Business – particularly small business – forms the backbone of the U.S. economy. According to the Small Business Association website, there are 28 million small businesses in this country, and they account for 54 percent of all sales and 55 percent of all jobs. There is no good definition for “small business” because this classification differs from industry to industry. However, all businesses face an unfortunate fact of life: most that start up must wind down sooner than later. Depending on the industry, at least one half of new businesses are unlikely to survive for five years. When a business begins to fail, it may look to protections that the Bankruptcy Code can provide. This often means looking at a Chapter 11 filing in an attempt to save the business, but this is a possibility exists mainly for one established as a separate legal entity, such as a corporation (including a Limited Liability Company) or legally formed partnership (including Limited Liability Partnerships).
A sole proprietor is in a different position. If the business or the individual files for bankruptcy, the individual or the business, respectively, also files. Chapter 11 generally is not available here. However, if the debtor wants the business to survive the bankruptcy, then a filing under Chapter 7 would not be helpful since a trustee will be appointed and will control the bankruptcy estate. The trustee is likely to shut down operations and liquidate assets in order to make payments to creditors.
When a debtor who is a sole proprietor wants business to continue in business after a bankruptcy filing, the individual should consider incorporation prior to filing or, possibly, a Chapter 13 case since the debtor generally would remain in possession of the business in a filing under Chapter 13. If there was an incorporation, then Chapter 11 again can be viewed as a possibility. This article will look at separate legal entities seeking to continue operating into the future. As with General Motors during the last decade, bankruptcy under Chapter 11 can succeed, but a small business that looks to protection under this chapter must understand what it is getting into and the likelihood of getting out of it successfully.
The general purpose for filing for bankruptcy under Chapter 11 is “reorganization.” This actually amounts to a plan for the repayment of debts while the entity continues in business. As an aside, Chapter 11 can be used by certain individuals when their amount of debt prevents them from filing under Chapter 13; however, this is the exception to the usual filing under Chapter 11. There also is Chapter 11 “liquidation” for a business, but this not the usual reason for a Chapter 11 filing so it will not be discussed here.
A business that continues to operate as it pursues bankruptcy under Chapter 11 is a “debtor-in-possession,” which essentially places it in the position that an appointed trustee usually occupies. The trustee is supposed to manage the bankruptcy estate and to sell off its assets in order to pay creditors when possible, but, with an ongoing business, its assets remain in the hands of the entity to provide an opportunity to continue operating. This also means that the business has fiduciary responsibilities and must act in the best interests of its creditors, which may be contrary to its own best interests.
While the business faces obstacles due to fiduciary responsibilities to creditors, Chapter 11 does give it various powers that can increase the chances of success. These include is ability to object to creditors’ claims, avoid liens, reject leases and contracts without penalty, extend the time to repay to current creditors and potentially reduce the amount owed to them.
Although having the potential to use these powers is beneficial, there also are realities that reduce the chance of emerging from Chapter 11 successfully. There tends to be more litigation involved in these bankruptcies – creditors suing the business, and vis-a-versa. Even if the litigation ends favorably, the cost to finance it can be considerable.
There are other practical problems when a business files under Chapter 11. It not only involves a time-consuming process (which could take years to resolve), but it also entails the likelihood of considerable costs beyond those already mentioned. As of February, 2016, the filing fee to begin the process is $1,717. However, there are additional costs that can be much higher. For example, attorney’s fees and related costs can begin in excess of $10,000 and may increase considerably depending on the case’s complexity and amount of work that is likely. Also, attorneys and any other professionals usually need to be paid prior to filing since any further payments require authorization by the Bankruptcy Court. There also are numerous administrative burdens along the way – there are reports that must be filed regularly with the Court as well as the Office of the United States Trustee, along with additional fees to be paid.
With so many difficulties facing a business that already is failing, one should not rush to file under Chapter 11. If there will be any chance of success, there must be significant planning in advance. Of course, this really applies to all bankruptcies – a successful outcome is unlikely when a debtor pushes to file right after meeting with the attorney. However, this is even more applicable to Chapter 11 filings, which have the additional financial burdens and administrative requirements that cannot be avoided. Therefore, anyone who would consider such a filing must plan well in advance of an attorney’s involvement in the case, producing as much relevant documentation as possible for the attorney to review before any decision is made.
With all of the requirements during the process itself, it must be remembered that the fundamental purpose here is to prepare a viable Plan of Reorganization that the Bankruptcy Court will confirm. This essentially becomes a contract with creditors, with details about how debts will be repaid as well as the source for payments. Before seeking court approval, creditors generally vote on the plan. They do so by particular creditor classes (secured, unsecured, etc.) that are established. If a creditor class does not approve the plan, the class members still may have to accept it, although this also may force the business to relinquish some assets as a result.
To improve the likelihood of a plan’s approval, a business should attempt to negotiate agreements with creditors for the payment of its debts. A skilled attorney who can craft a proposal that is acceptable to creditors and provides the business with an opportunity to attempt to move forward in a stronger, more stable position is essential.
In the end, all of these efforts may serve simply to forestall the inevitable – a business filing a Chapter 11 case may intend to continue operating after the bankruptcy, but most that file under Chapter 11 will not survive. This must be realized before filing, and other options must be reviewed, including filing a Chapter 7 case.
This is a quick primer on business reorganization under Chapter 11. Any entity that is considering this possibility needs to explore all of the details and implications involved before deciding to pursue this option.