Blogs by William Manchee
Defending the Small Business Under Siege - Part 18, Loan Consolidations & Workouts
1/4/2009 6:25:40 PM
Sometimes bankruptcy will not be a viable option for the Small Business Owner(SBO)in trouble. Luckily there are other alternatives.
A typical situation might be that the debtor has paid off a debt to a family member. If he files bankruptcy, the money that went to the family member might have to be returned to the debtor’s estate as a preference. Let's say two brothers, Luke and Wally, are contractors. Luke is good with money and has accumulated a nice estate. Wally, on the other hand, spends everything he has and is always broke. Consequently, Wally is always borrowing from Luke. Despite Luke’s help, Wally can’t make ends meet and finally gets so far behind that bankruptcy seems like his only option.
The problem is: he had previously borrowed $140,000 from Luke and over the last year has paid him back $75,000 leaving a balance of $65,000. If he files bankruptcy, Luke loses $65,000, which he is prepared to write off because he loves his brother. But then his bankruptcy attorney tells him that not only will he lose $65,000, but he’ll have to pay the bankruptcy trustee back the $75,000 that he received during the previous year.
Preference law is one of the most difficult legal principles to explain to SBOs. What the law tries to accomplish is to put all creditors on an equal footing. Since family members have inside information and influence, it is common for them to be paid all, or at least some, of what is owed to them before the bankruptcy is filed. This would be unfair to general creditors, so the law states that anything received by an insider (family member, employee, partner, etc.) must be returned to the bankruptcy trustee to be distributed to general creditors in accordance with the priority system of the bankruptcy code.
A preference can also occur between unrelated creditors of the bankrupt debtor. The time is shortened from one year to 90 days, however. I recall one case in which a manufacturers’ representative for a clothing manufacturer, Brandon, was owed commissions of about $60,000. This was the only company he represented, so he was very upset to learn his manufacturer was having financial difficulties. When he pressed the company for payment of his commissions, they put him off, but eventually gave him a check for $35,000, claiming there were some issues with the balance due. Several weeks later the company filed bankruptcy.
Brandon was upset to have lost $25,000 but glad to get some money at least to tide him over until he found a new company to represent. Then one day he got a letter demanding that he return the $35,000 that had been paid him because it had been paid within 90 days of filing bankruptcy. Flabbergasted, he shot back a nasty letter to the bankruptcy trustee telling him that it was his money and he was keeping it.
It wasn’t long after that he was served with a citation advising him that an adversary proceeding had been filed against him in a bankruptcy court in Maryland. At this point he conferred with a bankruptcy attorney and found out he may, in fact, have to return the money.
So, if an SBO has paid a preference to someone and he doesn’t want them to have to return the money, bankruptcy will not be an option until the preference period has gone by. Another reason he might not want to file is that he has personally guaranteed so much of the debt that filing a bankruptcy will not really be of much help. Just as soon as the corporation files Chapter 11, the creditors will start coming straight to him, so if he files bankruptcy for the company he will have to file personal bankruptcy as well.
In this case, the SBO may want to borrow money for a workout or a bill consolidation loan. A workout is the payment of a debt over an extended period of time or satisfaction of the debt for less than 100% of the balance due. For instance, I often can settle old credit card debts for 50 cents on the dollar. So, if an SBO who owes $30,000 in credit card debt gives me $15,000, I can usually convince the credit card companies to accept this amount in full satisfaction of their debts. This is just one of many types of workouts that can be negotiated with creditors. The key is to convince the creditor of the dire circumstances of the SBO and the tremendous risk he has of never getting paid. Usually a creditor would rather take a sure thing now rather than speculate on an uncertain future.
A bill consolidation loan is a new loan obtained for the purpose of paying off several existing debts with the net result usually being a longer payout at a lower interest rate. In this case if the SBO has $30,000 in credit card debt at 21% interest and is paying the 2% minimum monthly payment of $600. If he only pays the minimum payment each month he may never get the loan paid off. So he goes and gets a loan for $30,000 at 10% interest payable in 15 years. His monthly payment is now only $322 which improves his cash flow dramatically.
Whether the SBO can get a loan for either of these purposes will depend on several factors whether or not: (1) his credit is still good enough, (2) he has collateral for a loan, or (3) he can get a co-signer. One common source of funds for a workout is home equity. Lenders love it because they can have a fully secured loan and, if the debtor defaults, there is usually enough equity in the property to be assured of a full recovery.
Another common way to get loan consolidation or workout funding is with a loan guaranteed by someone with good credit or someone who has collateral to pledge. Friends, family members, or partners are usually good sources for this type of help. In one case a contractor, Peter Walker, was very popular and always busy. Unfortunately, he didn’t know how to run his construction business and got farther and farther behind on his payroll taxes, until the IRS was about ready to shut him down. Since payroll taxes are not dischargable in bankruptcy, a workout was his best option.
In this case Peter teamed up with a friend, Tom Banks, who knew how to run a business but knew nothing about building a house. Tom loaned him the money to pay the IRS with the promise that they would do future business together: Tom running the new venture and Peter handling operations. Thus bankruptcy was avoided and a new enterprise was begun that probably had a much better chance of survival than Peter had as a sole proprietor.
Another alternative to bankruptcy is the workout. What this involves is negotiating with creditors to get them to take less than what is owed to them. For instance, if $100,000 is due to creditors, the debtor might propose a workout of $25,000, or 25 cents on the dollar. Whether or not creditors will accept a workout depends on whether they can be convinced that it is a good deal. For instance, I often tell creditors that they can either accept 25% now or chance getting zero if a bankruptcy is filed. Some will tell me to take a hike, but most will reluctantly accept the lesser amount because, as a practical matter, it is very difficult to collect from a creditor in trouble. This is particularly true if the debtor is out of state.
Sometimes workouts take months or years to accomplish, as some creditors will resist the workout and file suit to collect the entire amount. Others will simply just stubbornly refuse to agree. Over time most will succumb and accept the amount offered. The ones who hold out will either end up getting paid in full or getting nothing.
In one instance I contacted a creditor of a florist I was doing a workout for and offered $18,000, which was 50% of what was owed. The creditor was very hostile and told me his attorney would be calling me back. The attorney was equally belligerent and asked if I would accept service for my client. Over the next nine months while we were litigating this case, all the funds we had for the workout were exhausted. Eventually, the hostile creditor got tired of the expense and hassle of litigation and offered to take the $18,000. We politely informed him that there were no longer any funds available for settlement.
In another case the opposite happened. The creditor jumped right in and filed suit. He prosecuted the suit vigorously and would have jeopardized the entire workout had we not settled with him. In this case he finally accepted an 80% payout, which was much higher than anyone else received, but necessary under the circumstances.
My standard advice to clients is, if possible, stay out of court. Once you surrender yourself to the jurisdiction of the courts, then you have lost control over your life and must accept whatever judgment the court imposes. So, if it isn’t absolutely necessary to file a bankruptcy, then a workout is the best way to go. Often you can accomplish nearly as much on your own without giving a judge control over your destiny.
Next: Employees: Double Trouble
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