For the last month I have been writing weekly about the challenges and issues that surround closing a business that is no longer profitable. I’ve discussed the decision to close, the steps needed to treat employees and trade creditors correctly and issues regarding business withholding and sales tax and personal income tax. I’ve also written about business owners filing a personal chapter 7 bankruptcy to protect the owners from their personal financial obligations related to the business. Last week I wrote about the rare instances in which a business that operates as an LLC or corporation is well-advised to file its own chapter 7 case. This week I will wrap up this business-centric discussion by looking at the situations in which filing a chapter 13 bankruptcy makes sense for a business owner. But first, let’s take a look at the bankruptcy chapter that specifically protects businesses that file bankruptcy - chapter 11.
Chapter 11 Bankruptcy
Chapter 11 of the bankruptcy code was put in place primarily to allow LLCs and corporations with financial difficulties to reorganize financial obligations sufficiently to allow the business to remain in business. Chapter 11 is a very useful tool for businesses to use when a business is not profitable, but the reason for the lack of profitability is not the market in which the business is competing, but rather that the business is structured in such a way that profitability is difficult, even in advantageous market environments.
Chapter 11, like the other bankruptcy chapters, offers a debtor the protection of the automatic stay against collection activities as soon as a chapter 11 petition is filed. Once the case is filed, the business in a chapter 11 case must file a plan of reorganization with the bankruptcy court. This plan is a proposal to restructure business obligations. The restructure can take many forms, including re-setting the business’s lease and secured debt payments, re-setting employee benefit packages and discounting the amounts paid to trade creditors.
Chapter 11 is unique in the fact that the business’s creditors have a vote as to whether to accept the chapter 11 reorganization plan. If sufficient creditors approve the business reorganization proposed in the chapter 11 plan, the Bankruptcy Court will confirm the chapter 11 plan and the business will continue, with a new set of obligations to honor.
If the chapter 11 plan does not win the support of a sufficient number of creditors, the plan can still be confirmed over the objections of the creditors by the Bankruptcy Court, when the court uses its “cram down” powers - that is, the court can order confirmation of the plan even if a majority of creditors don’t agree with the plan.
If a business that is in a chapter 11 is unable to win confirmation of its plan, or if the plan has been confirmed by the court but the business is unable to honor the terms of the plan, the Bankruptcy Court will convert the case from a chapter 11 reorganization and will instead put the business in a chapter 7 liquidation proceeding.
Why Don’t More Businesses use Chapter 11?
Despite the relief available in chapter 11 that is unique among all bankruptcy chapters, the fact is that there are not a lot of chapter 11 cases filed. In the State of Minnesota in 2015, for instance, there were only 17 chapter 11 cases filed in the entire year. Why aren’t there more chapter 11 cases?
First, the fact is that most businesses that are failing are doing so because the market will not support the number or type of retail shop or service the distressed business provides. Restructuring a business through a chapter 11 doesn’t make a lot of sense when the market simply isn’t big or broad enough to make a particular business financially feasible. In cases where the market prevents financial success, a chapter 11 reorganization isn’t going to do enough good to justify filing a bankruptcy case. When the market isn’t there, the better choice is to close the business, not reorganize it.
Second, there is a significant cost to filing a chapter 11 bankruptcy case. Prior to filing, there must be meticulously detailed work done to insure that the financial disclosures required in a chapter 11 filing have been done correctly. And while it is not required, many chapter 11 plans are prepared prior to filing. All of this involves significant attorney time, and that time is very expensive. Then, once a chapter 11 case is filed, there are a minimum of nine meetings and court hearings involved in the case - by contrast, chapter 7 and chapter 13 debtors have to attend one trustee’s meeting during the pendency of their cases. Again, these meetings and hearings involve attorney time, a significant expense.
So for these reasons, a business owner considering putting his or her business in a chapter 11 case must have the strong conviction that reorganization is feasible and the outcome of a successful chapter 11 case will lead to business profitability. And the business owner must have the financial resources to be able to afford to see the chapter 11 process through.
A couple more notes about chapter 11 before we end this topic: people with financial problems should understand that the chapter is available to individuals as well as LLCs and corporations. So a sole proprietor has the ability to file a chapter 11 bankruptcy if the proprietor is looking to keep his or her business open and operating profitably. And a person filing a chapter 11 bankruptcy does not have to be operating a business to file under this chapter. There are some rare circumstances where a personal chapter 11 filing is well-advised. Typically, this is when a person has significant debt issues, but also has significant assets that would not be exempt in a chapter 7 bankruptcy. Usually, chapter 13 is used to protect non-exempt assets. But chapter 13 has a debt limitation: an individual filing a chapter 13 case must have less than $394,725 in unsecured debt an less than $1,184,200 in secured debt in order to get a chapter 13 plan confirmed.
Chapter 11 has no such debt limits. So for an individual with significant debt and significant assets, a chapter 11 case might be the right choice to resolve financial issues.
Chapter 13 as a Business Debt Option
I’ve spent several weeks talking about business owners closing a business and filing a personal chapter 7 bankruptcy case. Until now, I haven’t discussed using chapter 13 to resolve business-related debt issues. And the reason for that is for most businesses that are no longer profitable, it doesn’t make a great deal of sense to file a chapter 13 bankruptcy case. There are several reasons for this.
One is philosophical: chapter 13 requires the commitment of disposable income by chapter 13 debtors into a chapter 13 payment plan. If a business owner has concluded that the business is no longer profitable, it is likely there is not a great deal of disposable income. A business owner may, in fact, have another source of income with which a hypothetical chapter 13 plan could be funded - but the question is whether this is wise. If a business is no longer profitable, doesn’t it make more sense to liquidate the business assets to pay as much as possible to creditors, and then close the business and move on? Is it wise to pay a business’s obligations with income from non-business sources? Or is a business owner better off using the income from a new venture to fund the expenses of daily life? Many business owners come to the conclusion that if the business is unable to pay its own bills, other sources of income should not be tapped to try to prop up a business that isn’t going to survive.
A second issue makes chapter 13 a more limited option for business owners is that if the business is a retail business, filing a bankruptcy case will in almost every case result in suppliers and vendors restricting or eliminating any credit terms relating to the business’s inventory purchases. A retail business with inventory that is eliminated or reduced is not going to survive. So a chapter 13 for the owner of a retail business rarely makes a lot of sense. Because of the difficulties business owners face with credit lines with vendors and suppliers, there are not a lot of scenarios in which a retail business owner will file a chapter 13.
The third issue is a relatively minor one, but it is worth knowing. Last week I discussed the fact that the business itself rarely files a chapter 7 bankruptcy - it is usually the business owner filing the bankruptcy case. But chapter 7 cases filed by the business itself, although rare, occasionally happen and the benefit of the bankruptcy automatic stay is available to businesses.That is not the case with chapter 13. Only people can file a chapter 13, LLCs and/or corporations can’t “Service” Businesses in Chapter 13." So in light of the issues above, the scenario in which a chapter 13 makes sense for a business owner is this: the business is small, the business provides a service - it doesn’t sell anything, and the business owner has personal obligations on business-related debt.
So why does chapter 13 work for service businesses? First, since there is no retail inventory involved, the service business will typically not have to be concerned with suppliers. Second, most service businesses that are in financial trouble tend not to have a great deal of value, since the most valuable “piece” of the service business is the service provider. We do not value people as a part of a business valuation in bankruptcy, so the most valuable asset of the business is not considered when the value of the business is calculated. And, most importantly, since in a chapter 13 bankruptcy, the debtor cannot lose any property, the business owner does not have to worry about the trustee liquidating the business.
In a typical business chapter 13 case, the business owner is current on the secured obligations of the business and the business is current in its tax obligations. The debt problems are with unsecured debt. In most cases where a chapter 13 makes sense for a business owner, the unsecured debt is usually in the form of credit cards or open lines of credit. And of course, the owner has to believe that the business will be viable, at least to the extent that the business generates enough income to allow the owner to support him or herself and generate enough income to pay chapter 13 monthly payments.
In theory, the business will cash flow more easily if the unsecured debt payments are made more affordable by the chapter 13 plan provisions. But there are big “ifs” with this hypothetical situation - and the most important for the business owner to understand is whether the unsecured debt is in the owner’s name personally, only, or if the business is also obligated. Because if a business owner files a chapter 13 bankruptcy to address unsecured debt issues but the owners creditors simply turn their collection attempts to the co-obligated business, the chapter 13 case has not done a lot of good for the business owner. So in cases in which a business owner is contemplating filing a chapter 13 bankruptcy case, that owner is well-advised to have a pre-filing conversation with the unsecured creditors of the business to make sure that the creditors understand that a chapter 13 case will be filed and to make sure that the unsecured creditors will forebear on the collection efforts they could take against the business. In most cases, this involves committing the business to a set payment over a period of time to cover the business’s liability for unsecured debt.
In cases like this, the business and the creditors must be on the same page in order for this to make a chapter 13 make sense. And in most cases, this is difficult to do; thus the relatively small number of business owner chapter 13s that are filed.
That’s enough (for now) for business issues. I’ll turn my attention to consumer debt problems next week.