My Small Business is in Trouble. Do I Need a Chapter 11?

This economy has been very rough on many people, but especially harsh on the small business owner. Small businesses don’t have access to the same tools available to larger businesses (access to credit, sale of stock or other security) to weather a stormy economy. Additionally, a small business may be reliant on one core line of business (construction of a certain type of building for which demand dries up) than a larger, more diverse business entity. So what can a small business owner do when the debts are deeper than the money to pay them? Unfortunately, the answers are somewhat limited and can be disappointing.

File a Chapter 11 Bankruptcy. This is the classic business bankruptcy, of which you have undoubtedly seen many examples in the news (pick an airline, the Phoenix Coyotes hockey club, GM and Chrysler to name a few). In this scenario, the business uses the bankruptcy court to help effect a reorganization of the debts of a company, often eliminating a large portion of amounts owed to vendors, and restructuring secured loans (mortgages on land, e.g.) to make for a more affordable debt load. Indeed, the last few years have seen a significant increase in the number of small business Chapter 11 filings. However, a Chapter 11 remains out of reach for most small businesses for a number of reasons:

• Cost of filing. Attorneys for a Chapter 11 are very expensive, often with fees in excess of $50,000. Many small businesses simply cannot afford that kind of outlay for legal representation.
• One large creditor. If most of the debt of a business is owed to one creditor, that creditor essentially has the power to scuttle any plan they don’t agree with.
• The business is no longer viable. It is often hard to admit, but sometimes the business has simply run its course, and needs to end, not restructure.
• Difficulty in obtaining ongoing financing. The credit squeeze has not only affected existing loans, but sharply limited the availability of new financing, especially for distressed businesses.

Informally restructure debts. In the instance of significant debt owed to one or a few creditors, it may be possible, if the creditor is willing, to restructure the debts sufficiently to allow for continued operation. This may require forming a new business entity to continue operations, or some additional personal risk for the owners of the small business. Absolutely consult with legal counsel before attempting this option.

Dissolve the business. Each state has a procedure for the orderly ending of business operations and paying creditors. Following these procedures will keep the officers, directors and shareholders of a business insulated from liability for the debts of the company (barring any personal guaranties or fraud). This has been done for many years, and is the method by which most businesses end. Your business attorney can help lead you through the needed steps.

File a business Chapter 7. Most of the time, it is neither necessary nor desirable to use a Chapter 7 to end a business. The state dissolution procedure is the preferred method. But there are circumstances when it is best to turn the liquidation of business assets to an independent third party (the Bankruptcy Trustee). If there are disputes over what property is secured by a given lender, and in what order they will be entitled to receive sale proceeds, then a Chapter 7 may be beneficial. But most businesses should not be in a Chapter 7, for they have no assets to distribute to unsecured creditors.

Generally I find that when a business owner refers to a “business bankruptcy,” they are referring to taking care of the personal obligations of the business, not the business obligations proper. In this case, they may be suited for a personal bankruptcy, but one that is primarily business-related debt. The distinction is fine, but important.

Remember, entrepreneurialism and the failure of businesses is the American economic way. Bankruptcy and dissolution are the methods that back stop our system, ensuring that the next great business idea can be developed without ruining the lives of the people behind the businesses.