The Financially Troubled Business
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A new business doesn’t come with a guarantee. Even with the best planning, there’s a possibility
that your business will go through hard times and maybe even fail. Many an
entrepreneur has weathered a number of shaky ventures before landing in a
business that proved solidly successful. So if your business becomes troubled,
or even if it needs to be put out of its misery, it shouldn’t be viewed as the
end of the world.
And, although it’s always unpleasant—and can be
heart-breaking—to have your business go bad, it’s important to understand that
there are many steps you can take to limit your losses so that you can get back
on your feet and move on to other, more productive ventures. Especially if
faced promptly, business troubles don’t have to be long-term financial
disasters.
A key economic preservation strategy is to protect your
personal assets from business debts to the greatest extent possible. How you
organize and run your business can make a decisive difference in whether you’re
able to do this. In addition, if your enterprise should find itself in
financial trouble, your day-to-day management decisions should be guided at
least in part by your knowledge of what legal and business actions can help or
hurt your personal situation. Finally, if your financial troubles become so
severe that you consider ending your business and maybe even declaring
bankruptcy, you’ll need to know exactly what legal options and protections are
available.
Copyright © 1999-2001 Nolo.com All Rights Reserved
A. Managing
the Financially Troubled Business
So far this chapter
has reviewed things small business owners can do in advance to limit potential
liability. Now let’s shift gears and assume your business is currently facing
financial problems. My focus here is to present several practical strategies
that will help legally protect both you and your personal assets.
1.
Keep
Taxes Current
Rule Number One for
the owner of any struggling business is to meticulously pay on time all taxes
withheld from employees’ paychecks. Even if you operate your business as a
corporation or LLC, the IRS and state tax authorities can hold you personally
liable for these taxes—plus penalties—if they’re not paid. And you’re still
legally on the hook to pay these taxes, even if the business goes bankrupt.
So if your business starts having financial problems,
stave off the other creditors as best you can—and use whatever cash is
available to take care of employment taxes. Paying these taxes is so crucial
that if your business is financially disorganized, you should pay for any
accounting help you need to be sure these taxes are computed accurately and
paid on time.
And remember that you don’t have to wait until the last
day to deposit employment taxes. It’s often wise to deposit the employment
taxes as soon as you know the figures so the money will be out of your bank
account and legitimately beyond the reach of any other creditor who is
attempting to collect a court judgment against your business.
Don’t pay employment
taxes with a charge card. If possible, use a check or cash to
pay employment taxes, since this means they’re really paid. By contrast, if you
use your personal charge card and can’t pay the bill later, you’ll continue to
be responsible to the charge card company for the amount you charged for
taxes—even if you go through personal bankruptcy. A discharge in bankruptcy
won’t cancel your personal liability for the portion of your credit card debt
that’s attributable to the tax payments.
2.
Don’t
Lie About Debts
When a business
starts to have financial troubles, its owner may frantically try to borrow more
money. Before doing this, think carefully about whether your business is really
likely to do better in the near future or if you’re only likely to compound
your debt problems. If you apply for a new loan or to consolidate old ones, be
forthright in disclosing the financial condition of your business. If you
misrepresent your debts to get a loan, you may not be able to get rid of your
personal liability for the debt—even if you go through bankruptcy—because the
law will regard your new debt as being obtained by fraud. Where big bucks are
involved, the debt could haunt you for many years.
The key to avoiding trouble with lenders is to be very careful
that all facts appear—and appear accurately—on any financial statement you give
a potential creditor. Even if you borrow money or have credit extended to you
without having to fill out a financial statement, it can be treated as fraud if
you knew that the business was having financial trouble and didn’t make all the
facts clear to your creditor.
Don’t rely on
shortcuts suggested by the lender’s agent. Some finance
company employees have been known to deliberately tell people—orally, of course—that
they don’t need to list all their debts. Often this is done because the person
in the finance company office is under pressure to make loans and therefore has
a motive to bend the rules to qualify you. Don’t fall for this. If you later
default on the loan and the company claims you obtained the money by
fraudulently withholding information about your finances, chances are the
employee will either be long gone or will say, “Of course I didn’t say to
deliberately omit debts.” Either way, chances are you’ll be unable to discharge
the “fraudulent” debt in bankruptcy.
Also, be aware that the bankruptcy laws take a broad view
of what constitutes fraud. Not disclosing negative financial information may be
considered fraudulent even if you acted with the best of intentions.
Example: Jimmy, a sole proprietor, owns a
secondhand furniture store. One day, the landlord raises the store rent by 50%.
Based on past performance, Jimmy knows that with the rent increase, he’ll have
difficulty making a profit. Nevertheless, he decides to stay at that location
because it would cost even more money to move elsewhere. At this time, he has a
line of credit for $25,000 with a local bank of which only $10,000 has been
used. A month later, already feeling the sting of the higher rent, he draws
against the additional $15,000 and uses it to keep afloat. Because Jimmy
neglected to tell the bank about the significant rent increase that put his
business in a precarious financial condition, the additional draws can be
considered to be a fraudulent use of credit and may well not be discharged in
bankruptcy. If the bank sues Jimmy in bankruptcy court after he’s gone through
bankruptcy, Jimmy may still be liable for the $15,000.
This doesn’t mean that drawing on a line of credit to meet
the ordinary ebb and flow of business constitutes fraud. It doesn’t. After all,
the bank expects that you’ll use your line of credit to cover leaner times. But
you do need to disclose significant changes in your business such as a lawsuit
or the bankruptcy of your largest customer that threatens the financial
well-being of your business.
3.
Be
Careful About Transferring Business Property
Occasionally, out of
desperation, a business owner will consider trying to protect personal assets
by hiding them. Since creditors are used to ferreting out such tactics, by and
large they prove ineffective and are likely to give rise to civil and perhaps
even criminal charges of fraud. Specifically, a business owner shouldn’t:
• transfer assets to friends or relatives in any
effort to hide them from creditors or from the bankruptcy court, or
• conceal property or income from a court.
4.
Avoid
Preferential Payments to Creditors
The Bankruptcy Code
frowns on your preferring certain creditors over others by making what are
called “preferential payments.” If you file for bankruptcy, all payments you
make during the year before the filing will be scrutinized by creditors to make
sure that some creditors weren’t given an unfair advantage by being paid while
others received little or nothing. If you did improperly single out some
creditors for more favorable treatment by paying money or transferring property
to them, the bankruptcy judge can order those creditors to return the money or
property so it can be added to the total (called your bankruptcy estate)
available to all of your creditors.
Fortunately, most payments you make as part of your
business’s ordinary operations won’t be considered to be illegal preferences
should you declare bankruptcy. Here’s a brief overview of the types of payments
that are safe and those likely to cause problems.
• Payments in the Ordinary Course of Business.
Neither you nor the payee has to worry about the payments you make in the
ordinary course of business. These payments are considered to be safe and won’t
be undone—even if you made them the day before you filed for bankruptcy.
Examples of payments you can safely make include:
– utilities
– rent
– payroll deposits
– retirement plan contributions
– insurance premiums
– payments to suppliers whom you pay on delivery
or with 30 to 60 day terms, and
– salaries—as long as they’re kept at the same
level you’ve been paying right along.
• Payments to Family Members or Insiders. If you
repay money or transfer property to a family member or insider and then you
file for bankruptcy within one year after the payment or transfer, the family
member or insider will probably have to return the money or property to the
bankruptcy court so it can be divided among your creditors. (An insider is
someone who’s in or close to your business such as a partner, a corporate
director or a corporate officer.)
• Payments to Other Creditors. When you repay
money or transfer property to someone who’s neither a relative nor an insider
and the payment isn’t in the ordinary course of business, the 90 days before
you file for bankruptcy are crucial. (Example: Paying off a bank loan that’s
not due for six months.) If you make such payments or transfers of property
during the 90-day period, the recipient may have to return the money or
property to the bankruptcy court to be added to the pool of funds available to
your creditors.
5.
Protect
Your Bank Account
If you face serious
financial problems and owe money to a bank, it’s often wise to keep most of
your checking and other accounts elsewhere. This is because typically your loan
agreement gives the bank the right to take your funds without prior notice if the
bank thinks you’re in financial trouble. (This is called a setoff.) To put it
mildly, it can be a rude surprise to learn that your favorite lender has
suddenly drained your account.
6.
Plan
for Ongoing Insurance Coverage
If your business
winds up in a Chapter 11 or Chapter 13 reorganization under the Bankruptcy
Code, you may have a tough time finding a carrier that’s willing to renew your business
coverage or one that’s willing to issue a new policy. So if you’re planning to
seek protection under either of those bankruptcy sections, make sure you have
insurance in place that extends at least 12 months into the future. You’ll need
to make payments on the policy as payments become due, but as long as you pay
on time, the insurance can’t be canceled and you’ll enjoy some peace of mind as
you continue in business.
7.
Don’t
Panic About Utilities or Your Lease
If you declare
bankruptcy, the utility companies can’t use your filing as an excuse for
shutting off services—although they can require you to post a reasonable
deposit if you want to keep the lights, phone service and heat.
Similarly, as long as you continue to pay your rent, your
landlord can’t kick you out. Don’t be spooked by the scary clause commonly
placed in commercial leases that says you’re automatically in default if you
file for bankruptcy. You can’t believe everything you read. These clauses are
not enforceable.
8.
Consider
Returning Some Leased Property
If you’re leasing
equipment and know you won’t want to retain it after you file for bankruptcy,
consider giving it back to the leasing company before you file. If you do so
and the equipment is currently worth less than what you owe under the lease,
the deficiency will get discharged in bankruptcy.
On the other hand, if you prefer to keep the leased
property, you’ll need to continue making your lease payments on time. When you
choose to hang onto leased property, the obligation to make lease payments
isn’t discharged by your going through bankruptcy.
Copyright
© 1999-2001 Nolo.com All Rights Reserved
B. Selling
or Closing the Business
Although selling
your financially troubled business may seem like a long shot, it’s always worth
a try. Naturally, you won’t get top dollar for your business when it’s in
distress—but if you arrange a sale, it may give you enough to pay creditors and
come away with a few bucks. Selling an operating business, even one that’s in
trouble, almost always brings more money than closing it down and selling off
the assets.
Before you give up and conclude that no one will buy your
business, consider that people buy businesses—even those with financial
problems—for all sorts of reasons, including:
• The buyer may have lower personal financial
needs and expectations and may be willing to squeak by on a modest return
that’s wholly unacceptable to you.
• The buyer may have a similar business and by
combining the two operate more efficiently than you can.
• The buyer may be extremely anxious to take
over one or more of your business assets—its location, key employees or name.
• The buyer may have better access to needed
financing than you do and therefore be able to stay the course until your good
business idea ultimately proves itself.
• The buyer may have greater expertise in your
business than you do and see a way to turn a profit by changing how the
business is run.
• The buyer may conclude that it’s cheaper to
buy your business and turn it around than to start a similar business from
scratch.
Value is in the eye
of the beholder.
Even if you believe it is an
illusion, the fact that the buyer merely thinks that he or she has greater
expertise than you do or that the business has unrecognized potential may be
enough to produce a purchase offer. Don’t let your ego get in the way of making
the deal by defending your business decisions and strategy so forcefully that
you talk the potential purchaser into withdrawing his or her offer.
If you have an opportunity to sell your business but the
proceeds of the sale won’t yield enough money to pay off all the business debts,
look carefully at what remaining debts you’ll be personally responsible for and
what personal assets have been pledged as security for the business debts.
Merely selling the business won’t be enough to relieve you from your personal
liability to creditors or the risk that creditors may take property that you’ve
pledged as security. To reduce or eliminate your personal liability or the
danger of losing pledged property, there are some solutions worth looking into.
On debts for which you’re personally liable, see if the bank or other creditor
is willing to substitute the purchaser of your business on the indebtedness and
release. The creditor may be willing to do this if the person buying your
business is financially stronger than you are or, in the case of a currently
unsecured debt, is willing to pledge security. A buyer who’s enthusiastic about
the prospects of the business may be willing to be substituted for you.
If the creditor won’t let you off the hook, another way of
dealing with unsecured debts that you’ll be personally liable for is to ask the
buyer to agree in writing to pay the specified debts and to indemnify and save
you harmless from those obligations. This means that if the bank or other
creditor comes after you because the debt isn’t paid, the buyer guarantees to
pay the debt and protect you from any liability. Of course, this kind of
guarantee is only as good as the buyer’s financial condition, so you won’t want
to rely on such a guarantee if you have any reason to believe the buyer is financially
shaky.
Where you’ve secured a business debt by pledging your
personal property as collateral—for example, your home, car or stocks—see if
the creditor is willing to release your property as security if the buyer
substitutes property of equal or greater value. The buyer, for example, may
have as much or more equity in his or her home than you do in yours and the
bank may be willing to substitute that home as security in place of yours, if
the buyer consents.
So much for selling your financially troubled business. If
you can’t sell it, consider closing it down. Even if you can’t pay all your
debts immediately, this option at least allows you to avoid running up more. In
addition, you’ll normally want to negotiate with your creditors to pay them off
for less than the full amount the business owes. Why should creditors accept
this? It’s often a better choice than either of their other options: suing you
and chasing down your assets to collect every last dollar or taking what’s
available in a bankruptcy liquidation. Trying this approach can be particularly
sensible, too, if you have a corporation or LLC and have personally guaranteed
some business debts. If you can reach a negotiated settlement, you’ll not only
avoid a business bankruptcy but also you won’t have to go through personal
bankruptcy to get out from under the debts you’ve guaranteed.
If you haven’t personally guaranteed any debts of the
corporation or LLC, one option is to simply close the business and pay the
debts on a prorata basis to the extent the business has funds. Then, let the
corporation or LLC die on its own. Since any remaining debts aren’t your
personal responsibility, this should, in theory at least, end matters.
Sometimes, however, you may want to consider having the business file for
bankruptcy in this situation. If the corporation or LLC hasn’t gone through
bankruptcy, some creditors may go ahead and sue the business and get judgments
against it. If that happens, you may be subpoenaed and have to go to court to
explain that the business used up all its assets. That can be a nuisance. So if
you have a number of creditors who are likely to pursue you to the bitter end,
putting the business through bankruptcy may make sense since it will save you
from having to testify in multiple lawsuits. Creditors, of course, lose their
right to sue once the corporation or LLC is bankrupt.
Watch out for
preferential treatment.
If at first you decide simply to close down your business but later
decide to file for bankruptcy, you may have backed into trouble. If your
business eventually has to file for bankruptcy, giving preferential treatment
to some creditors in the months before you file by paying off all or part of
their bills can create a problem. Creditors who didn’t receive preferential
treatment may complain, in which case the favored creditors will have to return
the money or property they received so it can part of an asset pool available
for equitable distribution among all creditors. So even if you hope not to file
for bankruptcy, try to work out similar deals with all creditors.
Copyright © 1999-2001 Nolo.com All Rights Reserved
C. Understanding
Bankruptcy
If your business is
in serious financial trouble, you’ll want to consider the possibility that
you’ll eventually need to file for bankruptcy if the other strategies mentioned
in this chapter won’t work for you. Fortunately, thoroughly understanding how
bankruptcy works and how you can best cope with it if it becomes inevitable can
result in major savings later on.
1.
Different
Types of Bankruptcy
Bankruptcy is a
legal proceeding handled in the federal court system. It’s based on the federal
Bankruptcy Code, which is divided into different chapters, each covering a
different type of bankruptcy as described below. Bankruptcy is usually
voluntary, but be aware that one or more creditors may force you into
bankruptcy by filing an involuntary bankruptcy petition against you. Because
lawyers and others with bankruptcy knowledge refer to the various types of
bankruptcy protection by their chapter numbers, you too will need to learn this
jargon which I explain below.
Legal advice may be
essential. If you’re a sole
proprietor and have a relatively small amount of business debt, you may be able
to handle a bankruptcy yourself or with a limited amount of professional help.
But be forewarned: a number of issues (property exempt from being taken to pay
debts, for one example) can be complicated when business and personal affairs
are intertwined. For sole proprietors with significant debt and for
partnerships, corporations and LLCs, it generally makes sense to seek advice
from a lawyer who specializes in small business bankruptcy. Professional help
is essential for corporations and LLCs because you can’t represent these
entities in a bankruptcy proceeding unless you’re a lawyer. Seek out an
experienced bankruptcy lawyer who will take the time to explain all your
options—both bankruptcy and nonbankruptcy—before he or she files papers for
you. Be wary of any lawyer who instantly assumes that you should proceed with a
Chapter 7 liquidation which, in many cases, will prove to be a poor choice.
2.
Liquidating
the Business Under Chapter 7
A Chapter 7 filing
is sometimes called a “straight bankruptcy.” It’s available to businesses
organized in all the usual ways—sole proprietorship, partnership, corporation
and LLC. Under Chapter 7, your business property is sold and the proceeds are
used to pay off debts to the extent funds are available.
If your business is a partnership, each partner is
personally liable for all partnership debts. Putting the partnership through
Chapter 7 won’t do away with your personal liability for these debts. To
accomplish that, you’d need to file for personal bankruptcy.
If your business is a corporation or LLC, you’re generally
not personally liable for debts of the business, unless you’ve personally
guaranteed a business debt, in which case you’re liable for repaying it. And if
you’ve put up any property as collateral, that property can be taken unless you
pay the creditor—known as a “secured creditor”—the value of the property or
agree to have the debt survive the bankruptcy. To escape from personal
liability for business debts, you’ll have to file for personal bankruptcy after
the corporate or LLC bankruptcy is wound up.
A personal filing under Chapter 7 will free you from
personal liability for most business debts—but it bears some potential
disadvantages. The fact that you’ve filed for personal bankruptcy remains on
your credit record for ten years. This can cause trouble when you apply for a
mortgage, a bank loan, a charge account or a credit card. What’s more,
employers sometimes use credit information to screen job applicants as do some
landlords in checking out potential tenants.
Co-signers and
guarantors are still on the hook. If a friend or
family member has co-signed for a business loan or guaranteed payment of a
business debt, putting the business or yourself through Chapter 7 bankruptcy
won’t relieve the co-signer or guarantor from personal liability for the debt.
This can be an added reason to try to resolve your debt problems through a
workout or other non-bankruptcy alternative.
Two Kinds of Creditors
Bankruptcy law distinguishes broadly between two types of
creditors: secured and unsecured.
A secured creditor is either one to whom you or your business has
pledged collateral in exchange for a loan or line of credit (voluntary secured
creditor) or one who has filed a lien (tax, judgment or mechanic’s) against
your property (involuntary secured creditor). Pledged collateral to a voluntary
secured creditor may consist of business property such as inventory and
equipment or your own property such as your house, car or boat. Either way, the
creditor ends up with a lien on the property. This means that if you or the
business can’t pay back the debt, the creditor can take the property to satisfy
the debt.
An unsecured creditor is either one to whom no collateral has been
pledged or one who hasn’t filed a lien. Typically, these debts will include
amounts your business owes for inventory, office supplies, minor equipment and
furnishings, rent and advertising, as well as what’s owed for services such as
maintenance contracts, equipment repair and professional advice. Credit card
charges, too, are unsecured.
In bankruptcy, the secured creditor is in a much more favorable
legal position than one who is unsecured. If the bankrupt business has little
or no money, the unsecured creditor is likely to wind up with little or
nothing, whereas the secured creditor walks away with whatever the collateral
is worth. A Chapter 7 bankruptcy gets rid of the debt but not the security
interest.
3.
Reorganizing
Your Business Debts
As an alternative to
liquidation under Chapter 7, you may prefer to reorganize your debts under
Chapters 11, 12 or 13 so that you can continue to operate your business while
the bankruptcy court protects you from the demands of creditors. In a
reorganization, you can often reduce the amounts you must pay back to unsecured
creditors. In addition, under a court-approved repayment plan, you can spread
your payments over a number of years.
Among the situations in which Chapters 11, 12 and 13 are
worth considering are these:
• You want to retain all your assets and keep
the business going.
• You want to partially liquidate your assets
and then keep the business alive on a scaled-down basis.
• You want to totally liquidate the business by
selling it either as a going concern or by selling any remaining assets.
• You want to buy time to put the business in
decent shape so that it’s more attractive to potential purchasers.
• You want to pay your taxes in installments to
stave off the IRS or state or local tax collectors who are poised to seize your
assets, which would put you out of business.
In each case, a Chapter 11, 12 or 13 proceeding may offer
the possibility of helping you achieve your objectives.
a.
Chapter 11
A Chapter 11
reorganization allows your sole proprietorship, partnership, corporation or LLC
to continue doing business while often reducing or even eliminating the amounts
you must pay back to unsecured creditors. Under a court-approved repayment
plan, you can spread your payments over a number of years. Five years is
typical.
If you file for a Chapter 11 reorganization, you’ll
immediately receive the protection of the bankruptcy court. All lawsuits and
other collection actions against your business will come to a screeching halt.
You’ll then have 90 days in which to submit a plan—called a reorganization
plan—showing how you propose to pay past-due debts while keeping up to date on
current ones. If your business debts don’t exceed $2 million, you can use a
new, fast-track version of Chapter 11 that simplifies procedures and gives the
creditors less control than they have in a regular Chapter 11 reorganization.
Your plan will have to meet a few legal guidelines; for
example, it must show that back taxes will be fully paid within five years. And
secured creditors—those to whom your business has pledged collateral—must
receive the collateral or the current value of the collateral or the current
value of the debt. Your plan doesn’t have to include payment to unsecured
creditors unless those creditors would receive some payment if your business
were to file for liquidation under Chapter 7.
After you file the plan, creditors vote on it. Secured and
unsecured vote separately and, to be adopted, the plan must be approved by 51%
of the creditors in each class. If your plan is carefully crafted, the
creditors will likely accept it. But if the creditors reject the reorganization
plan, all may not be lost. A solution may be found in the “cram down”—a phrase
used to describe the last-resort powers of the bankruptcy court. If your plan
is basically fair and equitable, the judge can cram it down the throats of all
the creditors.
To help your business stay alive, the judge can terminate
burdensome or unprofitable leases or contracts. If, for example, your business
is occupying expensive space under a lease that runs for seven years, your
business is contractually obligated to keep paying rent throughout those seven
years. But in Chapter 11, the judge can allow your business to move to a less
costly location, with no further obligation to your current landlord.
With these many benefits, Chapter 11 sounds like a good
deal for a financially troubled business, but the grim truth is that it rarely
succeeds. It’s usually an overwhelming task for a typical business owner to
keep up with current bills while simultaneously chopping away at large past-due
debts and paying chunky administrative and legal fees. The result is that more
than 90% of businesses that file under Chapter 11 eventually switch to Chapter
7 and liquidate their assets—although the new, fast-track procedures may lead
to a higher success rate.
Compare the payoffs
to creditors. Basically,
if you’re convinced that you can get
more money for the creditors by reorganizing under Chapters 11, 12 or 13 than
by filing for a straight liquidation under Chapter 7, then reorganize.
Otherwise, don’t waste your time, energy and money. Proceed directly with a
Chapter 7 filing. Why worry about how much the creditors get? Because the more
they get, the less you may be personally liable for.
b.
Chapter 12
A Chapter 12
bankruptcy is available to family-owned farming businesses. As in a Chapter 11
proceeding, the total amount of debt owed to unsecured creditors may be reduced
in the Chapter 12 plan. In addition, the financially ailing farm operation is
allowed to continue doing business under a court-approved plan for repaying its
remaining debts over a number of years. A court-appointed trustee serves as the
intermediary between the farm and its creditors. Because this book is primarily
for nonfarm businesses, Chapter 12 won’t be treated further.
c.
Chapter 13
Businesses, per se,
are not permitted to file for Chapter 13 bankruptcy. A sole proprietor,
however, may file as an individual and include the business debts for which he
or she is personally liable. There are financial limits: you can have no more
than $750,000 in secured debts and no more than $250,000 in unsecured debts. As
in a Chapter 11 reorganization, the amount you must pay back to unsecured
creditors is reduced (sometimes to as little as zero) and, under a
court-approved plan, you continue to run the business while paying off debts
over a period that can last up to five years. A court-appointed trustee—whose
fees you pay—makes payments to creditors under the pay-back plan.
As noted in the next section, there can be advantages to
filing under Chapter 13 rather than Chapter 11 if your business qualifies.
Prospects for keeping your business afloat over the long term are better with a
Chapter 13.
d.
Choosing between Chapter 11 and Chapter
13
All types of
business entities—sole proprietorships, partnerships, corporations and limited
liability companies—can choose to file under Chapter 7 for a straight
liquidation bankruptcy or under Chapter 11 for a reorganization of their
business debts. And as noted above, sole proprietors with no more than $750,000
in secured debts and no more than $250,000 in unsecured debts have still a
third choice: a reorganization under Chapter 13. Since Chapter 11 and Chapter
13 both allow a business to remain in operation under a court-approved plan, a
sole proprietor who qualifies for both may face the dilemma of choosing between
the two. Generally, it’s more advantageous to choose Chapter 13, for a number
of reasons:
• A Chapter 13 reorganization plan is usually
approved by the court in less time than a Chapter 11 plan.
• You don’t have to deal with a creditors’
committee—a committee that’s appointed in a Chapter 11 filing to represent the
interests of the unsecured creditors. This means you’ll expend a lot less time
and energy on paperwork, meetings and possibly attorney fees. Creditors may
object separately to your Chapter 13 plan, but they don’t carry the same weight
as a committee would in a Chapter 11.
• You’ll be able to pay less than 100 cents on
the dollar for unsecured debts. The bankruptcy judge in a Chapter 13 can
approve a plan which provides for partial debt repayment.
• If you meet the terms of the court-approved
payment plan, virtually all remaining, unpaid debts will be wiped away even if
some of them were obtained under circumstances the law might consider
fraudulent. For example, if you obtain credit by misrepresenting your credit
history, the debt probably won’t be discharged under either Chapter 7 or 11 and
the creditor will be able to sue you personally—but under Chapter 13, if you
make all payments as called for by the plan, the creditor can’t sue you for
that debt.
• A Chapter 13 filing will stop collection
action against a co-signer or guarantor if the Chapter 13 plan treats creditors
fairly. In short, this option can help you protect friends and relatives who
have obligated themselves to pay your debts.
There is, however,
one area in which Chapter 11 may be a better choice. In a Chapter 13
reorganization, you generally can’t modify the terms of a mortgage loan or
other credit agreement which is secured by your home. This means that even if
your house is worth less than what you owe, you must still pay the balance.
There are a few technical exceptions to this rule, but they’re of little
practical value to most people. A different rule applies to Chapter 11 filings,
creating the possibility of reducing the loan if the value of your home has
dropped. So if you have a huge mortgage on your home and the value of the
property has dropped, then Chapter 11 is probably better for you than Chapter
13.
4. Who’s Who in Bankruptcy
In addition to
understanding the various types of bankruptcy, you’ll quickly need to understand
who the major players are and at least some of the jargon involved in a
bankruptcy proceeding. Here’s a brief overview.
• Debtor. The debtor is the person or business
entity that owes the money—this can be your business or yourself or both. Generally,
it’s the debtor that files for bankruptcy, although creditors can sometimes
start the ball rolling, in which case it’s called an involuntary bankruptcy.
• Creditor. This can be any person, business or
governmental agency that has or may have a claim against you or your business.
A secured creditor is one that has a lien (claim) against specific
property—usually either in the form of a real estate mortgage or a security
interest in a vehicle or other equipment. A secured creditor is usually in a
better legal position than an unsecured creditor because if money isn’t
available to pay the debt, the secured creditor is entitled to grab the assets
pledged as security.
• Trustee. A bankruptcy trustee takes possession
of the debtor’s business assets in a Chapter 7 proceeding and liquidates them
to pay creditors. In a Chapter 7 personal bankruptcy, the trustee gathers the
debtor’s nonexempt property (a second home, for example), liquidates it and
distributes the proceeds to the unsecured creditors. In a Chapter 11
proceeding, the debtor usually retains control over the business assets while
the business continues to operate. But, especially if the business owner has
committed fraud or seriously mismanaged the business, the court may appoint a
trustee to take over in a Chapter 11 proceeding so that the creditors’
interests are better protected. In a Chapter 12 or 13 bankruptcy, the debtor
remains in possession of the property; the trustee collects monthly payments
and distributes them to creditors. Trustees are appointed by the bankruptcy
judge unless the district has a U.S. Trustee—a full-time federal employee with
a staff of assistant trustees who serve as trustees in Chapter 11 cases and
appoint and supervise outside trustees in Chapter 7, 12 and 13 cases.
• Judge. A bankruptcy judge is part of the
federal district court and has broad control over bankruptcy proceedings,
including authority to resolve all disputes between the business and its
creditors, as well as any issues involving the business’s property. Despite
this broad authority, the judge may abstain from trying issues that can be
litigated in a state court—for example, actions to foreclose on real estate or
to gain possession of cars and equipment, and cases involving environmental
cleanups. Bankruptcies are supervised, for the most part, by the trustee where
one’s been appointed—but debtors and creditors who disagree with a trustee’s
decision can seek a ruling from the bankruptcy judge who can overrule the
trustee.
• Creditors’ Committee. In a Chapter 11
proceeding, an unsecured creditors’ committee may be appointed to represent the
interests of all the unsecured creditors. If the proceeding is complicated,
there may be additional creditors’ committees representing special
interests—for example, pension and profit-sharing recipients, under-secured
creditors and secured creditors. A creditor’s committee may object that a
proposed plan writes off too much of the debt owed to its members or that it
gives the debtor too much time to pay.
5. Key Bankruptcy Concepts
Unfortunately, your mini-education in how bankruptcy works isn’t
quite complete. Since bankruptcy law is unique, with its own concepts,
procedures and jargon, it’s crucially important to understand the legal basics.
a.
Bankruptcy estate
Once you or your
business file for bankruptcy, the property—called the bankruptcy estate—is
controlled by the bankruptcy proceedings. Creditors can’t get their hands on it
without the court’s permission. Property subject to court control includes not
only the property your business owned when you filed the bankruptcy papers, but
also money your business earned but hadn’t collected before you filed for
bankruptcy. Also, in a Chapter 11, 12 or 13 proceeding, if your business
acquires property after your case is filed, that property becomes part of the
bankruptcy estate. However, if your business holds money in trust for third
parties—such as withholding taxes that are to be paid to the IRS—that money
isn’t part of the bankruptcy estate.
You may need a
separate bank account.
If you don’t pay the employment taxes immediately, keep them in a
separate bank account designated as a trust account so that it’s clear that
these funds are separate from other funds of the business. Then you’ll be able
to use these funds to pay the taxes and avoid personal liability and penalties.
b.
The automatic stay
As soon as your business has filed a bankruptcy petition,
creditors are stayed (stopped) from continuing their collection efforts against
the business. In addition, creditors can no longer seize any property owned or
leased by the business that secures its debts, such as a car, building or
equipment. Further, it’s illegal for creditors to contact you to push for
payment, start a lawsuit against you or pursue any other collection action.
Utilities such as the power, phone and water company must continue to serve
your business as long as you can guarantee payment for future services—for
example, by posting a deposit. Be aware that the IRS can continue an audit, issue
a tax deficiency notice, demand a tax return, issue a tax assessment and demand
payment, but can’t record a lien or seize your property.
c.
The bankruptcy filing
To start a
bankruptcy case, your business must file a form called a Petition for Relief
with the clerk of the federal bankruptcy court. To learn the location of the
bankruptcy court, call the clerk of the U.S. District Court that’s nearest your
business.
A list of
creditors (everyone your business owes money to) should accompany your Petition,
using a special format so that copies of your creditor list can be used as a
mailing list. Within 15 days, you must also file lists of debts, assets and a
history of your business. In bankruptcy jargon, these lists are called
bankruptcy schedules and Statement of Financial Affairs. You’ll want to include
all debts your business may owe and any claims that creditors may have against
your business—even those you have some doubts about or you dispute.
d.
Claims
Once notified of
your bankruptcy, creditors may file claims for payment of their debts with the
bankruptcy court. Your business has the right to challenge a claim if you think
it’s improper. The judge will decide if the claim is valid. In a liquidation of
a business, since there’s almost never enough money to pay all allowed claims,
the law establishes priorities. Your bankruptcy estate (any money or property
salvaged from your business) is used to pay the highest priority claims first,
then the next highest priority, and so on as long as the money lasts. Creditors
in the lowest category, to actually receive any money, will typically have to
take much less than the amount they’re owed since by definition there isn’t
enough money to go around. In fact, it’s not uncommon for unsecured creditors
to receive nothing.
Some
creditors can obtain a super-priority status. In a Chapter 11, 12 or 13
bankruptcy where the trustee or debtor must borrow new money to keep the
business running, the lender of these funds would obtain a super-priority claim
and be first in line when assets are distributed. Next come the secured
creditors who have liens on specific real estate, vehicles, equipment or other
property. After that come such claims as the expenses of administering the
bankruptcy, wages and commissions earned during the 90 days before the
bankruptcy started, money owed to an employee benefit plan, deposits made on
consumer goods and most taxes. At the bottom of the heap are general, unsecured
claimants who, if they’re lucky, receive a pittance. Often, unsecured claimants
get a few cents for each dollar they were owed or come away entirely
empty-handed. In a Chapter 13, secured creditors with liens and priority debts
could be paid simultaneously through the Chapter 13 plan.
e.
The effect of bankruptcy on secured debts
If you go through a
Chapter 7 personal bankruptcy, the creditor will lose the right to get a
personal judgment against you requiring you to pay the debt that’s owed. But
even though the creditor can no longer demand that you repay the debt, if
you’ve pledged property as collateral, the creditor will still have a lien on
that specific property. Because the creditor will be able to enforce the lien
and take or sell the property, you need to be aware of the three options
available to you—which can be summarized as The Three Rs:
• Relinquishment. You can simply give up the
house, car or other property on which the creditor has a lien.
• Redemption. You may buy it by paying the
creditor, usually in a lump sum, the value of the property. If there’s a
dispute about how much the property is worth, the bankruptcy judge will
determine the value.
• Reaffirmation. You may
reaffirm your obligation to pay the debt secured by your property before the
debt is discharged in bankruptcy. Then, you continue to make payments as you
had agreed before the bankruptcy. Of course, the lien will remain on the
property and, if you later miss payments, the creditor will be able to enforce
the lien by taking back property to pay for the balance of the reaffirmed debt.
f.
Exempt property
If you go through a
Chapter 7 personal bankruptcy where your asset are liquidated to pay your
debts, you don’t have to give up all of your personal property to pay back
creditors. The law allows you to keep some items (called exempt property) to
help you get a fresh start. Exempt property is listed in the federal bankruptcy
code, but states also have laws listing exemptions. Generally, you’ll rely on
your state law exemptions—either because the state law exemptions are more
advantageous or because, as is the case in most states, the state law gives you
no choice. If you do have a choice, check the homestead allowance carefully as
it’s usually more generous under state law.
Most state exemptions allow you to keep property in these
broad categories:
• motor vehicles, to a certain modest value
• clothing other than furs
• household furnishings and goods
• household appliances
• jewelry such as a wedding or engagement ring
and a watch
• personal effects—personal possessions that
don’t fall into the categories of clothing and jewelry
• life insurance (cash or loan value, or
proceeds) to a certain value
• pensions for public employees or pensions that
qualify under ERISA
• part of the equity in your home
• tools of your trade or profession, to a
certain value
• portion of unpaid but earned wages, and
• public benefits (welfare, Social Security,
unemployment compensation) accumulated in a bank account.
For detailed state-by-state lists of
exemptions, see Money Troubles: Legal Strategies to Cope With Your Debts, by
Robin Leonard (Nolo), or Bankruptcy: Is It the Right Solution to Your Debt
Problems?, by Robin Leonard (Nolo).
LAW IN THE REAL
WORLD
Carl and Phyllis Save Their Home
Carl starts a neighborhood restaurant, organizing his business as
a one-person corporation. To raise capital, Carl and his wife Phyllis borrow
$50,000 from a bank on their signature and additionally secure the loan by
giving the bank a second mortgage on their home.
In its first year, the business runs up a pile of debts. With
prospects of becoming profitable looking bleak, Carl decides to close down.
Carl considers putting the corporation through bankruptcy to make a clean break
with creditors. Unfortunately, this won’t help with the bank loan since Carl
and Phyllis are personally liable for that debt and their home is at risk if
they can’t pay it. Since this is a secured debt, even if they go through
personal bankruptcy, they’ll lose their home.
So Carl and Phyllis reduce the bank loan with $10,000 of personal
savings that Phyllis had set aside from her salary as a school teacher. They
then refinance their home by getting a new first mortgage that pays off both
the old mortgages. (Fortunately, Carl is able to get his old job back, so he
and Phyllis have income to qualify for the new mortgage.) Carl and Phyllis now
have 30 years to pay off the new mortgage in monthly installment payments.
Carl
closes the business, sells the corp-oration’s few remaining assets and, before
dissolving the corporation, distributes the proceeds prorata to the business’s
unsecured creditors. The business
failed but with this small-scale workout, Carl and Phyllis saved their
home.
Copyright
© 1999-2001 Nolo.com All Rights Reserved
Excerpted from the “Legal Guide for Starting and
Running a Small Business”, by Fred S. Steingold