When a business creditor starts threatening to sue, it typically means that your creditor wants to collect payment and is trying to put pressure on you to comply. It’s almost certainly not a good idea to ignore it - but you also don’t need to panic. Right now, many middle-market businesses are feeling a squeeze. Pandemic-era government incentives are drying up, interest rates are rising, and consumer demand for some products is falling. Bankruptcy filings are way up - first-half 2023 Chapter 11 reorganizations were reportedly up 68 percent and small business filings 55 percent - and the businesses that got hit the hardest are those that counted on easy cash and low interest rates, or that had been struggling even before the pandemic.
When a creditor threatens to sue, don’t just worry about that one; instead, take a step back and take a look at the big picture. You may be able to restructure the debt or refinance it, or you may need to sell the business, bring in a partner or liquidate in state court, or file for bankruptcy. It depends on whether the business can continue on.
“I’m going to sue you if you don’t pay” is not a threat you should take lightly, especially if it comes from a receipt funder. Desperate small businesses sometimes take terrible deals from receipt funders. These lenders charge sky-high interest rates and take assignment of the company’s accounts receivable as collateral. Many of the businesses can’t pay the money back and end up seeking state court dissolution or bankruptcy to get out from underneath. This is exactly the kind of lender a small business doesn’t need and probably cannot repay.
Alternatives to Bankruptcy
When a creditor threatens a lawsuit, a business owner’s first thought may be to file bankruptcy. Bankruptcy is a pretty extreme and an expensive step. But bankruptcy is the last and certainly not the first resort. Before getting a lawyer to file the paperwork, think about restructuring the debt, refinancing, or selling the business outright or finding a partner. Restructuring the debt or refinancing can keep the business alive. Selling the business or finding a partner bring in someone else’s money.
It also matters whether the creditor holds a lien. A secured creditor - typically a lender - can sometimes force the business owner’s hand by filing a foreclosure action in state court. Often a receiver is appointed to oversee the liquidation. The receiver will market and sell off the company’s assets free and clear of all liens, possibly even at going-concern value, to pay off the creditors. It can sometimes fetch a better price than a bankruptcy sale.
A struggling business owner may just want to cut their losses, pay their debts and close up shop. In that case, you may find the state courts offer you your best alternative. There are two debtor-driven alternatives to bankruptcy: the assignment for the benefit of creditors (ABC), and the orderly liquidation. In an ABC, the assets of the business are assigned to a designated assignee, who is overseen by a state court and authorized to market and sell the assets for the benefit of the creditors. With an orderly liquidation, the company dissolves either voluntarily or by court order, and then the assets are sold as part of the wind-up, which is court approved. The business may continue to operate during the wind-up, which may take several years depending on the complexity of the business and whether or not it can be sold “turnkey.”
As your cash situation deteriorates, you get pressure to give to the supplier yelling the loudest. While you’re dealing with that, creditors start filing lawsuits. So why would anyone facing that file for bankruptcy? The short answer: there are some things that bankruptcy can do and state court liquidation can’t. One of the key components of bankruptcy protection is the automatic stay, which means that all debts will be put on hold. That means none of your creditors can grab your assets, and it means they can’t continue their lawsuit. A state court injunction might restrain the parties in that case, but enforcement may be harder against out-of-state entities, whereas the automatic stay is enforceable by a federal judge anywhere in the country. Once in bankruptcy, you can call off the dogs.
Chapter 11 can be extremely expensive. For businesses that can afford the professional fees, though, it provides an opportunity to reorganize and continue operating. Often, a Chapter 11 will allow a company to stay in business through a five-year payment plan to reorganize. In contrast, when a company files Chapter 7, there is no discharge of the business entity. At the end of the case the company still exists, and there are extra costs to properly close it. That last point surprises a lot of owners. They think when they file bankruptcy, their business goes away and that’s the end of it. They don’t realize that they’ve gone through all the cost and trouble of filing for bankruptcy and their business still exists. They may have to go through more court proceedings and legal work to close the company.
Professional Guidance
A threat of lawsuit looks and feels like an emergency, and that’s when you should slow down. Whether you file for bankruptcy, let the state court liquidate you, assign your business for the benefit of creditors or try to restructure, there’s a cost and a trade-off in each option. And remember: the worst thing a business can do is panic and move too fast. Before you sign on the dotted line for a subprime loan, or at the first sign that a lawsuit might be coming your way, consider getting some professional guidance about better alternatives. Some lawyers specialize in workout situations, bankruptcy, and state court options, and financial advisers and CPAs can also help you analyze what else you can do before you make a decision that may make things worse for your already challenged business.
