Sometimes, bankruptcy can mean a fresh start.
The specter of bankruptcy can be a business owner’s worst nightmare. It’s a word that carries the stigma of financial failure and often signals the end of a dream. But filing for bankruptcy doesn’t necessarily preclude future success. Walt Disney did it, and so did Henry Ford, and yet both went on to build phenomenally successful businesses.
In 1923, Disney had to shutter his first company when he lost his financial backing, but he had talent and the idea for a character named Mickey, so he headed west from New York to California to build a magic kingdom that endures. Ford, an innovative engineer, had a concept for an automobile and, after his initial business sank in 1901 due to poor marketing, he established the Ford Motor Company and built the Model T, the first of many successes. Each man retained the elements of his defunct operation that had promise, even if intangible, used bankruptcy as a way to escape the weight of unmanageable debt and moved forward, demonstrating that, sometimes, bankruptcy can mean a fresh start.
Finding the way out
For a business in financial trouble, bankruptcy is often the best solution, but owners need to know their options and understand the repercussions of filing (or not) for bankruptcy protection. It starts with choices, but not everyone is aware of that. “Normally, they don’t know what they’re doing when they come in the door,” says Ellyn Lazar of the Law Offices of Ellyn M. Lazar, a bankruptcy attorney with offices in Santa Rosa and Napa.
Lazar’s clients tend to be small businesses, such as mom-and-pop retail stores, tanning salons and construction companies. For them, the choice is between Chapter 7 liquidation and Chapter 13, which lets them reorganize their financial situation. She starts by asking clients, if they had a choice, would they rather stay in business or cease business operations.
The result is more often liquidation than reorganization. She finds that by the time they reach her office, clients are often burned out, so Chapter 7 is the best option. “They’re tired and don’t want to continue,” she says.
If, however, a client does want to stay in business, she has them look at their budget very closely to determine its viability. “Once they step back and really see their budget, it becomes apparent as to why they’re in debt,” she says. “It should tell the story.” They could, for instance, owe the landlord a lot of money because they’ve deferred paying rent, in which case, she might suggest they cut costs by moving into a less expensive space. Other times, letting some leased equipment go can help in planning a reorganization.
In addition, she recommends her clients create a business plan, make a complete list of debts and meet with an accountant to discuss their complete financial situation. Lazar adds that struggling business owners should look at their profit-and-loss statements from the previous six months—and if they haven’t been doing them at all, she encourages them to get started (and work retroactively).
In a crucial question, she asks clients if they’re able to meet their business costs and make enough money for living expenses. Sometimes that’s the defining factor. Frequently, clients have accumulated personal debt to pay business expenses. “They’ve maxed out on their credit cards,” she says, forcing them to turn to bankruptcy because they have no more sources of cash.
Shops focusing on non-essential merchandise that went out of business at V Marketplace (formerly Vintage 1870), a shopping center in Yountville, are an example of retail businesses facing liquidation. But she’s seen successful reorganizations as well. Her most unusual case was a tourist attraction in Mendocino County that had insufficient revenues because it was closed for a substantial part of the year, leading to financial problems. “The owners went through the whole process of reorganizing and creating a repayment plan, and they concluded it successfully,” she says.
Something worth saving
The economic downturn in 2008 brought an increase in bankruptcies, but John Vos, of the Law Office of John A. Vos in San Rafael, believes the business climate is improving. Vos, who represents businesses such as small independent contractors in the half million to $2.5 million range, finds fewer seeking to restructure than liquidate, but observes that reorganization, ultimately, provides more possibilities. “More people have something worth saving as the economy improves,” says Vos, and reorganization gives them a second chance. In contrast, liquidation is final: “It’s like pushing delete on your computer and starting over,” he says.
Reorganization is a tool that can help companies regain control, he explains, citing the Johns-Manville Corporation as a high-profile example. Johns-Manville, a Denver, Colo.-based company founded in 1858, produced building materials that contained asbestos. In the 1980s, after asbestos was identified as a cause of lung cancer and other diseases, the company faced individual and class action lawsuits that numbered in the thousands. It filed for Chapter 11 bankruptcy protection in 1982, which let it consolidate the actions, make them manageable and deal with them all at once. It emerged in 1988 and is still operating today—minus the asbestos—as a wholly owned subsidiary of Berkshire Hathaway.
Vos considers the action Johns-Manville took a proactive step that let the company recover. Similarly, smaller businesses facing challenges can use bankruptcy as a strategy, albeit on a much lesser scale. He describes a client with financial problems who owns investment rental properties; as a result of his filing for bankruptcy, the bank is rewriting his loans. “Bankruptcy is powerful, because it can force things [banks] wouldn’t do,” he says. They might, for example, have to settle and accept less than they’re owed, letting a business reorganize.
Most businesses don’t pursue bankruptcy willingly. “Usually there’s a trigger,” says Vos. It could be a lawsuit or perhaps a bank calling in a loan. He says business owners need to pay close attention to their finances: When their debts are excessive and their cash flow isn’t strongly positive, they’re in trouble; if they find themselves in that situation, Vos suggests they write down the amounts they owe their creditors and try to make a plan to pay them back. “Over time, they could dig their way out of the hole,” he says.
Seeking help
Business owners should also consult an attorney—one who has the competence and experience to explain the complexities of bankruptcy law. “Law is kind of like a foreign language,” says Vos, adding that most people don’t know what to expect. “People should be able to talk to their accountants and attorneys and bounce ideas off them,” he says. “You don’t have to do it alone.”
Among the issues an attorney can explain is tax law as it applies to a particular client situation. Lazar explains that although filing for Chapter 7 bankruptcy protection lets a business discharge or reduce most debt, if payroll tax or sales tax is delinquent and a company fails, the individual owners may be held personally responsible for the taxes and any penalties that may apply. In that case, she’ll suggest Chapter 13 rather than Chapter 7, giving the business a chance to reorganize and pay off its debts to the federal government and California’s Employment Development Department.
The problem is that most people wait too long to seek help. “A lot of times, people procrastinate,” says Lazar, referring to business owners who hold off until their vendors cut them off or they’re sued. “It doesn’t hurt to see an attorney before they are totally in trouble,” she observes.
Vos finds that clients hesitate because they don’t see bankruptcy as a proactive step, and he observes that delaying can ultimately limit their choices. “Options get compressed if you’re too late,” he says. Part of that hesitation is a negative impression of bankruptcy as an option. Vos believes that’s changing, however. “The perception has changed since big companies like GE, General Motors and PG&E have done it,” he says, adding that people no longer believe bankruptcy puts “a big red ‘B’ on their chests.”
The value of communication
Tiburon attorney Kenneth Press Nemzer considers bankruptcy an alternative for a business in debt (the “debtor”) only when all else fails. “My view of bankruptcy is that it’s not so much an option as a tool,” he says. His interest lies exclusively in finding ways for businesses to get back on track and move forward—he does not handle liquidations—and he encourages clients to talk to their creditors and keep the lines of communication open in an attempt to avoid bankruptcy altogether. “Our free market system is based on people reaching agreements rather than being told what to do,” he says. “That’s why we have contracts.”
He finds that many creditors will be reasonable if a business owner makes an honest effort to work things out. “What’s most important is that when you have creditor problems, you stay in touch with them. Don’t play games,” he says, advising debtors to avoid adding anger and frustration to a situation that’s already difficult. “If you’re able to stay in business, it’s almost always better,” he says, but if a significant number of creditors refuse to cooperate, then bankruptcy is a way to reach a solution. “Always behind those negotiations is the tool of bankruptcy,” he says.
“Sometimes, creditors are impossible to line up, and the only way to get out of crushing debt is to go into bankruptcy. …Then the debtor goes to court to have a judge oversee a resolution,” says Nemzer, who counts high-tech businesses among his clients who have sought bankruptcy protection.
He describes the case of a dentist who went deep into debt to purchase state-of-the-art equipment, but then couldn’t meet the payments. The financer refused to lower the payments, forcing the dentist into bankruptcy. He had income from his practice, mostly from insurance claims, and it was clear what had to be done, but the creditor was intransigent. “It was a matter of fighting until everyone agreed to what had to be,” said Nemzer.
He says that creditors always try to be tough, because they don’t want to settle for a worse deal than anyone else, but, in the end, they usually accept something. He points out that communication and making the effort to work things out are to everyone’s advantage, because bankruptcy is costly and can be a long process.
Going to court
How a bankruptcy plays out depends on the size of the debtor’s business. But in every case, once a business has filed for bankruptcy, creditors must stop seeking payment for existing debt (they’re allowed to make arrangements to be paid for new transactions), existing lawsuits are stayed and new suits are disallowed.
At an early hearing, creditors cross-examine the debtor, as does a lawyer from the U.S. Trustee’s office. Creditors can volunteer to be appointed by the bankruptcy judge, to a creditors’ committee (typically, only large creditors volunteer). In a large bankruptcy, the committee may meet multiple times; in a smaller bankruptcy they may not meet at all. During the bankruptcy proceeding, communication between debtor and creditors, ordinarily through their lawyers, is useful. Mutual understanding is helpful at all stages.
All creditors submit their claims to the court. The debtor and their lawyer accept or reject each claim, subject to court approval, and the debtor’s lawyer prepares a Disclosure Statement and a Plan of Reorganization. Once those documents are satisfactory to the judge, they’re sent to all creditors for a vote. If the plan receives a majority vote of the creditors, both in dollar amount of claims and number of creditors, the plan is agreed to.
If the parties involved can’t come to an agreement, however, they head back to court. Sometimes, explains Nemzer, the judge will do a “cram down” and rule creditors have to accept the plan even if they don’t like it and didn’t vote for it. The lead up to a cram down may include hearings, negotiations and revisions. The goal is always to find a workable solution. If successful, the debtor settles his or her debts according to the plan and goes on with their business. If not, the business is liquidated and the assets (if any) are distributed to creditors.
Having a competent attorney is crucial for a successful bankruptcy outcome. In the wake of the economic downturn and resulting recession, bankruptcies spiked and a large number of attorneys inexperienced in bankruptcy law entered the field. The situation was so serious that Judge Alan Jaroslovsky of United States Bankruptcy Court, Northern District of California, in Santa Rosa, posted a strongly worded letter on his website in September 2009, chastising lawyers who weren’t qualified in bankruptcy law for their errors. “I see frequent malpractice in individual Chapter 11 cases, and I’m quick to note it on the record,” he wrote, warning that he would not allow lawyers in his courtroom who didn’t have adequate malpractice insurance.
Subsequently, the court ran seminars titled “How to be a Real Bankruptcy Lawyer,” including one in Santa Rosa in July 2012, to discuss ways an attorney could acquire the credentials necessary to qualify as a professional bankruptcy lawyer.
Business owners contemplating bankruptcy should look for attorneys with the appropriate credentials as well as a solid track record. The ultimate goal is an outcome that makes the best of a bad situation and lets them move forward in a productive way. The right lawyer can help them do that.
Bankruptcy is an obstacle to be overcome and, done well, it can open the way to a new start. Who knows? Today’s bankrupt business owner might just be an entrepreneur destined for future greatness.
About Bankruptcy
Business owners who are unable to meet their financial commitments and seek relief through bankruptcy have the following options:
Chapter 7: The court discharges or reduces the debts a business has accrued when a company needs to liquidate. Sometimes the debtor must give up property to satisfy obligations. It also applies to individuals who need to file personal bankruptcy.
Chapter 11: Allows the reorganization of a company, usually one with a very large amount of debt, and is the usual choice for large corporations.
Chapter 12: Relatively uncommon, it’s designed for family farms.
Chapter 13: Also called debt adjustment, it requires a business owner to file a plan with federal bankruptcy court outlining how the business will pay its creditors. It’s an option for small businesses and is useful for individuals considering personal bankruptcy as well.
Resources
Bankruptcy falls under the jurisdiction of the federal court. Find out more about United States Bankruptcy Court, Northern District of California, at www.canb.uscourts.gov.
Learn more about bankruptcy at the California Bar Association’s website, www.calbar.ca.gov. The California Bar Association publishes a pamphlet, “What to do if I can’t pay my debts?” To request a copy, send an email to pamphlets@calbar.ca.gov.
