Sometimes, the best option is to just fold and go home. How do you know when that is? Well, the answer is complicated and beyond the scope of this newsletter.
When the time to liquidate does come, however, it's in your best interest to care how this occurs. First, if you leave a mess behind for someone else to clean up, their interests will likely not be aligned with yours. Second, and as I outlined in my
March 2014 newsletter, when your business shuts its doors you can lose significantly more than just your investment.
Today's newsletter, then, is about choosing the best method for your set of circumstances when the business can't be sold as an ongoing concern.Here are the basic choices:
- Chapter 11 bankruptcy
- Chapter 7 bankruptcy
- Assignment for the benefit of creditors
- Statutory liquidation
- Similar methods as above but without Federal or State law backing
Note this article is not about selling the business as an ongoing sale to pay creditors. That is a whole other newsletter or more. However, these methods can be used to liquidate what is left after the bulk of the assets are sold.
Chapters 11 and 7 BankruptcyBankruptcy has its plusses and minuses.
Among the biggest minuses are cost; a need for upfront cash; a high degree of lost control compared to alternatives and the transparent and adversarial nature of bankruptcy in general.
As an example, a creditor or trustee may well take the remaining assets and use them to fund suing
you. In one case in which I was involved, the administrator of the liquidating trust spent over $300K in creditor funds on forensic accountants, to sift through tens of thousands of petty cash tickets in search of cash the owner may have taken. Fortunately, for the owner, they gave up.
On the plus side, the Federal nature of bankruptcy streamlines the handling of assets located in multiple states (particularly real estate). In addition, some contracts can be assigned (e.g., the right to use a trademark, real estate and other leases and more for less than market rates) - something that typically can't be transferred without the other parties' consent outside of bankruptcy. Furthermore, in bankruptcy, assets can be sold free and clear of liens; some constraints are put on feisty secured creditors; all civil legal processes are automatically stayed; and landlord claims are typically capped for something far less than the remaining rent that is due under the lease.
The two business bankruptcy options are Chapter 11 and Chapter 7, both of which can be used in the same case.
Traditionally, Chapter 11 has been used to reorganize companies so that the same company going into bankruptcy leaves bankruptcy - but with less debt and perhaps fewer onerous contracts. In a Chapter 11 case, the debtor usually remains in control of the company and the holy grail is to leave bankruptcy with a confirmed plan of reorganization.
But more and more companies are not being reorganized in Chapter 11. Rather, the assets are sold in an auction to a buyer or buyers and the proceeds from the sale (along with any remaining assets) are distributed to creditors in what is called a
Liquidating Plan.
To confirm such a Liquidating Plan (or any Plan), the Plan must be able to pay all administrative claims up front. These claims include the expenses for the companies' advisors and attorneys; the committee of unsecured creditors advisors and attorneys; all other necessary expenses incurred during the bankruptcy and payments to vendors for goods received in the last 20 days prior to filing the case. Additionally, during the case, payments may need to be paid to utilities and others as "adequate protection" for their services. All of this takes cash the company may not have, particularly after a secured lender takes his due.
Chapter 7,
is often used when there is not enough money to pay those administrative claims. Here, a Trustee is appointed to gather assets, liquidate them, and pay creditors according to a priority scheme set by the bankruptcy statute. The trustee may well use existing funds to sue business owners or "avoid" certain payments made to creditors prior to the bankruptcy, including those that relieved the owner or executive of personal liability.
The worst case scenario is if the Chapter 7 Trustee decides to abandon the case and call it a "no asset" case. At this point, the debtor is where he was before filing for bankruptcy - except that time has elapsed (sometimes years); tax returns haven't been filed; creditors haven't been paid and the debtor is in a bigger mess than before the filling.
Several years ago, this was a serious concern for one of my clients. The client was effectively an association of research hospitals, one that after several years of bickering, decided to dissolve. My client owned valuable R&D materials, had serious HIPPA exposure and a few, small but very irritated creditors. It took some convincing, but rather than file for Chapter 7, the members finally agreed to liquidate in a more controlled manner (by me.)
Assignment for the Benefit of CreditorsLegal in many states, with an "Assignment for the Benefit of Creditors," the assets of the company are transferred or assigned to a trust that liquidates them, settles claims and distributes the proceeds. The statute calls for noticing creditors and paying them equally.
The advantage of an ABC is that there is often some legal protection for the liquidator or trustee, as well as the company and its officers and directors (provided that various procedures and requirements are followed and met as detailed in the State's statute). An ABC may also convince a litigious creditor to stop and take his fair share. Note that while some states allow for priority payment of wages, many do not give the Trustee the power to recover prior payments made to creditors, a plus over bankruptcy from a debtor's perspective.
The downsides of an ABC, however, are many. As in a bankruptcy, all creditors must be notified (typically) and their claims resolved. This process costs money and can bring creditors out of the woodwork.
Furthermore, and unlike in bankruptcy, litigation can't be stayed as a result of statute; a landlord's claim can't (typically) be capped and assets can't be sold free and clear of any liens. Also, as ABC's are state-specific, they are limited in their capability to liquidate businesses with substantial multistate assets. What can or cannot be done may vary substantially by state.
Statutory LiquidationStatutory liquidations exist in some states, notably Delaware, where many companies are incorporated. These liquidations are the simplest and usually the cheapest.
Here, the assets are not transferred to a trust, but rather simply liquidated and distributed to creditors on a pro rata basis. When the statute is followed, the liquidator is typically protected from any claims.
For a corporation in Delaware, the entity exists for several years so it can wrap up its affairs. For an LLC, the entity no longer exists once the dissolution paperwork is filed, so everything must be done before the filing. In most cases, creditors and potential creditors do not need to be notified, making for a relatively short and cheap process.
Like the ABC, there is no automatic stay. Since distributions are made on a pro rata basis, distributions for wind down expenses such as for tax preparation, winding down benefit plans and any unpaid wages, should be made before the dissolution button is hit.
Liquidations can also be done without any statutory basis, but typically follow the Delaware dissolution example. This can work if creditors perceive they won't be better off than if they take legal action. Use of an independent party to oversee the liquidation will improve trust with creditors.
A Few Pointers Regarding Process- Always assess the situation with the help of legal and financial advisors versed in insolvency issues in the relevant states. Ideally, they would have prior experience with all of the available liquidation methods, so that lack of familiarity doesn't bias their recommendation.
- Each state is different - so understand the differences. Even for bankruptcy, State law defines many things and bankruptcy courts interpret some things differently, depending upon which appeals circuit the bankruptcy court falls under.
- For the non-bankruptcy alternatives, distribute enough money to appease creditors (5 to 15%). Consider adding funds to the pot to make this happen - it might be cheaper than litigation costs. Really? Yes. In the non-profit I mentioned earlier, we raised $1.1MM from among our fighting members to properly fund the wind down. The accountants were paid to file the tax returns, a home was found for the R&D crown jewel, and enough crumbs were distributed to creditors so that they wouldn't sue. And yes, the HIPPA disaster was avoided.
- To increase credibility, have an independent party of your choosing distribute the funds and communicate with creditors.
Shutting down a business that you've worked long and hard to build is never an easy decision. But if it comes time to fold your hand, ensure that the process goes as smoothly and in your best interests as possible by choosing the best option available.
