When a business can no longer pay its bills, the owner has two broad choices: file for bankruptcy or try to settle the debts outside of court. Which option is better depends on the situation, but let’s start with some basics.
Private Settlement
In our experience, an agreement reached outside of court is almost always the better result, for the business and for its creditors alike. The single biggest advantage is flexibility. You can design a settlement to meet the needs of both parties, something the bankruptcy court often can’t do. In a negotiated deal, the only parties who get to decide what the outcome will look like are the debtor and the creditors. No judges or juries weigh in, and nobody needs a bankruptcy judge to sign off. Next, think about the cost of the process. A private agreement generally involves much lower fees than bankruptcy, which often includes filing fees, attorneys fees, accountants fees, and various other fees.
The process is also much less formal. You don’t have to worry about jumping through a series of procedural hoops and requirements. A workout need not satisfy the rigorous notice and court hearing requirements of the Bankruptcy Code. Unless the company is publicly-traded or the owner is well-known in the community, the workout agreement is unlikely to be broadcast and there is no legal obligation to disclose it. Additionally, a bankruptcy creates a public record of the business’ financial difficulties, whereas a private settlement is much more discreet.
Nobody is looking over your shoulder, either. Outside of bankruptcy, the owner is in control of the business and its operations. There are no public hearings. There are no court-appointed monitors. The business can pay debts with cash, it can sell assets, it can hire consultants and advisors, and none of this needs to be cleared with the bankruptcy court or other creditors. In addition, the process can be much faster. When a deal is possible, it can be done in much less time than a bankruptcy case.
Settlement does have real drawbacks, though. There is no “automatic stay” to stop lawsuits, garnishments, foreclosure and repossession. Collecting the debt continues unabated outside of bankruptcy. Because creditors may continue to collect while you are in negotiations, you should try to get a forbearance agreement that stops collection while negotiations are pending. It buys time to get a deal done.
Another consideration is that creditors cannot be forced to agree to an out-of-court deal. One might hold out for a better deal than the others. If one or two creditors refuse to reduce, you may need a bankruptcy because all similarly situated creditors must be treated alike. If a majority of creditors are satisfied with your offer, you may not need to file bankruptcy, or if you do, your Chapter 11 plan can be built on the workout agreement.
So while settlement is usually the better path, there are exceptions. The most important thing bankruptcy offers is a judge watching over the process. Yes, that costs extra time and money. But it can help creditors trust a deal that might otherwise be rejected because of bad blood between parties, lack of sufficient trust, a single bad apple creditor, or a refusal to negotiate at all. Bankruptcy puts the debtor and other creditors under the supervision of the court. The Bankruptcy Code provides protections from particular creditors or other “bad apples,” who might prefer to get paid in full, or who might want to exercise unfair leverage to squeeze the business. For that reason, creditors often prefer a workout done under the Code. Most businesses use Chapter 11; Chapter 12 serves certain farm operations and Chapter 13 serves individuals.
Bankruptcy judges also tend to be friendly to debtors who act in good faith. So if it looks like you are the good guy at the table, you will probably get the judge’s support. The Bankruptcy Code gives honest but unfortunate debtors a “fresh start”. Then there is the automatic stay. The moment the petition is filed, automatic stay provisions take effect. This immediately places a moratorium on any action against the debtor. All creditor actions are suspended. Once a person files, the law says that creditors are not allowed to “go after” (take) the person’s things without getting the court’s approval. The Code and Rules are also the judges’ rule book for deciding whether the creditors’ claims are legitimate, who gets paid first, and how long the process will take, and provide a place where the debtor can propose and get approved a “plan” to pay back a portion of the debt.
Just as important, the court can change the debts themselves. A bankruptcy judge will generally back a good faith effort to reorganize, and creditors know it. That’s why they settle more readily. The idea is that if the debtor meets the Code’s requirements for reorganization, and creditors will get at least what they would get in a liquidation, the court will approve the plan over creditor objections. Once the plan is confirmed, all other debt is discharged. Bankruptcy also buys time. The debtor is the only party that can propose a plan in the first 120 to 180 days after filing. If the debtor can’t make payments under a Chapter 11 plan, it can convert to a Chapter 7 liquidation. With luck, bankruptcy can buy the company enough time to make money instead of spending it.
None of this comes cheap, however. The biggest negative of a bankruptcy is its cost. The filing fee and attorneys’ fees have to come out of the estate. The debtor’s financial records become public. In a Chapter 11 reorganization, the debtor must take on debtor-in-possession responsibilities while continuing to run its business, and many of its actions require court approval.
The Business Can Survive
Whichever road you choose, one thing does not change: you have to show that the business can survive. You must convince the judge or the creditor that, in time, it will generate enough cash flow to pay its debts. This could mean new business, getting receivables brought current, a payment by a guarantor, a new lender or an equity infusion from new or existing shareholders. Work this out with a turnaround consultant or accountant before you propose the workout. If your projections don’t prove the business will survive, the likelihood is that you will end up liquidating in Chapter 7.
The bottom line is that, in most cases, it is better to settle your business debts outside of bankruptcy. You can do a better job designing a deal that suits both sides, and you can do it with less expense and delay. If no deal is possible, however, or if one or two creditors refuse to budge, then bankruptcy provides the judge, credibility, and protection that can make a difference. Either way, talk to an attorney with experience in both workouts and bankruptcy before you decide.
