business – Pros and cons of various types of bankruptcy

Part 5: Getting through a bankruptcy case and coming out on the other side (coming soon)

Posted by Attorney A. Thomas DeWoskin. DeWoskin practices in the areas of bankruptcy, creditor’s rights, and commercial law. He represents creditors, as well as business debtors, and individuals with difficult or unusual financial situations. DeWoskin served as a bankruptcy trustee in the Eastern District of Missouri for more than 35 years. 

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