Alternatives to Declaring Business Bankruptcy
Excerpted from Bankruptcy for Businesses (Entrepreneur Press)
There are two common non-bankruptcy alternatives for a financially distressed business. The first is an out-of-court workout, which, if successful, would allow the business to continue to operate without court supervision. The second is an assignment for benefit of creditors, which is a vehicle for liquidating the business outside of a bankruptcy with minimal state court supervision.
Option 1: Out-of-Court Workouts
The term "workout" is an attempt by a debtor to solve a financial problem by a consensual agreement with creditors outside of a court proceeding. The form of the workout is limited only by the creativity of the business and the willingness of the creditors to work with the business. An out-of-court workout of a financial problem should always be preferred over a bankruptcy filing. However, by definition, a workout requires the consent of creditors. One or two holdouts among the creditors may prevent a workout from being successful, in which case, bankruptcy may be necessary to force the hold outs to the table.
Can the Business Survive?
Prior to approaching a bank or a group of creditors with a proposed workout plan, management must first determine whether there is any way to turn the business around. In a workout, creditors are normally repaid through one or more of the following sources: (1) future cash flow; (2) new financing; or (3) equity infusion.
In order to offer a repayment plan from future cash flow to creditors, a business must not only be able to sustain itself from its operations, but generate enough additional positive cash flow to repay some or all of its delinquent debt.
In the alternative, a business may need to find a replacement lender to pay off its existing creditors. However, locating a replacement lender on reasonable credit terms can be a difficult endeavor for a business on the verge of insolvency. Likewise, equity investors are often unwilling to allow their infusion of new capital to be consumed by the existing creditors of the business. There are professionals who are in the business of attempting to procure financing or capital infusion for troubled businesses although a substantial commission may be charged; and as with any profession, credibility, reliability, and competence can vary greatly from one to another. You should do your homework before engaging such a professional.
Before approaching creditors to ask for forgiveness or forbearance, a business should first devise a restructuring plan that shows it is sustainable on a going forward basis. The starting point in devising such a plan is to review the historical financials of the business and prepare projections of cash flow, profit and loss, and balance sheet through the term of the repayment plan. The projections should demonstrate that the business not only has sufficient cash flow to maintain current operations but also has enough additional positive cash flow in the foreseeable future that will enable creditors to receive a return on the delinquent debt. The amount of such additional positive cash flow will determine the amount of time necessary to repay creditors. You should consider hiring an outside financial advisor to prepare these financial projections.
If it appears that there is no way to turn the business around within a reasonable period of time, then the business may need to be liquidated. If the business is insolvent, this liquidation will normally be achieved by either a chapter 7 bankruptcy or an assignment for benefit of creditors, which will be discussed later.
Shopping for a Bankruptcy Attorney
When cash flow is tightening and the creditors are beginning to interfere with business operations, it is important to get legal advice from an attorney who specializes in business reorganizations. Management is unlikely to have any experience in managing or operating a distressed business. An experienced business bankruptcy attorney should be able to guide you through this process and can often act as a barrier or filter against disgruntled creditors. In addition, the retention of an experienced business bankruptcy attorney will send a signal to creditors that the business is seriously contemplating its need to file bankruptcy. For some creditors, this may prompt a more serious consideration of the workout plan.
In order to find an attorney with the necessary experience, reliability and competence, it is good to ask for a referral from your existing attorney, accountant, or other trusted advisors. The American Bankruptcy Institute also has a certification process for lawyers specializing in business bankruptcy law. You can access their website at www.abiworld.org.
Hiring a Financial/Turnaround Consultant
If the business has the resources, the business should also engage a turnaround financial advisor to assist its management in the workout process. Not only will the business have an experienced professional that has knowledge of the workout process, a turnaround financial advisor can often assist management in preparing the financial projections of the business, communicating with creditors, and formulating, negotiating, and implementing the workout plan. Managing a workout can be a very time consuming job. At a time when a business is failing, it is especially important that its management focus on maintaining and/or improving its operations and financial performance. The turnaround financial advisor and business bankruptcy attorney can alleviate some of the burdens and strains of managing a workout plan and communicating with creditors.
To the extent creditors may have ill feelings or concerns about existing management, a financial turnaround advisor may also deflect some of the negative perceptions by lending credibility, assisting with the formulation of a reasonable workout proposal, and serving as a disinterested third party in initiating and conducting discussions and meetings with the creditors.
An experienced business bankruptcy attorney should be able to recommend a turnaround financial advisor. There is also a national organization of turnaround consultants called Turnaround Management Association. You can access their website at www.turnaround.org.
Negotiating with the Creditors
The Bank or Secured Creditor. Most businesses have a secured creditor (usually a bank) whose loan is collateralized by substantially all assets of the business. When a business defaults under such loan, the bank has the option of foreclosing on its collateral, seeking the appointment of a receiver, and/or filing a lawsuit against the business to collect the amount owed. Prior to taking these drastic steps, however, a bank representative will normally ask for a meeting with the management of the business to review the financial affairs of the business.
Management should welcome this opportunity to begin a dialogue with the bank and should be prepared to open up its books and records to the bank. Most loan documents give the bank the authority to demand an inspection of the borrower's books and records. In addition, interaction with the bank normally buys time for a business. In many instances, the bank will send an auditor to the debtor's business to evaluate the business and the condition of the bank's collateral. In other situations, the bank will send its own turnaround financial advisor to the business to see if the business (and especially its collateral) can be salvaged. Most loan documents allow the bank to include the fees of its auditor or turnaround financial advisor to be added to the outstanding loan balance. If the business fails to be responsive to the bank, it is much more likely that the bank will take legal action to enforce its rights because the bank would be left with no other choice. A refusal to give the bank access to the business's financial books and records would only lead the bank to imagine the worst.
When a loan defaults, it is common for a bank to enter into one or more forbearance agreements pursuant to which the bank agrees to hold off exercising its legal rights to liquidate its collateral in exchange for certain concessions. Common concessions include acknowledgment of the bank's debt, general releases of claims against the bank, the addition of collateral or guaranties, or reconfirmation of guaranties. In some situations, the bank may also charge the debtor a forbearance fee as part of the forbearance agreement.
Once an agreement with the bank has been reached, the business will need to obtain consent from its unsecured creditors to the workout plan.
The Unsecured Creditors. Unsecured creditors are creditors whose debts are not secured by collateral pledged by the business. A business typically has a number of unsecured creditors, such as vendors that supply goods or services. Thus, rather than contacting each creditor separately, a meeting is usually scheduled with all or a number of key unsecured creditors for the business to present its workout plan.
In order to properly prepare for a meeting with the creditors in a workout, management should seek the advice of an experienced business bankruptcy attorney to analyze what would happen if the business filed bankruptcy. Normally a chapter 7 liquidation or chapter 11 plan will result in a "worst case" scenario for a creditor. If the business can demonstrate how the bankruptcy process will adversely affect the creditors and offer the creditors something better than what they would receive in a hypothetical bankruptcy, the creditors would be more likely to agree to the proposed workout.
The goal in communicating with the unsecured creditors is to obtain an agreement with all creditors to forbear from collecting on delinquent debt in exchange for repayment of all or a portion of the debt over time. A workout plan can provide choices to creditors. For example, option one can be a substantially reduced payment (for instance, 10 percent) that is made immediately, option two can be a higher percentage (for example, 30 percent) paid over one year, and option three can be an even higher percentage (such as 70 percent) paid over three years. Giving choices to the creditors may address the different financial needs and objectives of creditors, thereby increase the chances of the workout plan being accepted. Whether the creditors will agree to a proposed workout plan will depend largely on whether the creditors are better off accepting the workout in comparison to what the creditors will receive in a bankruptcy liquidation or reorganization.
The Pros and Cons of a Workout
A workout is often an effective tool in preventing creditors from taking legal action against the business in exchange for a partial or complete repayment of the delinquent debt. If an agreement can be reached with all creditors, it will accomplish many of the same goals and objectives of a chapter 11 bankruptcy without the expenses and burdens that are associated with a chapter 11 bankruptcy (the burdens on the time and attention of management and the costs and expenses of professionals that are needed to represent the business in a chapter 11 bankruptcy can be substantially greater than the burdens and costs of a workout). Using the funds that would otherwise be used to pay the costs and expenses of a chapter 11 bankruptcy to repay the creditors is often a good incentive for creditors to consider accepting the workout plan.
The disadvantage of a workout is that the business has no ability to involuntarily bind any unwilling creditor that may refuse to consent to the workout plan, whereas in a chapter 11 bankruptcy, a dissenting creditor could be compelled to accept a plan. In addition, the invitation to creditors to meet with management will also give the creditors a forum to meet one another. Depending upon the situation, this introduction may serve as a vehicle for creditors to force the business into an involuntary bankruptcy or to allow creditors to share unwanted information about the business with one another. For example, if a competitor of the business is also a creditor, that competitor will learn of the financial difficulties of the business, which could give it an unintended advantage in its ability to force the business to shut down or to take over the business through a forced sale. In cases where the potential cost savings may not be sufficient to offset the risks of hold outs or takeovers, a workout may not be a viable non-bankruptcy option.
Option 2: Assignment for Benefit of Creditors
A general assignment for benefit of creditors is a liquidation of a business under state law. It is an alternative to chapter 7 bankruptcy liquidation under the federal bankruptcy law. Assignment laws vary by state and an assignment is overseen by the state courts, not the federal bankruptcy courts. Assignments are generally intended for business liquidations, not to reorganize or rehabilitate a business. Under an assignment, an independent assignee is selected and acts as a fiduciary to the creditors of the business. The assignee is similar to a bankruptcy trustee and is responsible for liquidating the assets of the business at maximum value. If all the creditors are fully paid through the assignment, including the fees and costs of the assignee, then any residual interest or funds will be returned to the owners or shareholders of the business.
Initiating an Assignment
Under an assignment, the business assigns its assets to a new assignment estate in writing. The assignment estate is represented by the assignee. The assignee is usually selected by the business, although creditors can sometimes influence the selection process. There are many organizations that specialize in serving as assignees under state law assignments. It is important for management to select a reputable assignee so that creditors will have confidence in the process. An experienced assignee can also ease the process for management.
In connection with the assignment, management is required to file a schedule of assets and liabilities as well as a list of names and addresses of all creditors of the business. The assignee will then notify the creditors on the list that an assignment has been filed. The assignee will also establish a deadline by which all creditors must file a claim with the assignee. While assignments do not have the "automatic stay" injunction that is found under the bankruptcy laws, practically speaking, the business is not likely to endure continued collection efforts after an assignment. Continued collection effort against a business that has assigned its assets to an assignment estate is a meaningless exercise because the business is nothing more than an empty shell with no assets.
Administering Assets of the Business
Sale of Assets: Assignment vs. Bankruptcy. When the business wants to sell its assets but the sales price is not sufficient to repay all of its debts, selling the assets through an assignment may present a more efficient alternative to selling the assets in a bankruptcy case. The buyer, if one has been located, will often dictate to the business whether it would prefer to purchase the assets of the business through a bankruptcy or an assignment.
In an assignment, the buyer will receive a "bill of sale" from the assignee that the assets are transferred free and clear of claims of creditors. The sale in an assignment is likely to occur with very little delay or disruption to operations. Upon selection of the assignee, management can immediately work with the assignee and the buyer to market the assets of the business to third parties in advance of the assignment in order to assure the assignee that the value of the assets to be sold is being maximized. While an assignee is required to maximize the value of the assets to be sold and creditors have the right and ability to voice concerns to the assignee regarding a proposed sale, the assignee is typically empowered with the ability to carry out a sale without a state court order. The assignment statutes typically do not provide a readily available vehicle by which dissenting creditors can object to a sale.
One significant disadvantage to selling assets through an assignment is that the assignee has no ability to force the transfer of leases and contracts absent the consent of the lessor or other party to the contract. In a bankruptcy case, such consent is usually not necessary and the bankruptcy court could force the transfer of certain leases and contracts to a third party if defaults are cured and there is an adequate showing that the third party will be able to perform in the future. Therefore, where the value of the business is in its long term real property leases used at its retail locations or its franchise agreement, a bankruptcy case is likely to be more advantageous than an assignment when the lessor or franchisor is unwilling to consent to a sale and transfer of the leasehold or agreement.
In addition, in a bankruptcy case, the buyer is likely to receive a more comprehensive "bill of sale" in the form of a court order that allows the assets to be sold free and clear of all liens, interests and encumbrances and a court finding that the buyer is a "good faith purchaser," which protects the buyer from losing the benefit of the sale in the event of an appeal of the sale. However, there are costs, risks, and delays associated with a sale in a bankruptcy case (both chapter 7 and chapter 11), which may cause an assignment to be more appealing to the buyer.
A sale in a chapter 7 bankruptcy may result in an extended cessation of operations, which can often be fatal to selling a business as a going concern or to fully capturing the good will value of a business. The business will be operated in a chapter 7 case only under extraordinary circumstances, with the bankruptcy trustee's consent, which is given in his/her sole discretion, and with the bankruptcy court's approval.
The filing of a chapter 11 bankruptcy case with the goal of selling substantially all assets in the early phase of the case can also be problematic. First, a chapter 11 bankruptcy case (where the business acts as the trustee) is often prohibitively expensive for small to medium size businesses. An experienced business bankruptcy attorney will usually require a sizable fee retainer to be paid before filing the case. Second, although management can continue to operate the business, absent exigent circumstances, 20 to 30 day's notice of the sale is required to be given. Third, the bankruptcy court is likely to pay closer scrutiny to the sale of substantially all assets of the business in the early phase of a chapter 11 case than a sale in a chapter 7 case because the goal of a chapter 7 case is to liquidate assets whereas the goal of a chapter 11 case is to reorganize and rehabilitate the business.
Avoidance Powers of the Assignee
In addition to selling assets, in many states, the assignee also has powers to avoid transfers made by the business during certain statutory periods prior to the assignment. These recoveries include transfers made to creditors in the 90 days preceding the assignment filing that allowed the creditors to receive more than they would have in a hypothetical bankruptcy case, as well as transfers of assets to third parties pursuant to which the debtor received less than reasonably equivalent value, i.e., a fraudulent transfer.
Distribution of Assets
After the administration of assets and the expiration of the deadline to file claims, the assignee will review the claims that are filed. If a claim is not timely filed, the claim will normally be disallowed. A creditor with a lien in the assets of the business will retain such lien in the assets, even after the assignment. The assignee will usually file objections with the state court if a claim is disputed.
Upon resolving all claim disputes, the assignee will distribute the funds in the assignment estate first to any creditor that has a valid lien on assets of the assignment estate, second to pay the fees and costs associated with administering the assignment estate, third to pay priority unsecured creditors, fourth to pay all other creditors, and fifth to pay the owners of the business. If the funds are not sufficient to pay a particular class of creditors in full, the creditors in that class will receive pro rata payments and the classes junior to that class will not receive payment.
Once the assignee is satisfied that all the assets of the assignment estate have been liquidated and all claims have been paid in the priority scheme set forth by statute, the assignee will prepare a final accounting and request the state court to close the case.
The Costs of an Assignment
While assignments are usually a little less expensive than chapter 7 bankruptcy liquidations, and significantly less expensive than chapter 11 bankruptcy reorganizations, the process can still be costly. The fees of an assignee are negotiated as part of the assignment contract executed with the business when the assignment takes place. The assignee's fees are often calculated based on a percentage of the funds disbursed to creditors, similar to a chapter 7 bankruptcy trustee. Some states place maximum limits on the amount that an assignee can charge an assignment estate. In addition, the assignee has the right to retain its own professionals, such as lawyers or accountants, who typically charge the assignment estate for fees on an hourly basis and for all out of pocket expenses.
Rights and Remedies of Creditors in an Assignment
Unlike bankruptcy, the creditors' rights and remedies in an assignment are usually not expressly provided for by statute and it may be difficult for dissenting creditors to object to actions of the assignee. A creditor can argue that an assignee has breached its fiduciary duties to the creditors although such claim can be difficult and expensive to establish. In addition, if a creditor is unhappy that the business has used the assignment process, a creditor may institute an involuntary bankruptcy proceeding by filing an involuntary bankruptcy petition with the bankruptcy court. The bankruptcy court would then decide whether to: (1) allow the bankruptcy process to be used to liquidate the assets of the business; or (2) to "abstain" and allow the state law assignment process to continue under the supervision of the state court. In other words, an assignment could force the business into a bankruptcy case, notwithstanding the business's careful deliberation and evaluation of its non-bankruptcy alternatives.
Learn more about business bankruptcies-and how to save your business-in Bankruptcy for Businesses (Entrepreneur Press).