Although some people think bankruptcy is a death knell for businesses, it is actually a vital part of our economic system. Bankruptcy can allow a reorganized business to emerge stronger and better positioned to compete in the market. In fact, at its core, bankruptcy rewards entrepreneurship. Bankruptcy provides a safety net for businesses, which face economic challenges, to restructure their debts or even wind down the company in an orderly fashion. In this way, bankruptcy rewards innovation and creativity in the market. As discussed below, Chapter 7 and Chapter 11 bankruptcy can be helpful strategies for distressed companies.
Chapter 7 for Businesses
Businesses contemplate filing for bankruptcy for many reasons, and the various chapters under the Bankruptcy Code can help a business accomplish its objectives. In some circumstances, a business may face such severe financial challenges that it decides to close its doors. In these cases, a Chapter 7 bankruptcy allows the liquidation of the business and payments to its creditors in an orderly manner. This orderly liquidation process alleviates the pressures the company faces in juggling the competing demands of multiple creditors.
In Chapter 7, the business ceases operating, and a trustee is appointed to liquidate the business’s assets and make payments to the business’s legitimate creditors. The Chapter 7 trustee plays a vital role in administering the bankruptcy case. The Chapter 7 trustee identifies assets to liquidate or sell. These assets could include recovering transfers (or payments) the company made to creditors in the months before it filed for bankruptcy.
A basic rule under the Bankruptcy Code is that similarly situated creditors must be treated the same, and one should not be preferred over another. The trustee may unwind some of these pre-bankruptcy payments to ensure similarly situated creditors are treated equitably in the bankruptcy case. If the trustee is successful at identifying and liquidating assets, it then makes payments to the debtor’s creditors.
After fulfilling its duties as a debtor under Chapter 7, the business sheds its pre-bankruptcy debts. Although the company is no longer operating, its owners can seek new opportunities. It is this process that allows entrepreneurs a “fresh start” to pursue other business ventures.
Chapter 11 for Businesses
A company may have other objectives for filing bankruptcy that do not include closing its doors. For example, a company may need to restructure loan payments or rework existing leases to adjust to market changes. In Chapter 11, the company continues to operate its business while it works to restructure its debts. In these cases, a Chapter 11 bankruptcy gives the business a breathing spell to negotiate more favorable contract terms.
When a company files its bankruptcy petition under either bankruptcy chapter, the automatic stay of the Bankruptcy Code arises, and parties can no longer take action against the debtor company without an order from bankruptcy court lifting the automatic stay. This automatic stay is designed to give the company time to determine a plan of reorganization without the pressure of pending debt collection activity. Any steps taken in violation of the automatic stay are considered “void” or “voidable,” and sanctions may be available against creditors that willfully violate the stay.
Bankruptcy can also be a useful tool for a company to manage difficult litigation that threatens the company’s operations. High legal bills and lengthy lawsuits can take their toll on a company. It is not uncommon for a debtor’s largest creditors to be the very same parties who were fighting the company in the courtroom prior to the bankruptcy. When managed correctly, bankruptcy may assist a company in resolving its difficult legal issues.
Under Chapter 11 protection, the debtor company focuses on negotiating payment plans with its creditors. Often, the company will locate an outside financing source to pay off existing lenders on more favorable terms. The company can also determine whether or not to close certain store locations, reject cumbersome contracts or leases, adjust existing equity interests, sell business lines or reassign management duties.
Bankruptcy debtors under Chapter 11 also can market and sell their assets, but usually only with bankruptcy court approval. In fact, through bankruptcy, a company can rework its corporate structure by “rolling up” subsidiaries or through mergers and acquisitions. Additionally, the debtor can work with taxing authorities to structure payment plans. Like under Chapter 7, once a Chapter 11 debtor completes its duties, including payments to creditors under the reorganization plan, it receives a fresh start. Ideally, the company emerges leaner and more nimble.
Examples of Corporate Reorganizations
Some examples of national Chapter 11 reorganizations include Blockbuster and Kodak. Bashas’ is among the local businesses, both large and small, which have benefitted from bankruptcy. Often, bankruptcy trends are dictated by market forces such as changes in technology, laws and regulations, or industry. In Arizona, we are seeing an increase in bankruptcy cases in the healthcare industry. The recent changes in healthcare laws have forced some healthcare companies to reevaluate and restructure their business models through Chapter 11.
In one recent case, a local company faced significant exposure in multiple lawsuits with various creditors, and filed bankruptcy to manage the litigation and complete a possible sale of the company. The company was the majority interest holder and managing member of multiple subsidiaries that did not file bankruptcy. Those subsidiaries owed significant amounts to secured creditors, repayment of which the parent company had guaranteed. Through the Chapter 11 plan of reorganization, the company was able to negotiate settlements with its pre-bankruptcy litigation opponents as well as the subsidiaries’ secured creditors. The plan of reorganization also allowed the company and its subsidiaries to determine the future corporate structure outside of bankruptcy.
A business owner contemplating whether bankruptcy is a good option for his or her company should talk to an attorney — the earlier, the better, in most cases. There are many issues that must be addressed before a company files for Chapter 11 bankruptcy protection, including paying employees, creating new bank accounts, maintaining relationships with critical vendors, ensuring the lights stay on, and starting dialogs with creditors. A skilled bankruptcy attorney can assist in navigating these complex issues.
Despite the common myth that bankruptcy always means “going out of business,” bankruptcy also can be a good way for companies to adjust to market demands. Effective Chapter 11 reorganizations help companies streamline their business models and exit bankruptcy better prepared to succeed. In the event a business must go out of business, Chapter 7 bankruptcy provides an orderly liquidation process that allows business owners to move through bankruptcy and seek new opportunities. Either way, bankruptcy can be a growth strategy.
Kami M. Hoskins is an attorney with Jennings, Strouss & Salmon, P.L.C. focusing her practice on bankruptcy, commercial litigation, and labor and employment. Hoskins represents corporate, small business and individual clients by implementing effective resolutions to complex legal issues.
Each case a business or individual may face is unique and may require legal advice. This article does not constitute, and should not be considered, legal advice. Individuals are urged to consult with an attorney on their own specific legal matters.