Although it’s best used as a last resort, filing for Chapter 11 bankruptcy can offer struggling businesses a chance to restructure debt and emerge as successful entities, says Marc Merklin, managing partner at Brouse McDowell.
“Chapter 11 is a tool and not an end in and of itself,” he says. “Businesses that go into it without knowing what they want to accomplish often flounder and fail because it’s an expensive process. The longer it goes on, the greater the risks and costs. Companies that succeed have a specific goal and accomplish it as quickly as possible.”
Smart Business spoke with Merklin about alternatives to bankruptcy and how to best utilize the Chapter 11 process, should it prove necessary.
Are there options short of bankruptcy that should be considered first?
A workout is the best option because bankruptcy is expensive and risky. Try individual negotiations with the lender or creditors. Often with the lender there can be workout or forbearance agreements. They can be difficult to negotiate and disruptive to cash flow as lenders often add fees and expenses, as well as interest rate increases. Still, it’s usually desirable to attempt to work that out before seeking Chapter 11 protection. Most lenders understand that Chapter 11 will not only delay the exercise of their remedies and cost additional funds, but also carry risks such as ‘cramdown,’ which means forcing creditors to accept a plan they oppose.
Even if you have multiple creditors, you can negotiate with a group of them through an out-of-court settlement, whereby you give creditors notes for past due obligations and then amortize them. That can be difficult depending on the number of creditors.
What are the differences between Chapter 7 and Chapter 11 bankruptcy filings?
Chapter 7 is liquidation, so there is a trustee appointed and the business is almost never sold as a going concern. Even if you’re going to sell the business or liquidate it, it’s often better to do it under Chapter 11 because the company can still manage itself rather than being liquidated by someone who has no knowledge of the industry or business.
The goal under Chapter 11 is to restructure and emerge. In the past five years, more Chapter 11 filings have been sales as going concerns rather than true reorganizations. In a sale as a going concern, assets go to a buyer who will operate them as the business but under new ownership and a new structure free of claims and debts. In a restructuring, the company largely emerges the same even if there is a new investor or new ownership.
What are the benefits of filing Chapter 11 bankruptcy?
One is cramdown — the ability to force a payment plan when creditors are not willing to agree to a payment plan on their own.
The other is the ability to reject burdensome contracts that are causing huge losses. You can go into bankruptcy and reject that contract, convert it to a claim that you pay under a plan and not be bound by the contract. For example, if you’re selling to a customer at a huge loss and they’re holding you to that contract, you can reject that contract. They’re going to have a claim, but it would be an unsecured claim under bankruptcy and might be paid at 10 cents on the dollar. The company is then freed from the requirement of producing those goods at a loss and can generate positive revenue going forward.
But while Chapter 11 can be a very useful tool, it’s not the most desirable process because of the cost of accountant and attorneys’ fees, as well as the risk for existing owners and equity holders in the company. Under the absolute priority rule in bankruptcy code, equity holders or owners fall last in line. They cannot retain their equity ownership without contributing new value to essentially ‘pay’ for those equity interests after confirmation of the Chapter 11 plan.
Marc Merklin is a managing partner at Brouse McDowell. Reach him at (330) 535-5711 or firstname.lastname@example.org.
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Is declaring bankruptcy really the best course of action? In some cases, this can be true. But in most instances, it may be time to step back and consider other options, says Lewis Landau, senior counsel at Dykema Gossett LLP.
“I have found that by the time the debtor arrives at a bankruptcy lawyer’s office, there is an extreme bias in favor of pulling the bankruptcy trigger,” Landau says. “It’s almost as if the gravity pull of just going to a bankruptcy lawyer means you’re ready to do it. However, bankruptcy is just one of several tools available to a debtor.”
Smart Business spoke with Landau about how to determine the difference between needing to declare bankruptcy and simply wanting to declare it.
What is the difference between needing to file and wanting to file?
Have-to-file cases are ones in which there is an immediate loss of control of something, such as a pending eviction, forthcoming foreclosure, or a bank account has been levied up and has already lost money. Control has been lost — or is imminently going to be lost — and the debtor needs to take action through the help of the bankruptcy process today to regain control. In those instances you generally will have to file.
Those are the easy calls. However, most cases are not have-to-files, they are want-to-files, when people feel the need to do something to cure their problems.
If there is nothing that elicits the immediate loss of assets, the attorney should ask what is creating the pressure, why are you here and why are you contemplating bankruptcy?
The answer is generally a lawsuit. The sheriff has come and scared the owner by handing over papers. They panic and wind up in a bankruptcy lawyer’s office the next day because, having been served, they feel that they have to do something immediately.
However, lawsuits take a very long time to resolve; in Los Angeles, it generally takes a year. So you have to measure the cost of allowing the lawsuit process to continue. Even though you ultimately may wind up with a bad judgment, it could be smarter to let that timeline string out. You eventually could settle that case, and the problem is resolved.
Some of the hardest advice a bankruptcy lawyer gives is to not file when someone wants to do so. Your first reaction upon hearing that may be that the lawyer doesn’t know what he or she is talking about, but there may be a better alternative.
How can cost deter you from declaring bankruptcy?
To go into bankruptcy, you have to be able to afford it. Chapter 11 bankruptcy is a very expensive process. Much like you wouldn’t want to drive to Las Vegas from Los Angeles on half a tank of gas because getting stuck in the desert is never good, you don’t want to get involved in a bankruptcy case and not be able to finish the process because of the cost. At a minimum, figure $50,000 to re-organize, and the sky is really the limit.
Another concern is that the moment you file, a whole host of new people and agencies are involved in your life who weren’t before, such as the U.S. Department of Justice’s Trustee Program and its trustee offices, the court and the creditors, who have a large stake and influence in a debtor’s future. There are degrees of loss of control that happen by filing that may not happen if you don’t file, and those need to be measured and balanced.
What else should a business owner be thinking about when considering filing?
A business cannot operate in the red in bankruptcy.
A company may go into bankruptcy and have a few months of losses before going back into the black, and that’s OK if a debtor can show the low point of a seasonal business or orders that will create a profit in the future.
The reason why accrual of losses in bankruptcy is especially treacherous is that post-bankruptcy debt — to the extent that it is unpaid — receives administrative expense priority, which means it’s the top priority at the same level as unpaid legal fees.
The day before bankruptcy, if credit is extended to a business without collateral, it is general unsecured debt. That same credit extended the day after bankruptcy is top priority and entitled to be repaid in full, immediately, in order to exit the bankruptcy. General unsecured debt, on the other hand, generally gets paid back over years, or not at all.
If too much post-bankruptcy debt is accrued and unpaid, the ship can’t sail to its goal. It gets top heavy and falls over because the organization can’t pay its debts to get out of bankruptcy.
The process is a partnership between the bankruptcy lawyer and the business. The lawyer can do a lot to make it work but can’t do anything without a profitable business. Bankruptcy attorneys fundamentally take that profit component, drop it to the bottom line and make deals with creditors to split that. And if there is no profit, the attorney has nothing to work with.
If you have a bias toward filing, you will always be able to find a bankruptcy attorney to file for you. However, if an experienced bankruptcy attorney who knows the system and who understands the adverse consequences advises against it, it may be prudent to heed that advice.
Lewis Landau is senior counsel at Dykema Gossett LLP. Reach him at (213) 457-1754 or LLandau@Dykema.com.
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Your parts distributor has always been reliable, offering you prices that its competitors couldn’t beat. It was a great deal for you — until the distributor went bankrupt.
You find another supplier and move on. But months — or years — later, you are called on by a bankruptcy trustee that has been appointed to oversee the bankruptcy case. The trustee says that the commodity you were purchasing was priced much lower than market rate. And because the trustee’s job is to collect funds in this case, he’s delivering you with a lawsuit to charge you with paying the difference between your below-market prices and the market rate for those years you purchased the commodity.
“Increasingly, customers of bankrupt businesses are being caught by surprise with fraudulent transfer claims asserted by bankruptcy trustees, who claim that they received a deal that was too favorable,” says Alan Koschik, co-chair of the Commercial & Bankruptcy Practice Group at Brouse McDowell. “These claims seek to renegotiate sale transactions long after they took place and create a new layer of uncertainty for certain business transactions.”
Smart Business spoke with Koschik about how businesses can help protect themselves against fraudulent transfer claims.
What are fraudulent transfers and when do they most commonly occur?
Technically, a fraudulent transfer claim is a transfer of property that is made with the intent to hinder or delay a creditor, or put property beyond their reach. In typical cases, a debtor might transfer his home or savings accounts to another person, an insider such as family or a spouse.
Fraudulent transfer claims most often arise in these familiar situations: transfers to insiders, as described; so-called upstream guaranties of a corporate parent’s debt by a business that ultimately cannot pay its creditors; and leveraged buyout transactions that cause an insolvent debtor to take on too much debt while permitting former equity holders to cash out of the business.
What is surprising about the new class of fraudulent transfer claims?
The new class of claims is distinctly different from these typical cases. They do not involve insider transactions, or extraordinary transactions. The claims are being charged against customers that have engaged in day-to-day business transactions, such as simply buying a commodity a company sells.
The customer isn’t trying to defraud or hinder anyone; it simply wants to buy the product and the seller (debtor) is offering an attractive price. However, bankruptcy trustees are seeking to change the price term of regular sales transactions long after they were completed by arguing that the value paid was less than ‘reasonably equivalent.’ Litigation ensues and usually involves an expensive debate about the sufficiency of the price.
What typical business transactions could lead to fraudulent transfer claims?
Sales of commodities are the most typical sales that can trigger a fraudulent transfer claim because a bankruptcy trustee has access to pricing information. Commodities are traded in a variety of exchanges, so trustees can look up idealized prices and make comparisons to prices actually paid to the debtor, the business that went bankrupt. Then, the trustee can calculate the difference and come up with a figure that he contends the customer should have paid.
The trustee justifies this based on commodities prices, charging that the debtor would have collected X more dollars if it had charged the reported market price. Commodities are more likely to be subject to a pricing comparison and lead to a fraudulent transfer claim than, say, accounting or legal services that are typically considered unique and less likely to have a non-negotiable ‘market price.’
In case of a lawsuit, what defenses can a business raise?
These new fraudulent transfer claims can be challenged with the argument that non-insider customers that negotiate at arm’s length set their own market price and should not bear the burden of guarantying the debtor-seller’s debts to its creditors. The customer shouldn’t have to help pay the vendor’s debt just because it was offered a lower price on a commodity during a regular business transaction.
A non-insider customer’s negotiated price should be considered to be ‘reasonably equivalent value’ by definition and the trustee’s claim should fail. However, the problem is that litigation is a lengthy, costly process, and customers frequently end up paying more in a settlement.
How can businesses protect themselves against fraudulent transfer claims?
If your business purchases commodities, dig deeper when vendors offer a surprisingly low price. Why is the price so low? How long has the company been in business? Are you aware of the financial state of the vendor’s business? Is it in trouble? How much lower than market rate is this vendor charging?
While it’s prudent in business to seek out vendors with competitive prices, if a deal seems too good to be true, it just might be. That said, if you move forward with a vendor offering a price you can’t resist, engage in a futures contract or swap agreement. These transactions are common in the commodity trade, and there are safe harbor defenses built into the bankruptcy code regarding futures trading.
It’s a good idea to consult with your attorney if you engage in commodities purchases to discuss pricing and the potential risks associated with fraudulent transfer claims. Then protect your business by making decisions not based solely on cost.
Alan Koschik is co-chair of the Commercial & Bankruptcy Practice Group at Brouse McDowell. Reach him at email@example.com.
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While the light of economic recovery may be appearing on the horizon, many sectors of the economy continue to suffer slow growth and persistent or periodic struggles with liquidity as a result of low demand for goods and services. Until consumers determinatively shake off the historically low levels of confidence and reverse the current trends of debt reduction and increased savings rates, some businesses will fall on hard times.
A struggling business and its leaders (e.g., directors and officers of corporations, or managers of limited liability companies) seeking to avoid the entity’s failure as it experiences liquidity challenges or insolvency need to heed some legal rules that may not be readily apparent.
Smart Business spoke to Steve Dettmann and Douglas Landrum of Jackson DeMarco Tidus Peckenpaugh about a few common legal matters for those businesses, and their principals (and guarantors), to consider when the business experiences difficult times.
Management may be liable to creditors
Normally, the duties of the directors of a corporation and the managers of a limited liability company are owed to the equity holders of the business. However, if a business has insufficient equity or is insolvent, management personnel may become personally liable for approving distributions to shareholders or other equity owners. For a Delaware business entity, the Delaware Supreme Court has held that when a corporation is actually insolvent, fiduciary duties arise for the benefit of creditors in the place of shareholders — under the theory that the creditors of an insolvent corporation become the beneficiaries of any increase in value and suffer the detriment of further decreases in value of the corporation’s remaining assets. Thus directors and managers should ascertain an accurate financial understanding of proposed actions of struggling businesses.
Not all guaranties are the same
Another area where principals become exposed to personal liability for obligations of the business is by executing guaranties. In many lending circumstances involving small and medium-sized business entities, lenders will require guaranties of varying types from principal equity owners. These guaranties come in many forms — some absolute, some limited and some contingent. Some guaranties are unconditional and others may limit the lender’s recourse to a specific set of assets or circumstances. Most guaranties contain a set of waivers pursuant to which the guarantor waives statutory suretyship defenses — some ironclad and others suffering notable deficiencies. Understanding the difference is key.
In commercial real estate lending, the borrower’s principals are frequently induced to give the lender a “springing” guaranty (sometimes referred to as a “recourse carve-out” guaranty) under which the lender’s right to seek recovery beyond the borrower or the specific secured collateral arises only upon the occurrence of specified events. These events typically include “bad boy” acts of the borrower (notwithstanding that only certain of the acts are inherently “bad”) including, among others, fraud, misrepresentation, commission of waste, prohibited transfers, failure to pay real estate taxes or failure to properly apply security deposits, reserves or insurance proceeds. The spring on some guaranties is sprung (i.e., the recourse obligation arises) when the borrower, during times of financial difficulties, seeks legal protection from its creditors through the filing of a petition in bankruptcy — even though the bankruptcy petition may be later dismissed (i.e., like bells that cannot be unrung, certain springs cannot be unsprung). Therefore, if a commercial real estate enterprise is failing, guarantors having influence over the actions of the borrower should consult with counsel to ascertain the potential consequences of a borrowing entity’s proposed actions before those actions are taken, and to carefully navigate through potential foreclosure of real property security so as to avoid, where possible, the triggering of liability under a guaranty.
Completion guaranties are commonly used as credit enhancements for construction financing, but the remedies available to a lender are uncertain. Generally, recovery under a completion guaranty is limited to the increase in value of the collateral that completion would offer; and where a lender on an underwater project cannot demonstrate that the value upon completion would exceed the as-is value, then the completion guaranty may be worthless.
Knowing which type of guaranty binds the principal, and whether there may exist a partial or complete defense to recovery, is essential to determining what actions should be taken or decisions should be made on behalf of the business.
Filing bankruptcy may not be a good idea
While a debtor-in-possession (DIP) usually acts as the trustee upon the filing of a bankruptcy petition under Chapter 11 of the United States Bankruptcy Code, if the business cannot present or implement a viable plan to reorganize in a Chapter 11 bankruptcy, under certain circumstances, the bankruptcy case can be converted to a Chapter 7 liquidation upon request of the creditors. Independent U.S. Trustees appointed by the court in Chapter 7 bankruptcy liquidations are compensated based upon what they are able to collect on behalf of the estate for payment to the creditors of the bankrupt entity. With this motivation, the trustees frequently look into the pre-petition acts of management and equity holders to determine whether the bankruptcy estate may have causes of action that could bring a recovery. A Trustee may therefore act in a manner opposed to management and equity holders, as they look for evidence of insider transactions, misuse of corporate assets for personal benefit, distributions to equity holders at or near the time of insolvency or breaches of duties that could provide access to policies of directors and officers liability insurance.
Accordingly, if a struggling business is unlikely to be able to reorganize in bankruptcy, then it may be a better course for management to wind-up the business and distribute assets to creditors (similar to a bankruptcy liquidation) without filing a case with the United States Bankruptcy Court. Negotiating with creditors for a liquidation of the company’s assets without a bankruptcy case may avoid the appointment of a trustee who turns out to be the worst enemy of former management or owners.
Remember tax obligations
One of the knee-jerk reactions of management in a difficult business setting is to use funds withheld from employee wages (income tax, social security tax or Medicare withholdings) for liquidity purposes instead of paying over the funds to the IRS and other tax authorities. This is one of the worst methods that management could employ to prop up the business as it begins to fail, as any “responsible person” of the business (meaning the individual or group of individuals within an organization who, individually or collectively, has sufficient authority to pay over withholding taxes) may be held personally liable by the IRS for a Trust Fund Recovery Penalty — a 100 percent tax penalty — for failing to pay over taxes withheld from the employee.
If a business is struggling, management and equity holders must be mindful of the many traps that exist from which could arise personal liability, and a small investment in consultation with legal counsel before actions are taken may be essential to avoiding unnecessary loss.
Steve Dettmann is Senior Counsel, Real Estate Practice Group and Douglas Landrum is a Shareholder and a Member of the Corporate Practice Group at Jackson DeMarco Tidus Peckenpaugh. Reach them at SDettmann@jdtplaw.com and DLandrum@jdtplaw.com, respectively.
(Reuters) ? Perkins & Marie Callender's Inc, owner of the Perkins and Marie Callender's restaurant chains, filed for bankruptcy in a Delaware court on Monday, citing a slump in sales due to weak economic environment in its primary markets.
Perkins & Marie Callender's, which is owned by New York-based investment firm Castle Harlan Inc, said in its filing it witnessed a sharp decline in restaurant sales in the Midwest, Florida and Pennsylvania, where it primarily runs its restaurants.
High unemployment and foreclosure rates in Florida and California led to a decrease in discretionary income for many historically loyal customers, resulting in a decline in customer traffic, the Memphis, Tennessee-based company said.
The company listed total assets at $290 million and liabilities at $440.8 million in its Chapter 11 petition. Eleven of its affiliates were included in the bankruptcy filing.
Perkins, which was formerly known as The Restaurant Company, operates or franchises around 600 restaurants in the United States, Canada and Mexico, court papers show.
The company was formed after the Perkins Restaurant & Bakery chain was merged with Marie Callender's Restaurant and Bakery in 2006.