What Happens When A Business Files For A Chapter 11 Bankruptcy?
When a business files for Chapter 11, the hope is that the debtor gets a handle on making some money. The business has to propose a plan that’s going to pay its creditors’ claims. Typically, the creditors in the plan are divided into several classes. In many cases, there is secured debt, which may continue to be paid or modified through the proposed plan. Taxes are considered priority claims and entitled to their own class in the plan. Generally, tax liabilities can be paid through the plan over a number of years (often 6). The debtor, upon the plan’s effective date (the date upon which the initial dividends called for under the plan are made), the taxing authorities will receive a percentage of its claim, often 10% to 25%, with interest on the balance being set by statute and, in these times, quite low. A third class of creditors can be unsecured creditors who are paid a percentage of the allowed claims based on the liquidation analysis of the business and the cash flow of the debtor. If we go back to the previous example where there’s $20,000 worth of assets securing $50,000 worth of secured debt, the unsecured creditors will look at what the cash flow may show, usually next to nothing. The, the plan would pay perhaps 10 cents or 20 cents on the dollar over a period of time to the unsecured creditors. Every Chapter 11 requires a different approach and though many cases may seem to be alike, all are different.
In order to have a plan confirmed, the debtor has to file a disclosure statement. The disclosure statement is like a stock prospectus. It’s calculated to enable the poor ignorant creditors to make an informed determination on the viability of the debtor’s plan. It also includes all types of financial information about the debtor’s business during the Chapter 11 and its future projections post-confirmation. Being a cynic and always suspicious of statistics, I feel that if having this stuff makes people happy, so be it, but I believe you can make them read any way you would want them to read. In the kinds of Chapter 11 cases I have handled, I know that no one reads any of this dreck, but it still needs to be filed.
The Bankruptcy Court then holds a hearing on the adequacy of the disclosure. Assuming it’s allowed, a package goes out to all the creditors that contains the disclosure statement, the plan, a ballot, and some other boilerplate documents. The creditors are entitled to vote yes or no on the plan.
In my cases, we painstakingly put together these documents, spend a fortune in postage and the result of these efforts winds up in the trash. Knowing that, I entertain myself when I draft disclosure statements. As one of the judges in Boston used to say, I should write for TV because I always tell an interesting story regardless of the debtor’s business. When I draft these documents, at least I have a good time when I give my debtors’ backgrounds.
Decades ago, crafty attorneys would propose and confirm plans that called for the creditors to receive their first dividend a year after the plan’s effective date. However, few confirmed debtors made it to the first anniversary of their confirmation and those promised dividends were never paid. Nowadays, the debtor has to be able to fund the plan, which means that the debtor has to come up with the money necessary to pay the initial dividend to the unsecured creditors, the initial dividend to the tax claims, and any lump sum payments or other payments due the debtor’s secured creditors at confirmation. Once you get through that, it’s just a matter of informing the Bankruptcy Court that all required distributions have been made and the case should be closed.
Confirmation hearings can be entertaining for those of who practice before the Bankruptcy Court. I represented a restaurant in Westborough, a city near Worcester, in a Chapter 11. They had phenomenal Italian food and steaks, and I remember Judge Quinan asking at the confirmation hearing why I didn’t bring any food for him to taste. He thought that confirmation of that debtor’s plan should have included a taste of its food. He would have loved the food. I took my wife and parents there for dinner. It was very nice.
What Is The Value Of Closely Held Businesses?
Most closely held businesses aren’t worth more than the assets’ liquidation value, especially if they are having financial problems. Oftentimes, the “business” of the closely held business is the person who operated the business, its principal . . . without him or her, there would be no business. If your business is having financial problems, how much is good will worth? How much is a customer list worth in a distressed situation? In many instances, if the primary owner decides to walk away, you may as well say Kaddish, which is a prayer for the dead, for the company. The reason is that either the sons, daughters, or relatives cannot carry on the business or do not have the business knowledge to make the business successful. If the primary person walks away, how much is the business worth? What I suggest doing is to liquidate the company.
You can have a business liquidated for you through a process called receivership. This happens when a creditor who has an unsatisfied judgment against a debtor petitions the Superior Court for an order appointing a receiver to liquidate the company. It’s not a voluntary thing. It doesn’t happen that much today, but it is a possibility.
The second way is through an Assignment for the Benefit of Creditors. In Massachusetts, an Assignment for the Benefit of Creditors is a document that says you are liquidating the assets of the corporation for the benefit of its creditors. It’s about 15 to 20 pages long. An Assignment for the Benefit of Creditors is my preferred way of dealing with closely held corporations. An assignment can help businesses that are looking to go out of business or who want to have another shot at things since there is a way to use it as a jumping point for new entities.
The third way is to have three creditors get together who have an aggregate of more than $15,000 worth of debt owed to them and file an involuntary bankruptcy against you, which becomes a Chapter 7. The creditors would allege that the company is not paying their bills as they come due. Recently, I recommended this to a contractor who was stiffed $25,000 on a job. As we know, filing a lawsuit doesn’t get your money. The contractor said that he knew of several other creditors who are owed money. I recommended that they get together and file an involuntary bankruptcy that ends up in one of two ways. In order to avoid to avoid the involuntary, (1) the debtor pays the creditors or (2) if they don’t, the company gets liquidated. The latter result does not always result in any dividend to the petitioning creditors, but they perhaps get the satisfaction of their being a consequence for non-payment!
The last way is to file a Chapter 7 for the closely held corporation, but I don’t recommend it. Why? You will be subjecting the principals to the scrutiny of the Chapter 7 trustee personally. I can give you many examples where the Chapter 7 Trustee’s inquiry does not necessarily stop at the borders of the corporation. It often extends into the principal’s affairs, sometimes with untoward results.
I once had clients who had a very successful business. They made a lot of money too fast and got into trouble with the state taxing authority. They went to the old family retainer who filed a Chapter 7. As I understand it, they had an accountant who suggested that because they had loaned money to the business, they should take it out as loan repayments rather than salary, the latter of which they would have to pay taxes on. An excellent strategy for a solvent business, not so great for an insolvent one that filed a Chapter 7! Why is that? Payment made by a debtor to insiders, such as the two principals and their one year of loan payments can be recovered by the debtor’s Chapter 7 Trustee. When you file a bankruptcy petition, this information must be disclosed and can be done in such a way as to lessen the potential harm, but the old family retainer listed every loan repayment that had been made within the prior year repayment of which, as I noted above, can be a preference and recoverable by the Chapter 7 Trustee (see the Madoff case). When I took over the Chapter 7, the trustee, who I had known for a long time, asked if my clients had $96,000 to pay the estate for preferences since every loan repayment made within the prior year had been documented in their bankruptcy petition. Due to these preferences, after they had lost their business, adding insult to injury, they had to file a Chapter 13 for themselves to deal with their remaining tax problem. Eventually, everything worked out. The irony was they called me one day and said that they received a check from the IRS for $32,000. They had no idea why. Evidently, they issued a refund to them in error. Under certain circumstances, the refund can be kept. Poetic justice!
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