Many business owners ask this question only after suffering for many months, dealing with a cash flow crisis, and receiving calls from creditors - sometimes even a lawsuit. In short, the answer is: sooner rather than later, as soon as bankruptcy becomes a possibility, because the timing depends on the type of bankruptcy that’s right for the business. Determining which bankruptcy to file is the first thing a bankruptcy attorney needs to figure out. There are three types of bankruptcy that are common for businesses: a traditional Chapter 11 reorganization; a streamlined version of Chapter 11 for small businesses, called Subchapter V; and Chapter 7 liquidation. Two of these keep the company in operation; one shuts it down. All have varying degrees of expense, timeline and impact on the owner. Let’s look at each of those types of bankruptcy in detail and how that can affect the timing of hiring an attorney.
A Reorganization Plan While It Continues to Operate
Chapter 11 gives a business the time to reorganize its debt and file a reorganization plan while it continues to operate. It’s often used by big businesses to restructure their balance sheets and get rid of bad contracts. This is usually the right choice for a business that is healthy but has unsustainable debt. The business stays in business with court supervision and restructures its debt without forgiving it entirely. Chapter 11 is a good option for businesses that need to renegotiate burdensome leases and contracts (like real estate or equipment), obtain new financing, or modify the terms of repayment.
Chapter 11 begins when the business files a petition with a statement of its financial affairs and schedules of assets, liabilities, contracts, expenditures, and leases. The business’s current management typically continues to operate the company as a “debtor-in-possession.” As soon as the petition is filed, an automatic stay is put in place that stops most collection activities and lawsuits. The reorganization plan will be subject to the absolute priority rule, which requires the plan to pay all senior creditors in full before giving anything to junior creditors or equity holders. It must be voted on by impaired creditors and confirmed by the court. If the plan isn’t supported by every class of impaired creditors, the court can still approve it if it is not found to “discriminate unfairly” and is “fair and equitable,” also known as a “cramdown.”
Of the many benefits of Chapter 11, one of the most significant is that the debtor-in-possession can re-negotiate contracts. Section 365 of the Bankruptcy Code provides that the debtor in possession can assume, assume and assign, or reject executory contracts and unexpired leases with court approval. As an example, a commercial real estate lease generally needs to be assumed or rejected within 120 days from the date the petition was filed (or extended 90 days by the court) or it will be considered automatically rejected. Rejection is treated as a breach of the lease immediately prior to the filing of the petition. The landlord’s resulting claim will be deemed a pre-petition general unsecured claim for damages. The ability to reject the lease gives the debtor leverage because the landlord and other counterparties generally want to continue to receive payments under the lease rather than be left with an unsecured claim worth much less. The result is that the debtor can renegotiate the terms of the lease or other service contracts. In addition, pursuant to Section 506 of the Bankruptcy Code, the court determines the current fair market value of any collateral securing a loan or other claim against the company. Only the amount of the claim up to the value of the collateral remains secured; the remainder becomes an unsecured claim against the company, which will likely be repaid at a steep discount.
Chapter 11 can be time-consuming and expensive. It can take years for a reorganization to be completed. Professionals such as lawyers, financial advisors, and accountants will all have to be paid to assist the company through the process. In addition, unsecured creditors may organize and oppose any plan of reorganization proposed by the management of the company. As such, preparation is key, and experienced legal counsel is essential.
Cost-efficient Reorganization Process
Subchapter V was established by the Small Business Reorganization Act of 2019. It provides a streamlined, cost-efficient reorganization process for certain small businesses while retaining many of the advantages of Chapter 11 with reduced complexity and expense. A small business is eligible for relief under this subchapter only if its aggregate noncontingent, liquidated, secured and unsecured debts do not exceed $3,424,000. (This amount is subject to adjustment every three years due to inflation.) To be eligible, the debtor must be “engaged in commercial or business activities,” and more than 50 percent of its total debt must be attributable to those activities. Eligible entities include small business corporations, partnerships, and individuals with a commercial enterprise. Single-asset real estate owners and publicly traded companies are ineligible.
A trustee is appointed in every case to assist in the negotiation of a consensual plan of reorganization between the debtor and its creditors. Within 60 days of the commencement of the case, the court must hold a status conference and the debtor is required to submit a report on the debtor’s efforts to obtain creditor consent to a plan no later than 14 days before the conference. Typically, no disclosure statement is required and no unsecured creditors’ committee is appointed, unless ordered by the court. Only the debtor may file a plan, and it must be filed within 90 days of the petition date (unless the debtor can show that the need for the extension is due to circumstances for which the debtor should not justly be held accountable). There are no quarterly fees to the U.S. Trustee.
Subchapter V plans can be confirmed by consent or cramdown. A Subchapter V plan is “fair and equitable” if the debtor commits all of its projected disposable income (or its value) to payments on the plan over its life. There’s no absolute priority rule, and the business owners can retain their interest, even if creditors are not fully paid. The debt limitation, the more stringent time period and absence of judicial precedent make Subchapter V, potentially, less flexible and more uncertain. If you are a small business and you may be a Subchapter V candidate, then you have even less time, as your status conference will be within 60 days of filing, your plan is due within 90 days, so you need to get your homework done before you file.
Orderly Liquidation
Generally, a business in Chapter 7 will cease to operate. A Chapter 7 trustee will take over any non-exempt assets, liquidate them and disburse proceeds to creditors according to the priority rules under the Bankruptcy Code. There is no plan for reorganization, but rather the orderly liquidation of the business. Chapter 7 is chosen when there is no potential for a viable business going forward, there are no valuable assets to reorganize, or where management has determined reorganization is not economically feasible. Equity holders are last in line for claims, so small business owners are likely to receive nothing.
A business entity does not receive a discharge in Chapter 7. Unpaid debts can still be collected from individuals who provided personal guarantees on the debts. Unpaid trust fund taxes and debts obtained through fraud are also the responsibility of the individuals involved. The company is controlled by the trustee and the trustee will act in the best interests of unsecured creditors. The business entity will cease to exist post-liquidation.
So when should you make the call? The time to hire a lawyer isn’t after the decision is made, but before. The decision, not surprisingly, determines what you do in the bankruptcy (chapter 11, Subchapter V, or Chapter 7), and all of those cases have very different deadlines, requirements, and pitfalls. If your company is a good one that is suffering from too much debt, or where a lease or piece of equipment is squeezing you too tightly, you might consider Chapter 11. It’s complicated and, depending on the situation, could last years, so you need to start planning. Even if you decide that there is no way your business can survive, you still should talk to a lawyer before filing Chapter 7. No discharge will be granted for the company. If you signed a personal guarantee or are responsible for trust fund taxes, you will be on the hook. Usually, the more you wait, the fewer choices you have.
