When Bankruptcy Looms

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If your business is in financial trouble, should you file for bankruptcy protection under Chapter 11? Learn your options and your alternatives in this Quick-Read.

OVERVIEW [top]

Your business is showing signs of financial distress when high-turnover goods are depleted and shelves can't be restocked, when sales drop and unfilled orders mount, and when cash is short and borrowing replaces revenue. When this happens, quick legal action is key to survival. The sooner you tell your attorney, the more options she or he may have to negotiate a better position for your business.

In this Quick-Read you will find:

  • Some common telltale signs of financial distress.
  • How to know if your business is a candidate for Chapter 11 bankruptcy.
  • What alternatives to bankruptcy may be possible.
  • Which steps to take if you're on the brink.

SOLUTION [top]

About 10,000 businesses file for bankruptcy under Chapter 11 each year (News Release, Administrative Office of U.S. Courts, May 23, 2001). About one third can be expected to emerge successfully and continue in business (Phoenix Forecast, PriceWaterhouseCoopers, 2002). Bankruptcy laws balance the right of creditors to be paid for their goods or services with the right of the debtor to make a fresh start. Most business bankruptcy filings are voluntary, but creditors can force it under certain circumstances. Under Chapter 11 (reorganization), you as owner generally are entitled to retain control of business assets while making payments to creditors, assuming there's no attempt to hide or waste assets. Chapter 11 will be considered here, not Chapter 7 (liquidation) or Chapter 13 (commonly used by individuals to pay off debt in installments after settlement).

If bankruptcy is threatening but not certain and further refinancing seems impossible, work with your attorney to determine the best way to communicate your predicament to your creditors and propose a work-out arrangement. Offer to pay them less than they're owed, later than it's due, but still more than they'd get if you were forced to file for bankruptcy. A work-out will require unanimous agreement among creditors to succeed. It's likely to fail if even one attempts to repossess or file a lien on your property.

Calculate the amount of cash you need to get past your financial jam by breaking out monthly cash-flow projections from your forthcoming year's budget. See the Quick-Read titled "How to Create the Financial Projections of Your Business Plan" for tips to improve your chances for more financing by improving cash-flow perspective for prospective lenders.

If bankruptcy is inevitable, work with your attorney to be sure you do not violate bankruptcy laws. Be especially careful not to pay off a favored creditor or transfer any money in a way that creditors and the court could consider wasteful or fraudulent in the 90 days before you file.

Plan for reorganization

You have four months from the filing of the bankruptcy petition to file a plan for reorganization. The plan designates classes of claims and indicates whether creditor interests are "impaired" by the plan. An impaired interest is one in which the contractual, legal or equitable rights of a creditor are changed by the business's financial situation, and the reorganization plan would not cure the resulting defaults, meaning creditors in the impaired class won't be paid according to the original contract terms. After you file, your lawyer can negotiate with creditors to see if they will accept less than the full amount they're claiming. Nothing prevents a creditor from voluntarily accepting less favorable treatment than other creditors in the same class or priority of payment, and occasionally a creditor will do so if it's advantageous in some way. The agreement to accept less than the original contract specified is known as a composition.

Filing for bankruptcy automatically stays litigation to collect on a judgment rendered before the bankruptcy proceeding began. But creditors who are insecure about being able to collect if they win a money judgment can ask a court to attach business assets before trial. That means you have little or no control over the assets subject to the attachment order until the debt is satisfied. Creditors can also enjoin you from transferring money or property to hide assets. Even if you don't intend to defraud creditors, an asset transfer that effectively gives a preference to some creditors to the disadvantage of others could be unlawful under the federal Uniform Fraudulent Conveyance Act and state laws covering constructive fraud.

If you have an acrimonious relationship with a creditor, the court may appoint a trustee to represent the business. The trustee will investigate and file financial reports. Because a trustee does not represent you or your business other than as an entity obligated to satisfy creditors' rights, your business lawyer is called into play during this investigation. Even if the court does not appoint a trustee, it may appoint an examiner to investigate any allegations of fraud, misconduct or mismanagement.

Disclosure statement

In addition to filing a reorganization plan, you must disclose information about the circumstances giving rise to the bankruptcy petition, assets available to satisfy the debts, outstanding claims against the business, accounting assumptions used in preparing the disclosure statement, and information about litigation not related to the bankruptcy proceeding. The disclosure must also spell out information about the company's management, including future executive compensation, tax consequences of the proposed reorganization plan and information about accounts receivable. You should have legal counsel prepare this disclosure statement to assure all bases are covered.

REAL-LIFE EXAMPLE [top]

Virginia-based Value America Inc. advertised "low cost" personal computers to customers who bought long-term Internet service contracts. When some customers canceled their service contracts early, they were socked with charges the Federal Trade Commission said had not been adequately disclosed. Value America denied deliberately misleading anyone but agreed to clarify its advertising. That practice — coupled with the chairman's micromanagement of day-to-day operations and top management's excesses, including a corporate jet — frustrated employees. Financial analysts were frustrated as well by the officers' failure to disclose information on the company's health.

When the company worked out an agreement with a major credit-card company to offer Value America members discounts on Internet purchases, executives failed to monitor the program and some customers defrauded the company by reselling their discounted "Value dollars" to other customers. Massive layoffs ensued. Thomson Financial Securities Data called Value America the worst-performing Net IPO of 1999. But rather than pulling the plug entirely using Chapter 13, the company's officers chose to work out debts through Chapter 11. They talked with customers, jettisoned the retail business altogether, and reconfigured the firm as a services business assisting other companies to take and deliver online orders.

DO IT [top]

  1. Inventory your situation to determine if bankruptcy is your best option.

    • Project your monthly cash flow for the next year.

    • Weigh your assets and debts. Is your assets-to-liabilities ratio so low it precludes further borrowing?

    • Are creditors threatening to take action, such as repossessing collateral?

    • Consider your future business objectives and organizational threats, such as a mass exodus of management personnel.

    • Make your best estimate of the costs of personnel problems you may be having, such as actual or potential costly discrimination claims.

    • Have you made payments or transfers of business property that could be considered fraudulent or advantageous to some creditors but not others?

  2. Communicate your predicament to employees. Ask them to help with conservation measures and provide suggestions for improving efficiency. If reducing employee costs to improve cash flow can salvage the operation, take a deep pay cut, and ask others to take a smaller one.

  3. Tell your business attorney about financial trouble you're having. She or he may be able to negotiate a long-term payout or reduce the debt altogether. She or he will be able to discuss the problem with your creditors in a way that does not impair your rights under any contracts you may have with them or your rights to discharge any particular debts in bankruptcy if you decide to go that way. Don't wait. The sooner you tell your attorney, the more options she or he may have to negotiate a better position for your business.

  4. If negotiation fails to offer relief, look to federal and state bankruptcy laws. Expect your attorney to ask the following questions to determine whether your business is a candidate for bankruptcy:

    • How were the debts incurred?

    • Which debts are secured?

    • Is legal action against your company imminent?

    • Have you or any principal of your company:

      • Transferred money or property in contemplation of litigation.
      • Transferred substantially all of the company's assets, particularly to creditors of your choice as opposed to a trust benefiting all creditors.
      • Made transfers to family members.
      • Used the property that was transferred.
      • Failed to document or record a transfer of assets.

      An objective of this rule of thumb is to avoid even the appearance of inequitable preference of one creditor over others.

  5. Adhere to steps prescribed by the bankruptcy court and you may qualify as debtor in possession. That entitles you to keep control of business assets, continue to employ workers and maintain operations. You may even be able to return to profitability if the business qualifies for bankruptcy protection and all steps are followed correctly.

RESOURCES [top]

Books

Business Rx: How to Get in the Black and Stay There by Gary Goldstick (Wiley, 1988).

A Basic Guide for Valuing a Company, 2nd edition, by Wilbur M. Yegge (Wiley, 2001).

Bankruptcy and Debtor/Creditor: Examples and Explanations, 3rd edition, by Brian A. Blum (Aspen Publishers, 2004).

Lawyer's Desk Book, 11th edition, by Dana Shilling (Prentice Hall, 2000). "Bankruptcy," ¶501-523.


Articles

"The Internet Guide to Bankruptcy Law" by Melanie Putnam, Internet Law Researcher, March 1999. FindLaw.com

"Why Bankruptcy Works" by Robert A. Mamis, Inc. magazine, October 1996.

"When Bad Loans Happen to Good Entrepreneurs" by Martha Gershun, EntreWorld.org, August 1999.

"Bankruptcy and Your Board: 6 Rules to Remember" by Ralph Ward, Inc.com, March 2001.


Internet

American Bankruptcy Institute.

Bankruptcy Basics. Administrative Office of the U.S. Courts, 2000.

Bankruptcy Law. FindLaw.com.

Bankruptcy FAQ. Nolo.com.


Article Contributors

Writer: Beverly M. Poppell

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