Light at the End of the Tunnel - Often, Bankruptcy Isn't the End, but the Beginning - of a Turnaround

August 25, 2003

Jhd
Bankruptcy is a term that carries many negative connotations. Indeed, society often reacts to both personal and corporate bankruptcy as a sign of failure or ineptitude. That’s why companies and individuals will try to avoid it all costs.

But while most business owners and creditors do not like thinking about the possibility of having to deal with a bankruptcy, in some instances, filing bankruptcy can actually provide the best possible financial outcome for everyone involved.

Generally, bankruptcy is a company’s last resort, and only thought about when large amounts of debt prevent the business from meeting its basic operating expenses. In some instances, a business may even be concerned about being able to make payroll for the following week. In these tough economic times, sometimes businesses need help dealing with mounting debt and slowing sales.

In situations like these, bankruptcy may provide a struggling business with the resources to turn things around and eventually operate profitably again. In addition, although creditors are often fearful of businesses filing bankruptcy, in many instances, a reorganization bankruptcy will provide creditors with a means of repayment, which is better than receiving next to nothing if the business simply closes its doors.

If a business does decide to file bankruptcy, the federal bankruptcy laws ultimately determine how companies recover from overwhelming debt, or, in the alternative, the procedures that must be followed if a business liquidates its assets. While there are technically five different types of possible bankruptcy filings, most business-related filers will chose between either a Chapter 11 or Chapter 7 bankruptcy.

Under a Chapter 7 bankruptcy, a company ceases operations and completely goes out of business. A trustee is appointed by the bankruptcy court to liquidate all of the company's assets, and the funds produced by the liquidation are used to pay creditors. Unfortunately, unsecured creditors in a Chapter 7 bankruptcy often receive only a small portion, if any, of the money they are owed. This is due to the fact that a business filing a Chapter 7 bankruptcy often has more debt than it does assets. A decision to file a Chapter 7 bankruptcy is usually made when the owner has completely given up on the possibility of any type of rebound, and wants to walk away from the business venture altogether.

On the other hand, most business owners have made tremendous investments in their business in the form of time, energy, and, of course, money. Naturally, they do not want to have the business terminate due to outstanding debt.

In this situation, a company may be better off filing a Chapter 11 bankruptcy and attempting to reorganize its business, in an effort to become profitable again. The hope in filing a Chapter 11 bankruptcy is that an ongoing business has a greater value to the parties involved, when compared to a business that is foreclosed upon and forced to file a Chapter 7 bankruptcy.

After a successful Chapter 11, the hope is that a business can come out of the process with a restructured debt load and operate more efficiently than before. In doing so, the company can then pay its debts, preserve jobs and assets, and hopefully become profitable.

Potential bankruptcy filers need to realize that, by seeking the court’s assistance in reorganization, they are opening up all aspects of their business to the court’s review. Although the business will enjoy some immediate benefits, it may also lose some of the management independence enjoyed before the bankruptcy filing.

In most cases, the filing of a Chaper11 bankruptcy will provide the financially strapped business owner with several immediate Band-aids. First, the filing of the Chapter 11 petition invokes an instant injunction (known as an ‘automatic stay’), which prohibits creditors from trying to collect or foreclose on the business’s pre-petition debts. The automatic stay will stop collection letters and phone calls, foreclosures, seizures, and most collection litigation. At the outset of the Chapter 11 bankruptcy, the company does not have to make payments on most pre-petition debts.

The halting of collection activities and the ability to suspend many payments to creditors allow the company to ‘take a breath’ and begin thinking about its reorganization and debt structure. In addition, another benefit of a Chapter 11 bankruptcy is that, in most cases, the company is permitted to maintain existing management and can continue to run its day-to-day business operations. Despite this fact, significant business decisions may require bankruptcy court approval. If creditors, and ultimately the court, are not satisfied with the competency of the administration, it is possible that the court could also install new management.

In most cases, the ultimate goal of a Chapter 11 bankruptcy filing is to create a plan of reorganization that allows the business to restructure its debt and eventually emerge as a viable company. The plan proposes a repayment schedule for creditors based on the corporation’s expected future expenses and income. Under some circumstances, the business can also get out from under certain burdensome contracts and leases, thus freeing up additional capital. The business makes payments into the plan for the benefit of creditors from future profits or acquisitions.

Unsecured creditors also have certain rights when a business files a Chapter 11 bankruptcy. For example, the U.S. Department of Justice employs a trustee who creates one or more committees made up of creditors to work with the company in formulating a plan of reorganization. The bankruptcy court must approve the plan before it can be implemented. These committees give creditors a voice in the bankruptcy proceedings and ultimately allow them the opportunity to negotiate debt repayment terms with the business.

After the committees work with the business to develop a plan, the bankruptcy court must find that it legally complies with the Bankruptcy Code before the plan can be implemented. This process is known as plan confirmation and can take anywhere from a few months to a year or more to complete.

It is never easy for a business to decide to file for bankruptcy protection; however, when a business has hit a dry spell and must make a decision to either close its doors forever or try and stay afloat, there may not be any other options available.

Ideally, Chapter 11 bankruptcies keep businesses open in tough times, keep people employed, and allow an owner to correct poor management or bad business decisions that have caused the business to incur substantial losses or excessive debt. In addition, a creditor of a business in bankruptcy is able to keep an eye on how the business is operating financially, and hopefully will have a say in negotiating debt repayment terms as part of the plan approval process.

Hopefully, the business and creditor come out of Chapter 11 in a better position than they would have been in had bankruptcy not been filed.

Justin H. Dion, Esquire, is an associate with Bacon & Wilson, P.C. He is a multi-faceted practitioner who specializes in personal and business insolvency. He can be reached at 413-781-0560 or jdion@bacon-wilson.com

by: Justin H. Dion, Esquire

BusinessWest
August 2003