December 1, 2020

Barbara L. Yong

Insolvency is defined as either having more debts than assets based on a balance sheet test or being unable to pay your debts as they come due. 

Once a business is insolvent, and is operating in the “zone of insolvency”, business owners have a fiduciary duty to operate in the best interest of creditors. If they fail to do so, they can be held personally liable for newly created business liabilities, despite the protections normally afforded them by the corporate veil. 

Business owners must also recognize they have personal liability for certain business debts like unpaid income tax, sales tax, employee withholding tax, union dues, wages, unfunded and underfunded pensions. 

It is important to determine whether the business can break even or become profitable. Once way to do that is to prepare a 13-week cash flow analysis taking into account projected income and expenses, both fixed and variable. 

Sometimes you can create or increase profitability by making operational changes like eliminating certain product lines, changing vendors or renegotiating vendor contracts, closing some locations, renegotiating leases and business loans, laying off employees and making other changes. Chapter 11 bankruptcy can help accomplish some of these goals.   

But if, at the end of the day, despite these efforts, the business is going to continue to lose money, the owner needs to decide whether it would be better to close the business.

Possible alternatives include:

  1. Winding down the business yourself. Under the Illinois Business Corporation Act, a business has 2 years to wind down its affairs after it is shut down. The owners are responsible for notifying creditors (and customers) that the business is closed, selling assets to try to maximize their value, and making a distribution to creditors under the priority scheme established by Illinois law. Secured creditors are paid first up to the value of their collateral. Priority claims (taxes and wages) are paid second. Followed by unsecured creditors. Owners holding claims can be paid along with the other creditors, but they cannot take dividend type distributions until all claims have been satisfied.
  2. Filing chapter 7 or 11 to liquidate the business. In chapter 7, the liquidating is done by a trustee appointed by the bankruptcy court. In chapter 11, the debtor conducts the liquidation or reorganization as a “debtor-in-possession” or DIP.
  • a) Chapter 11 of the Bankruptcy Code provides a corporation or an individual an opportunity to reorganize their business. Because of the dramatic changes in the law that occurred last February, a conventional Chapter 11 should not be considered unless the undisputed debts exceed $7,500,000. Chapter 11 can be an expensive long drawn out process, but in the right circumstances can be a very effective tool for reorganizing a struggling business.

The primary goals of filing Chapter 11 are (1) to provide for an equality of distribution among creditors of equal priority in order to prevent a race to the courthouse by those same creditors, (2) an ability to preserve the business whose intrinsic value is worth more than its liquidation value, and (3) that distributions be fair and equitable between classes in a scheme established by Congress.

Either a company or a group of a company’s creditors can file a Chapter 11 Petition under the Bankruptcy Code in order to provide for either a restructuring of debt or an orderly liquidation of the assets. It is generally preferable to enable a Debtor to continue to operate rather than reorganize or sell the business. A Debtor that is forced to close its doors cannot obtain a discharge of its debts. Moreover, once the bankruptcy is over the creditors would be able to obtain judgments against the Debtor and attempt to pierce the corporate veil in order to attack the principals of the Debtor.

To enable reorganization, the Debtor is provided with several tools to assist in restructuring its debts without the hindrance of creditors:

  • the Debtor is permitted to continue to operate and to remain in possession of all of its assets;
  • upon the filing of the case an automatic stay is entered stopping collection of prepetition claims and stopping creditors from interfering with the property of the DIP;
  • the DIP can use, sell, or lease property of the estate even if the property is subject to the interest of another entity;
  • the DIP can obtain financing for its customary business operations and offer incentives to the lender such as a priority claim to recover their loan ahead of certain other creditors; and
  • the DIP can elect to assume or reject any leases or executory contracts and the damages sustained by the other party to the executory contract will be in the same priority of payment as general unsecured creditors.

In addition, the DIP has the ability to recover money or property transferred before the commencement of the case. Section 547 of the Bankruptcy Code permits a debtor, subject to certain conditions and defenses, to “clawback” payments made to creditors within 90-days of the filing of a bankruptcy petition (or one-year for “insiders”).

The Debtor also has an exclusive period of 120 days to propose a Plan of Reorganization. That period can be extended with Court approval for as long as 18 months. The Plan may modify the rights of any class of creditors and the Plan can be confirmed even though one or more classes of creditors oppose the Plan. All that needs to happen is for one class of creditors who are impaired to vote for the Plan.

There are also protections provided to creditors under Chapter 11. First, a creditor may obtain a dismissal of the case if it was filed in bad faith or in which there is no feasible prospect of a Plan. Creditors can also obtain the appointment of an independent trustee or an examiner when there is evidence of fraud, gross incompetence, or misdealing. Additionally, any secured creditors may obtain relief from the automatic stay when its interests are not adequately protected and the property is not necessary to reorganize the Debtor. Finally, the secured creditors can obtain adequate protection when property it has a security interest in is being used, sold, leased or borrowed against during the Chapter 11.

Once the exclusive period for a Debtor expires, creditors may propose their own Plan. The court may not confirm a Plan if the holder of a claim that is impaired will not receive under the Plan at least what it would have received if the Debtor liquidated under Chapter 7. The court may not confirm a Plan unless the court determines the Plan confirmation is not likely to be followed by liquidation or further reorganization. Finally, for protection of creditors the UST may appoint committees of creditors to investigate the Debtor’s past and current operations, oversee the DIP operations, and negotiate with the DIP concerning the reorganization Plan.

  • b) The Small Business Reorganization Act -- Chapter 11, Subchapter V.   In the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (“BAPCPA”), Congress amended the Bankruptcy Code and Title 28 of the U.S. Code to provide special rules and procedures for “small business debtors.”[1] The small business provisions of BAPCPA “institut[ed] a variety of time frames and enforcement mechanisms designed to weed out small business debtors who are not likely to reorganize.”[2]

After more than ten (10) years of practice under BAPCPA, Congress concluded that “[n]otwithstanding the 2005 Amendments, small business Chapter 11 cases continue to encounter difficulty in successfully reorganizing.”[1] In response and to “streamline the bankruptcy process by which small businesses debtors reorganize and rehabilitate their financial affairs,” Congress enacted the Small Business Reorganization Act of 2019 (“SBRA”). The SBRA was signed by the President on August 26, 2019 and became effective on February 19, 2020.[2]

The primary effect of the SBRA is the creation of a subchapter to Chapter 11 for small business debtors. SBRA addresses the unique issues faced by small businesses in the bankruptcy process. Originally, the threshold jurisdictional amount for SBRA was $2,725,625 in secured and unsecured debts combined. On March 27, 2020 the amount was increased to $7,500,000.

SBRA’s primary advantage was the creation of the new Subchapter V for Chapter 11 for small business debtors. SBRA also amended or otherwise affected many other provisions of the Bankruptcy Code, including by declaring about two dozen Sections and subsections of Chapter 11 to be inapplicable in Subchapter V cases, a half-dozen of which may become re-applicable if the court so orders “for cause.”

Here are just a few of the highlights in the provisions of new Subchapter V:

  • A trustee will be appointed in every Subchapter V case. Ordinarily, a trustee will act as a fiduciary for creditors; usually in lieu of the appointment of a creditors’ committee. However, a Subchapter V trustee has different duties, such such as[1]:

    • Overseeing the debtor’s case, including examining proofs of claims and, if advisable, opposing discharge of the debtor;
    • Furnish information to any party in interest;
    • Make a final report and file a final account of the administration of the estate with the court and with the United States trustee;
    • Investigate the acts, conduct, assets, liabilities, and financial condition of the debtor, the operation of the debtor’s business and the desirability of the continuance of such business, and any other matter relevant to the case or to the formulation of a plan;(A) file a statement of any investigation conducted under paragraph (3) of this subsection, including any fact ascertained pertaining to fraud, dishonesty, incompetence, misconduct, mismanagement, or irregularity in the management of the affairs of the debtor, or to a cause of action available to the estate;
    • Appear at hearings related to the administration of the bankruptcy case including, hearings on valuation of property, confirmation of a plan, modification of a plan, sale of property of the estate;
    • Facilitate the development of a consensual plan of reorganization; and
    • If a plan is not consensual, make the distributions to creditors pursuant to the plan.
  • Only the small business debtor may file a plan of reorganization, and it must do so within 90 days after the order for relief (which may be extended by the court “if the need for the extension is attributable to circumstances for which the debtor should not justly be held accountable”).

  • The rules for the contents of a Subchapter V plan of reorganization are more debtor-friendly than under existing Chapter 11. Notably, a loan secured by the principal residence of the debtor may be modified by the plan if the proceeds of the loan were used for the small business.

  • The requirements to confirm a plan are more debtor-friendly than under existing Chapter 11, particularly the rules for confirming a plan over the opposition of an impaired class of creditors.

  • You can still confirm a Plan even without a class of accepting creditors so long as you pay your creditors all of your disposable income over the next 3 to 5 years.

  • No Absolute Priority Rule. The requirement that equity holders of a small business provide “new value” to retain their equity interest in the Debtor without paying creditors in full has been eliminated. Instead, the new law only requires that the Plan does not discriminate unfairly, is fair and equitable, and provides that all of the Debtor’s projected disposable income be applied to payments under the Plan or the value of the property to be distributed under the Plan is not less than the projected disposable income of the Debtor.

In addition to the creation of “Subchapter V” to Chapter 11, the SBRA also makes important amendments to the statutory provisions governing preference actions. Currently, the Bankruptcy Code does not explicitly require a debtor or trustee to undertake any due diligence prior to commencing an action under Section 547, but simply says that a debtor or trustee “may” do so. The SBRA addresses this issue by requiring a debtor or trustee to consider a party’s statutory defenses “based on reasonable due diligence in the circumstances of the case and taking into account a party’s known or reasonably knowable affirmative defenses” prior to commencing an action under Section 547.

The SBRA also impacts where preference defendants can be sued. Currently, claims under $13,650 must be brought in the district where the defendant resides (as opposed to where the bankruptcy case is pending), but the SBRA raises this threshold amount to $25,000. Often times, the simple costs to defend an out-of-state preference action outweighed the benefits of pursuing valid defenses in small preference actions. This change flips the analysis, requiring debtors or trustees to weigh the costs of bringing out-of-state actions with the prospect of minimal recovery.

  1. Making an assignment for benefit of creditors (known as an ABC). This is an out of court bankruptcy-type process where you hire a chosen individual to perform the liquidation. The assets are transferred to the assignee, they notify creditors of the assignment, conduct the sale of assets and make a distribution. They publish notice of the sale which is conducted as an auction subject to higher and better offers. If the assets are sold quickly, they can sometimes preserve the “going concern” value of the business. It is also possible for former owners to use the ABC process to reacquire assets without being deemed a successor and being saddled with the debt of the former company. 

  2. Giving the collateral to the lender to liquidate. If the business owes the bank or other secured lenders more than the business assets are worth, the owners can turn over the keys and relinquish possession. With real estate, this is known as a deed in lieu of foreclosure. With personal property, you can simply turn over the collateral to the lender. This may include inventory, equipment, vehicles, furniture, accounts receivables, etc. The lender must liquidate the collateral a reasonable manner if it wants to hold the business owner liable under his or her personal guaranty.

At the end of the day, all of these alternatives are preferable to simply ignoring the warning signs of a struggling business, waiting to get sued, and paying a whole lot of legal fees.