Should my business file for Chapter 11 bankruptcy?

Some business owners buried in debt assume they’ve got to file Chapter 11. That is usually an unhelpful assumption. Bankruptcy is often not the only escape hatch. Before you commit to filing Chapter 11 to try to keep the doors open, weigh how the process can help, and what you will spend to go through it.

Chapter 11’s upside is it puts a brake on the barrage of bad news. Most filers are already being sued, or are facing the immediate likelihood of being sued. The lawsuits drain cash and can consume time on their own. Filing halts most pending litigation, and unsecured debts coming due before the case can often be put off while an exit plan is crafted. A timely bankruptcy petition will for the most part keep landlords, banks and equipment lenders from seizing most of the business’s assets. Even if they do get your property, you may have a way to make it yours again, and on any unsecured debt, the interest will stop once the case is filed. In chapter 11 a company can reject money-losing leases and contracts, so claims that survive the treatment are no better than unsecured debt. One instance this can help is your lease. If the rent is too high, you may be able to use Chapter 11 to give it back to the landlord. Even labor contracts can be reopened. Utilities, meanwhile, may have to keep you on. Utilities can even be made to restore service. Together, these measures give you a chance to breathe.

The downside: the price of admission is steep. Like any criminal defense lawyer, lawyers in bankruptcy usually want a big retainer upfront. After filing, money use gets strict. During bankruptcy money can usually only be spent as permitted by rules the court applies, and a lender whose rights reach the cash will want assurance they will get their money. In addition to your legal fees, the company usually must pay lawyers for the creditors’ committee, made up of unsecured creditors. There will be additional accounting and government fees, and loans inside a bankruptcy are usually more costly. Lending to a company in the midst of financial trouble is risky, and lenders add a fee for the risk. Historically about one in ten cases survive. Part of the blame is that many of those cases should never have been filed. Some businesses, however, by their natures do not lend themselves well to a prolonged, costly court-supervised reorganization.

Many of the ground rules governing business bankruptcy have their gray areas, which can give rise to disputes between creditors and the owners. While the owners usually run the daily operation, big decisions like asset sales must get the blessing of the judge and may take more time as a result. Creditors, even more than in most cases, weigh in on crucial decisions, imposing costly delays and, from the point of view of longtime managers, unpleasant impositions. Owners often built the company with their sweat, time and ideas. For them answering to creditors is frustrating, and hard to accept. And some of the benefits noted above may get challenged by the creditors, or may not exist at all. There can also be tax consequences, especially in chapter 11 reorganizations.

Three Types of Chapter 11 Cases

Chapter 11 is not one thing. Three types of Chapter 11 cases are possible. Usually in each type the people running the company stay in charge of day-to-day decisions. Each is still a bankruptcy, but what distinguishes them is the goal for the company at the end of the process.

First, the liquidating Chapter 11. In a liquidating case, managers concede that the business must be wound down. Assets would be sold to realize value, or they may be turned over to a secured lender whose lien exceeds the asset’s value. Owners who have all agreed that the end is nigh will sometimes file in Chapter 11 anyway. A case in the bankruptcy court stops most lawsuits and lets the owners sell in an orderly fashion. Instead of creditors suing one by one and grabbing assets piecemeal, the owners control the sale. Your lender, on the other hand, just wants to resolve your file and get to the next. The lender’s troubled-loan officer is already busy. Owners who put their own guarantees on the business’s debts often work harder to pay off the loans than a workout officer under pressure to close out the file. Ownership, however, owes a fiduciary duty to maximize values. Long ago bankruptcy courts recognized that not every Chapter 11 business should keep the lights on. Taking the business through bankruptcy to its final destination is not a failure. It is a legitimate use of the law.

The second kind of Chapter 11 has the business sell itself to a third party. These asset sales have one main advantage: buyer gets legal protections that new investors do not get outside bankruptcy. Bankruptcy can ease the buyer’s concerns about what comes with their purchase by giving the business’s assets a fresh slate, free of some old claims. A prearranged asset sale may appeal to buyers’ lawyers, who have a tendency to prefer clean over messy. Creditors left out of the prearranged deal are going to have something to say. The court will have to hear all parties out. Approval can be hard to win. A prospective buyer, in turn, might seek the former owners’ services, their know-how and a promise not to compete. When owners expect to be paid for their knowhow, a non-compete or for providing outside services, the value can be difficult to predict. Where the business loses money during the sale process, that creates its own problems.

But for a business with strong value, even distressed, as a going concern, a true Chapter 11 reorganization can work. The company can shed the assets that are dragging it down, or the locations or other obligations. The plan projects both profit and payments to creditors. Getting the courts to approve the plan, however, is not always easy. Owners may have to add more cash, or bring in investors. In the end, the capital raised from owners or new investors can make or break your plan. That money is often key to persuading creditors and the judge to approve the Chapter 11 plan.

Chapter 11 Reorganizations Are Not for Every Business

For a specific type of business Chapter 11’s odds are usually poor. For these businesses, filing can accelerate failure instead of reviving it. So how do you know if that is you?

One sign is that spending cash can be a real problem. Owners probably have no spare change. With a blanket lien, lenders don’t usually agree to continued use of cash. Chapter 11 financing exists, but at punishing rates. All these obstacles can sometimes be overcome, but doing so will demand a lot of planning, a lot of know-how, and probably more money.

If fraud, repeated misrepresentation or gross mismanagement is involved, don’t be surprised if the judge appoints a trustee to replace the owners. Fearing personal liability, these hired bosses generally try to shut it down. Once a trustee takes over it means the business is no longer yours.

Not insuring assets or not paying new debts once the case has started almost always brings trustee liquidation; likewise, sales or payroll taxes after filing cannot wait. While the business case goes on, debt accumulated before the case started can stay unpaid for the time being, but ongoing bills and any new taxes must be paid as they come due.

The final warning sign in a Chapter 11 case: the business keeps losing money even after you file. Of all the signs, your business continuing to lose money is the most glaring indication your case cannot succeed.

A better way of looking at it is this: what kind of business does Chapter 11 help?

The first candidate is a company that has been profitable historically but that is derailed by an uninsured loss.

The next candidate is a once-profitable business badly crippled when a major customer becomes insolvent.

The next type of Chapter 11 case that might work has mostly good management decisions in its track record, with one exception.

Another business ripe for Chapter 11 is one short of cash, but with assets that are worth more than its liabilities.

Yet another candidate for Chapter 11 reorganization is a business that has misjudged the market or the economy, overexpanded and paid with borrowed money. The downsized company should be able to stand on its own, but the smaller business may not carry the debt load of its bigger predecessor.

One more Chapter 11 candidate is a business with a sale of itself already in the works, but the price won’t cover all its debts.

Finally, some businesses have assets so specialized that the owners are the natural people to handle liquidation.

These lists are incomplete and rough. Each business is unique. Other factors are important. Cases that would seem to be doomed sometimes survive. Further, in each particular business success is never assured and even the most promising cases can sometimes fail. But these observations are for what they are intended: an introduction to the topic.

Emergency Bankruptcy Filing

One unusual feature of emergency bankruptcy filing is that you can file within 24 to 48 hours, hiring a lawyer you have never seen. To file an emergency petition, only the barest of paperwork is required at first, with the rest due by a later deadline. Filing on the fly is surprisingly common. Sometimes the decision to file makes itself: the bank seized your business account, your landlord has changed the locks and the Sheriff is preparing to take your equipment. At that point it may be too late to devise a long-term strategy. You file simply to halt the erosion.

Sometimes waiting til the end is the right decision, but looking into other solutions beforehand will usually improve the company’s chances. One factor that plays for both sides of that equation: by choosing bankruptcy you have given up on settling out of court. The downsides of bankruptcy are real, so before filing explore a workout with the business’s creditors while that door is still open. Due to their past work experience, workout professionals can estimate the chances that the business can escape without declaring bankruptcy. One downside of waiting until the eleventh hour: a rushed petition means you may miss out on some advantages. Still, putting off talking to a professional may be a bigger mistake than whatever got your business in trouble.