If you’re the owner of a business and you’re behind on a business loan, a great place to start is by understanding a very important distinction between a business default and bankruptcy. Most business owners are very confused by this distinction, and will benefit immensely from clarity on this point. The key difference? Bankruptcy is an act of choice, while defaulting is an action forced upon you. Filing for bankruptcy puts you in control, giving you a chance to reorganize, while defaulting gives the lender power to repossess what they have loaned to you, potentially following that repossession with a deficiency judgement. The clearest way to see how that plays out is with a loan backed by the Small Business Administration.
The SBA is a federal agency, and in most cases it does not hand you the money itself. The SBA makes a guarantee to the bank that provides the loan, paying up to 85 percent of the original loan balance if the borrower fails to pay. The SBA only makes direct loans in limited circumstances, under an Economic Injury Disaster Loan or Physical Disaster Loan, and even then it has to determine that the business cannot get credit elsewhere. (During the pandemic, the SBA did have a direct EIDL loan program, but it stopped accepting new applications in January 2022.) For a guaranteed loan, the bank is your lender. So the issue of a default on your SBA-backed loan is a matter between your business and your lender.
Talk About a Workout
A lender usually places a loan in default when you miss 120 days of payments. If you miss a couple of payments, the loan is simply delinquent and not yet in default. The lender will usually give you a chance to catch up. The lender most likely does not want to declare a default because it would prefer to have you repay the loan. But the 120-day wait also gives you a chance to rework your cash flow and talk about a workout, so this is the time to be proactive.
The usual options are a deferment, a restructuring or an offer in compromise. You can go on a deferment (forbearance) if you can show that a temporary pause in payments, generally no more than six months, will improve your cash flow enough to resume payments. A restructuring changes the terms of the loan, typically by extending the term of the loan or by reducing the interest rate. In an offer in compromise the borrower offers to pay a certain amount now, and the lender agrees to consider the loan paid. That requires giving the lender detailed financials from the borrower and all guarantors. The offer is usually a lump sum, and any collateral has to be liquidated as well.
The Loan Goes into Formal Default
If none of that works, the loan goes into formal default. If the loan comes from a local lender, the process of default usually starts with a letter. It declares the loan in default and demands immediate repayment of the entire amount. Depending on the terms, the lender must give you a certain amount of time - usually between 30 and 45 days - to pay in full. Then the lender can seize whatever property you used as collateral. That could be your business accounts, accounts receivable, real estate, equipment, inventory, and more. Collateral seizures, like home foreclosures, may end up in court. Any amount not paid off in a sale may be subject to litigation to recover the remaining balance. Judgments in New York are valid for up to 20 years. They can also be used to put a lien on other real estate you own. At this point most local lenders recover the portion of the balance that is insured by the SBA and turn the remainder of the debt over to the SBA.
If the SBA loan was made directly, the process is similar, but the SBA has more leverage than local banks. First, the SBA will force you to liquidate the collateral and turn over the proceeds. Then, if there’s still a balance, the SBA may consider your offer in compromise, a program that allows financially distressed borrowers to settle debts for less than the amount owed. You have to show that your business is shut down and liquidated, and that your own finances are in a bad way. This is a very difficult process.
If the offer in compromise fails, the SBA can send your debt to the Treasury Offset Program. The government is authorized to intercept a portion of federal wages or Social Security payments that are payable to the borrower. They can even go after any payments coming from vendors or your income tax refund, and those can be taken in full. The SBA may also issue an Administrative Wage Garnishment notice to your employer. Administrative Wage Garnishment can withhold up to 15% of your disposable income, or your pay after deductions. Local lenders and the SBA have six years from the date of default to sue to collect. There is no statute of limitations for the Treasury Offset Program or Administrative Wage Garnishment. Either can start after 6 years, and stay in place until the debt is paid, including interest and collection costs.
Where Bankruptcy Comes In
That is where bankruptcy comes in. There’s bankruptcy for the business, and bankruptcy for you as guarantor. You can reorganize your operations, get out of default and keep your doors open. Or, if the business is shut down and you can’t pay, you can wipe out the debt. Bankruptcy stops all collection activity including Treasury Offset and garnishment. Please note that while bankruptcy may be very effective in addressing the defaulted loan, it has many consequences, both positive and negative. So, any decisions about bankruptcy must be made very carefully.
As you can see, the outcome of a defaulted SBA loan depends a lot on your strategy and timing. If you are knowledgeable about your options and execute a plan, there is a chance for a positive outcome. Remember that you don’t need to have a default on file before you can start taking steps to save the loan. And when you are ready to address these debts, you want to do it now, while negotiation is still on the table.
