Blogs by William Manchee
Defending the Small Business: Part 17 - Bankruptcy: Friend or Foe?
12/29/2008 6:35:13 PM
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Bankruptcy is a double edged sword. A customer's bankruptcy can devasate a small business, but when the small business itself is in trouble bankruptcy may be the only way out....
For the SBO, a customerís bankruptcy can be devastating. Rarely is there a reserve for the loss of a large receivable. Even if it is a Chapter 11 or 13, which provides for the payment of a portion of the debt, it often takes months or years to actually receive any part of it. All the SBO can do is file a proof of claim and wait. Occasionally there are objections that can be filed and a bankruptcy attorney should always be consulted to see if there is any way to get the claim bumped up to secured or priority status. In some cases, it may be that the claim is non-dischargable. So donít give up. See a bankruptcy attorney and explore your options.
In many cases, the SBO will have to file bankruptcy himself for his own protection. If he wants to stay in business, it will be a Chapter 11 or 13. If he wants to shut down the business or if he is in the service business and has no business assets, a Chapter 7 might be appropriate.
Chapter 7 is designed to clean the slate and give the person filing a fresh start. To be eligible for bankruptcy, the SBO must prove (1) he has more liabilities than assets, or (2) that he is unable to pay his debts as they become due.
If an SBO qualifies for Chapter 7, he must surrender all his non-exempt property to the trustee appointed in the case. He is allowed to keep his exempt property such as automobiles, household furnishings, personal effects, qualified employee benefit accounts, life insurance policies, tools of the trade, and homestead. He must choose between the state and federal exemptions which have significantly different provisions concerning what property can be kept. In Texas and Florida, the state exemptions are more favorable but, in certain cases, the federal exemptions may be appropriate. The attorney will help the SBO decide the appropriate exemption election.
Getting a discharge is the main objective of a bankruptcy, as it is the release and forgiveness of certain debts. After the discharge creditors are prohibited from attempting to collect the discharged debts.
A secured creditor is the one who holds a mortgage or lien on property owned by the SBO. Secured claims only extend to the actual value of the collateral and the remainder of the debt is unsecured. Secured debts may be reaffirmed if the SBO wants to keep the collateral, or surrendered if he does not. A reaffirmation is a new promise to pay a debt that would otherwise be discharged. Reaffirmations must be made before the discharge, must be in writing, and may be revoked prior to discharge or within 60 days after it is made. An SBO debtor has no obligation to reaffirm a debt.
A Chapter 13, sometimes called a ďdebtor adjustment,Ē is designed to allow the SBO debtor to reorganize his personal or business affairs. The objective is to allow the SBO debtor to keep certain assets in exchange for paying a portion of the debt that otherwise could have been discharged in Chapter 7. These payments are made to a trustee and extend over a period of three to five years. For the SBO debtor in trouble, a Chapter 13 may provide a way to save the business.
To be eligible for Chapter 13 the SBO must be an individual, have a regular income, have secured debt of $750,000 or less, and unsecured debt of $250,000 or less. In Chapter 13, a plan is submitted for approval, called confirmation, which will provide for a monthly payment to be made to the standing chapter 13 trustee. The chapter 13 trustee distributes the plan payments to the creditors as set forth in the chapter 13 plan and in accordance with the requirements of the bankruptcy code.
The amount of an SBOís plan payment will depend on his income and allowable expenses. He will have to prepare a reasonable expense budget that will be subtracted from his income to arrive at the amount available for plan payments. The amount must be paid for a minimum of three years and maximum of five years.
The Chapter 13 discharge is much more extensive than in Chapter 7. Fewer objections are allowed, and some debts which are not dischargable in Chapter 7 are discharged in chapter 13. Most debts not paid through the Chapter 13 plan will be discharged upon the completion of the plan. Secured debts will still have to be paid if the SBO debtor desires to keep the collateral.
If the SBO debtorís circumstances change during the course of the Chapter 13 case, they may be eligible to modify their plan to take these changes into consideration. For example, if one spouse loses a job, the plan may have to be modified to reduce the payments or suspend payments until the spouse gets a new job.
The SBO debtor receives immediate relief from creditors the moment a bankruptcy is filed, as an automatic stay or court order takes effect that prohibits creditors from making contact with an SBO debtor or attempting to collect their debt.
To commence the bankruptcy process the SBO debtor must complete schedules and a statement of financial affairs. The SBO debtor will need to provide to his attorney the name and address of all his creditors and the balance owed to each, complete asset information, and copies of his last three income tax returns. He will also be asked to prepare a budget of the SBO debtorís monthly income and expenses.
Several weeks after the bankruptcy is filed, the SBO debtor will have to attend a creditor meeting before the trustee appointed in the case so he can determine if your paperwork is in order. At this time creditors can attend and ask you questions. The SBO debtor and his spouse, if married, must attend this meeting for the bankruptcy to be finalized.
There is a downside to filing any kind of bankruptcy that the SBO debtor must be aware of prior to filing. The most significant is the effect bankruptcy will have on his credit. A credit bureau can show a Chapter 13 on a credit report for seven years and a Chapter 7 for up to ten years from the date of filing. If the SBO debtorís credit is already damaged, this might not matter. Or, if there is no other option, the loss of credit might be an acceptable risk.
Another drawback that SBOs donít always understand is that in Chapter 7 they must surrender any non-exempt property such as investments, non-exempt real estate, and cash immediately after filing. In Chapter 13 they may be allowed to keep non-exempt property but they will have to pay additional monies into the plan equal to the value of the non-exempt property that they keep. The theory is that unsecured creditors should recover more from a Chapter 13 than a Chapter 7.
The trustee can make an SBO debtor turn over assets acquired after the filing too, such as tax refunds, inheritances, insurance proceeds, lottery winnings, and other windfalls. The SBO debtor must report any such receipts to the Chapter 7 trustee promptly so the trustee can decide whether to claim those assets or not. Large sums will always be taken, but many times smaller amounts will be abandoned by the trustee. In Chapter 13 the SBO debtor must amend his schedules and Chapter 13 plan to reflect the receipt of any subsequent receipts or windfalls.
Another risk in filing bankruptcy is the adverse publicity that often results. This is particularly bad for the SBO debtor trying to reorganize a business. Sometimes sales will decline as some customers are scared off by the bankruptcy. Creditors who owe the SBO debtor money will suddenly get the idea they donít have to pay their debt because the business is in bankruptcy. This is a false, but common belief. The SBO debtor will have to stay on top of his accounts receivable and advise anyone owing money that their obligation must be paid in a timely manner or it will be turned over to an attorney.
There are some debts that Chapter 7 will not discharge such as certain taxes, student loans, child support, alimony, intentional injuries to persons and property, and liability as a result of driving while intoxicated. If an SBO debtor has any of these types of debts on the date of filing, he will have to arrange for payment of these debts outside the bankruptcy.
Secured debt, of course, is not discharged by a Chapter 7 or 13 bankruptcy, so the SBO debtor will have to continue to pay such secured debts or surrender the collateral. If the collateral is surrendered, any deficiency will be discharged. Many times assets previously purchased are no longer needed in the business. Bankruptcy provides the option to surrender those assets to the creditor and get relief from that obligation. A similar provision applies to leases and contracts. This ability to pick and choose assets and debts to reaffirm is a critical tool for the SBO debtor which often is the key to a successful reorganization.
Chapter 11 is another type of reorganization for individuals with larger estates, corporations, partnerships, and limited liability companies. It is dramatically different than Chapter 13 in cost, procedure, and complexity. Whereas a Chapter 13 may only cost the SBO $2,000 or $3,000, a Chapter 11 will be at least $10,000 to $20,000. A Chapter 13 is administered by the standing Chapter 13 trustee who takes care of much of the work that ordinarily would have to be done by the attorney. In a Chapter 11 the attorney has to do everything.
Consequently, there will many more meetings with the attorney, hearings before the court, and administrative red tape in order to prosecute a case from start to finish.
Other differences include a much higher filing fee, the possible appointment of an unsecured creditorsí committee, closer financial scrutiny, and the filing of a detailed disclosure document similar to what would be required in a stock offering. An accountant is almost always needed to help prove the feasibility of the plan by making future projections of how the plan will perform financially.
One advantage to a Chapter 11 is that it has more flexibility. The term is not limited to five years as is the case in the Chapter 13, and the attorney can be much more creative in the specifics of the plan. Unlike a Chapter 13, the Chapter 11 plan will be put to a vote, so there is some politics involved.
There are some basic requirements for filing either a Chapter 11 or 13. Any debts owed at the time of filing must be listed on the debtorís schedules and cannot be paid during the plan without a court order. Debts and expenses incurred during Chapter 13 or 11 must be kept current. The SBO debtor is not allowed to get further in debt without permission of the court.
What this means is that the debtor must be able to operate at a profit immediately after filing bankruptcy. This is the downfall of most debtors. When they first file they donít always know what has gone wrong, so they donít know what adjustments need to be made to be profitable. So, oftentimes, in months two or three of the bankruptcy, they will be already starting to get behind. In a Chapter 11 the U.S. Trusteeís office monitors each debtor-in-possession carefully and, if they get behind on post-petition payments, the trustee assigned to the case is likely to file a motion to dismiss the case or convert it to Chapter 7.
Consequently, itís extremely important at the very outset of a Chapter 13 or 11 to identify what has caused the SBO to be in the predicament he finds himself and take swift, effective measures to resolve that issue. If the problem canít realistically be fixed, then a Chapter 7 should be filed and the business shut down. Thereís no point in prolonging the agony if the business canít be saved.
Bankruptcy is a very useful and powerful tool for the SBO in trouble. Obviously, it should only be used if there is no other way out, but once it is invoked, it will likely be the best chance the SBO has for survival.
Next: Loan Consolidations and Workouts
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