Finding a Fresh Start in Bankruptcy Court

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(Bloomberg Businessweek) -- There are some companies for which bankruptcy is not an end, but a chance for a new beginning. Chapter 11 of the U.S. Bankruptcy Code establishes a process for a business to reorganize, eliminating  some obligations and restructuring others to lower monthly costs going forward. “Banktuptcy is good for taking debt that's been accumulated and right-sizing it," says Michael Goldberg, a bankruptcy lawyer in Boston. It's also an opportunity to make additional adjustments to the business—to give it a fresh start with a fighting chance.

In Chapter 11, the debtor usually gets first crack at presenting a plan to reorganize its affairs. The plan can be approved over the objections of individual creditors or even whole groups of creditors. In crafting a plan, a debtor has some powerful tools at its disposal. For example, a debtor reorganizing under Chapter 11 can accept or reject each of its ongoing contracts (though it cannot unilaterally modify those contracts), including purchases, sales, and leases.

That can make bankruptcy especially attractive in some circumstances, says Deborah Williamson, who heads the bankruptcy practice for the Dykema law firm. For example, “if you’re a retailer and you have a customer base, but you know that you have stores that weren't performing well, it may be to your advantage to say, ‘I reject these leases.’” A contractor who finds that particular jobs don’t allow for any profit can use bankruptcy to quit that work. The damages a counterparty suffers from losing those contracts then become unsecured claims (that is, obligations that aren’t backed by collateral such as real estate or equipment).

The bankruptcy code also puts limits on some unsecured claims—including leases, which, says Williamson, are typically capped at a year’s worth of rent. So if, as part of a reorganization, you pull out of a lease with six years remaining on it, the landlord can claim only one year’s worth of rent. (However, if you have personally guaranteed the lease, your landlord can pursue the claim against you personally, outside the bankruptcy case.) Sometimes lenders will lend new money  to insolvent companies only  when they file for bankruptcy.

All this takes place in court, so there are plenty of chances to object and drag out proceedings, which makes bankruptcy an expensive proposition. “I’ve never confirmed a case for less than $100,000,” says Rob Charles, who practices bankruptcy law in Las Vegas and Tucson, Ariz., “and most of those didn't have a lot of fighting.” Moreover, equity owners have traditionally had to surrender their stake in the reorganized company. As a result, few small businesses in recent years have relied on the courts to supervise reorganization.

Fortunately, though, a new provision of Chapter 11 known as Subchapter V should make reorganization easier and cheaper—perhaps half as expensive as a regular Chapter 11 case, Charles estimates—and owners will be able to keep their stakes. “I think bankruptcy will be a more effective and more frequently used tool for small businesses that can make it,” says Goldberg. Currently, businesses with up to $7.5 million in debts can use the streamlined procedures, but the limit will drop to $2.7 million at the end of March 2021 unless Congress acts to preserve the higher limit.

Some companies try to reorganize outside of court, particularly those fearing that their reputation—and sales—would tank if they were to declare bankruptcy. “You can do it out of court, but your tools are more limited,” says Goldberg. Without the hammer of bankruptcy court looming, any single creditor can block your plans. If your relationship with your creditors has soured, you’ll particularly need to hire a lawyer or turnaround specialist who knows how to talk to them. And you have to be able to convince them there’s an exit strategy outside of bankruptcy that’s better than the exit strategy inside of bankruptcy.”

©2020 Bloomberg L.P.

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