Help! Should My Business File for Bankruptcy Protection?

Evan Lee

John Van Swearingen

By Evan Lee and John Van Swearingen

This article has been republished with permission from Waldrep LLP.

It is July of 2020, and domestic and international news cycles are full of stories of global pandemic, record unemployment, and an uncertain path towards international economic recovery. In light of the extraordinary circumstances being reported, it is important to remember that, in more mundane (or even strong) economic conditions, businesses and individuals have always found it necessary to avail themselves of bankruptcy protections.

Externalities, such as poor market conditions and pandemics, often serve to exacerbate existing financial issues. In fact, this May, clothing retailers J.Crew, Neiman Marcus, and J.C. Penney all filed petitions for Chapter 11 Reorganization, after years of struggling sales coupled with recent store closures, the result of the COVID-19 pandemic. Several other notable retailers have followed suit. However, internal issues, absent such externalities, are typically the primary drivers of business bankruptcies.  A business may suffer from inflexible management or adhere to strategies that prove unsuccessful—the familiar names of department stores and other brick-and-mortar retail giants have graced the news with bankruptcies throughout the past decade. A business may struggle with cash flow, have its access to financing cut off, or may be overburdened with uneconomical contracts. Assets that could be liquidated to increase cash flow may be encumbered by liens, making those assets unattractive to buyers.

An individual with out-of-control consumer debt may seek bankruptcy protection, but individuals often have substantial triggering events that precipitate a bankruptcy—e.g., the loss of a job, medical difficulties, or even divorce. An individual may be facing a foreclosure or the burdens of personal guaranties on business debts. Finally, both businesses and individuals may find themselves facing mounting litigation and its concordant costs and disorder.

The various forms of bankruptcy—the different chapters of the Bankruptcy Code—provide debtors with mechanisms to restructure payments to creditors, re-amortize or refinance debts, and in some instances discharge liabilities. Bankruptcy can also provide means of “cramming down” a secured creditor’s security interest to the value of collateral as well as rejecting uneconomic contracts or leases—avoiding deficiency judgments that would otherwise result when a sale of collateral, outside bankruptcy, fails to satisfy the full amount of debt owed. Assets encumbered by liens can be sold free and clear of existing liens and interests, making those assets more attractive to third parties. Finally, but perhaps most vitally, bankruptcy generally provides an automatic stay against (i.e., a breathing spell from) pending litigation, foreclosure, repossession, or collections efforts, forcing those legal actions or collections efforts into a centralized bankruptcy administration.

Bankruptcy is by no means a remedy for all the above problems, but it can afford a business or an individual the opportunity to correct a struggling course. There are associated costs to pursuing a bankruptcy case, and certain chapters are more expensive than others. Transparency before a bankruptcy court and various officials, such as trustees and administrators, is essential to obtaining a positive outcome. Pre-bankruptcy transfers of assets must be disclosed, and depending on the chapter, a debtor will be accountable for every dollar earned and disposed for the pendency of their case. On that note, bankruptcy cases are rarely quick proceedings; many last several years with monthly hearings, if not more often.

There are also intangible concerns of reputation and creditworthiness.  A business that is in or has recently emerged from a bankruptcy case may be viewed with skepticism by vendors from which that business may seek credit and even the general public. Closing locations and laying off employees, which may occur during public bankruptcy proceedings, will almost certainly cause the public image of a business to decline. An individual’s credit report will reflect their bankruptcy case for a number of years. However, if the costs, scrutiny, time, and reputational concerns are outweighed by the necessity and benefits of a bankruptcy case, it may be one of the best possible options available to a business or individual facing difficulties.

Bankruptcy is not the only option available to those who are struggling. A debtor may opt to allow a foreclosure to occur if the collateral is not a necessity. Financed equipment or vehicles may be repossessed.  A state or federal court can enter a receivership order allowing a third party to manage the assets of a struggling business. A putative debtor could assign its assets for the benefit of creditors in a state court proceeding. Finally, a debtor can seek an out-of-court liquidation of its assets or, if it has sufficient leverage, other means of negotiating or restructuring debts.

Other factors, relevant to the administration of bankruptcy proceedings, may make bankruptcy unattractive. Creditors may have liens on accounts and other receivables, i.e., the business’s operating funds and, in bankruptcy jargon, “cash collateral.” Upon the filing of a bankruptcy case, a debtor cannot use cash collateral without a court order for any purpose, including making payroll or payments in the ordinary course of business. If a business (or an attorney advising a business) is not prepared to resolve cash collateral issues before employees or critical vendors must be paid, the medicine of bankruptcy may prove to be worse than the diagnosis.

Also, a debtor in bankruptcy, or a trustee appointed under certain chapters of the Bankruptcy Code, has a duty to investigate transfers of property prior to the bankruptcy filing. Transfers to business insiders, family members, and other associates; payments to creditors prior to the case; and transfers made as part of an asset protection strategy may all be vulnerable to avoidance actions in the Bankruptcy Court. It is not uncommon for trustees to pursue litigation against the directors, officers, or management of a business. Every transaction during a bankruptcy case should be presumed to be scrutinized.

Non-bankruptcy options may not be available to every business or individual, and certain conditions may render bankruptcy the best—or only—available option. Aggressive collections activities or pending litigation may force a debtor’s hand. Vendors may refuse to ship inventory. An onslaught of litigation, such as the California wildfire liability actions filed against Pacific Gas & Electric Company in recent years, can render non-bankruptcy options insufficient for addressing a plethora of newly-founded, and unliquidated, claims. Creditors may simply refuse to cooperate with voluntary out-of-court workouts or assignments for the benefit of creditors.

Determining whether a business or individual would be best suited by seeking the protections of the Bankruptcy Code is just the tip of the iceberg. The goals of the business or individual filing for bankruptcy protection, as well as the nature of their finances, dictate the chapter or chapters under which that debtor may be eligible for bankruptcy relief, and of those chapters, which chapter would be most beneficial. Certain entities, such as trusts and probate estates, are not eligible for bankruptcy relief. Generally, any individual person is eligible for relief under the Bankruptcy Code, as are corporations, limited liability companies, partnerships, and sole proprietorships.

Bankruptcy takes two primary forms: liquidation or reorganization. Liquidation is available to practically any person or business under Chapter 7 of the Bankruptcy Code. In Chapter 7 bankruptcy, a court-appointed trustee liquidates the assets of a debtor existing at the time of the bankruptcy filing, pays the value of those assets to creditors, and, to the extent provided for in the Bankruptcy Code, discharges the debtor of further liability. Chapter 13 bankruptcy is a form of reorganization aimed at individuals and sole proprietorships with debts below a statutory limit, wherein the debtor tenders court-approved payments, through a trustee, to creditors in exchange for a discharge. Chapter 12 is a special form of bankruptcy for fishermen and farmers with debts below a certain amount combining features of Chapter 13 with certain components of Chapter 11.

Chapter 11 is the prototypical business reorganization, though it is also available to individuals. There are no debt limits for Chapter 11—the debtor must simply be eligible for relief under the Bankruptcy Code. There are instances, however, where a Chapter 11 is essentially a liquidation of assets (often in sales intended to strip liens and interests that would follow the assets outside of bankruptcy) and winding down of affairs, tantamount to a Chapter 7 without an appointed trustee. Chapter 11 also includes the new subsection “Subchapter 5,” which provides for streamlined treatment of “small business” reorganizations for businesses with debts below a certain amount.

The CARES Act, the COVID-19 stimulus bill recently passed in response to the current pandemic, contained several amendments to the Bankruptcy Code. The debt limit for small business Subchapter 5 debtors was increased almost threefold to $7.5 million. The CARES Act amendments also provide that stimulus payments to individuals are not to be included in the “disposable income” parameters of Chapter 13 plans, that Chapter 13 plans may be modified due to COVID-19-related hardship, and that Chapter 13 plans may be extended up to seven years. The temporary amendments of the CARES Act expire in the next year, but any person considering the relevance of bankruptcy relief to their given situation should be mindful of future amendments or acts of Congress arising from the current pandemic.

What type of bankruptcy should my business file? Click here to read the rest of the article on the Waldrep LLP website.