Liquidating in Chapter 11 versus Chapter 7

So you have a business that needs liquidating?  What's the best way to do it?  There is the classic Chapter 7  route, which after all is the liquidating chapter of bankruptcy, but there is also something known as a "liquidating Chapter 11" bankruptcy. Why would anyone choose to use the reorganization chapter of bankruptcy to wind down a business?  The answer is that sometimes there is more value for everyone when business assets are sold off as part of a going concern rather than at a bankruptcy garage sale by an trustee in Chapter 7.

First the basics: if you do it correctly, Chapter 11 allows the existing business owners to stay in control while the business is marketed for sale. Business owners often like this because they can remain in control and keep existing employees on staff (including themselves).  The advantage to creditors is that the business owners are often the only ones who can really run the business as a going concern.  Chapter 11 is premised on the concept that there is sometimes more value in an operating business than in a sale of its parts.  That's why reorganization exists in the first place.   If this is true in a particular case, that's why selling all the assets of business in a Chapter 11 is permitted: the net proceeds, even after factoring the increased costs of case administration, are greater than a straight liquidation.

The process of selling the assets of a business in Chapter 11 includes many challenges.  Here are some:

• Any blanket lien holder, like a bank with an interest in cash collateral, must be dealt with.  Usually it's necessary to convince such a lender that Chapter 11 route will result in full payment of their claim.
• The business may need cash to operate after filing bankruptcy.  In which case, debtor-in-possession financing must be obtained.  This is sometimes comes from the proposed buyer of the business assets.  However, there obviously timing issues at play when a business is running so low on cash that basic operations are imperiled.
• A buyer must be found and the procedures for counter-bids must be fair.
• The price for the assets must in most cases must pay off all secured debt.  That is because of, among other things, credit bidding, but there is a possible exception for sales via a confirmed Chapter 11 plan.  
• The debtor may have to negotiate a deal with the committee of unsecured creditors to pay them a partial dividend from the sale or the sale may be tied up in litigation in the bankruptcy court.
• The estate must be administratively solvent.

This is just a quick treatment of some of the issues involved in selling a business through a Chapter 11 plan. If a business has real value it makes sense to consider this option. In the right case, everyone can benefit.

Fraudulent Transfers and Closing a Business

I previously wrote about closing down a small business in Massachusetts. One of the point I alluded to, I am going to expand on a bit here. What happens to the assets of the business when the small business folds? There is a temptation for the business owners to just keep the assets for their personal benefit after closing the doors and leaving business debts unpaid. This is what is called a fraudulent transfer, and a business creditor can make you personally pay the value of these assets over to them if you just keep them in this manner. The reason for this is the Massachusetts Fraudulent Transfer Act. The big picture is that the law does not permit giving away the assets of a business that can't pay its debts: the business creditors are entitled to get the value of those assets before anyone else does. It usually makes sense to administer and distribute assets to creditors in a fair and transparent manner, such as via a business bankruptcy. However, not all transfers of assets to business owners are problematic.

In Massachusetts, generally, an insolvent business can transfer assets to a business owner if the owner pays a fair price in cash to the business. Any such transfer and accompanying valuation must be well documented and supported, and the "payment" to the business must not simply be debt forgiveness by the business owner. It is also important to document transactions of this type because if the insolvent company ends up in bankruptcy, the trustee can sue the owner to recover the value of the assets if they are sold for less than reasonably equivalent value.

Winding Down a Business in Massachusetts

There are many reasons why you might want to close a business. It may just be the time in your life to move on. However, if there's no way to sell your business and there's not enough money to pay the debts off, what do you do? This "insolvency" can create challenges in winding down a business in a way that allows you to move on.

Here are a few key questions to consider:

1. Have you personally guaranteed business debts?

This is a key consideration. Any debts you, your spouse, or partners guaranteed will have to paid by the guarantor(s) should the business close without satisfying these debts. Business credit cards are typically personally guaranteed by the owners. The same with most bank debt. Trade credit (vendor debt) usually is not personally guaranteed, but sometimes it is. Personal guarantees are common and can end in the bankruptcies of individual business owners if these debts cannot be paid. I call these business-personal bankruptcies and have written a bit more about them here.

2. If there are no personal guarantees or the personally guaranteed debts have or will be paid, does the business have valuable assets?

Some examples of assets include inventories, equipment, cash, and accounts receivable. If the business has assets, it can't just close its doors and leave debts unpaid. Where would the assets go? The business owner can't just keep them. In theory at least, these assets must be distributed equitably to creditors before the business owner can just take a dividend. So, if the business is operating in the red and there is not enough money to pay all the debts, who should get what? Lien holders should receive their collateral or its value. Taxes and employees should be paid in full. (It is important not to leave employee wages unpaid in Massachusetts). But after the secured and priority creditors receive their share, who should be paid what if there is money or assets left over? The answer to this depends on the goals of the business owner and the extent of the assets, but it may at this point make sense to file bankruptcy for the business so that the assets can be distributed fairly to creditors by a trustee. Whether to do this or not depends on a few factors, like the exposure of the business owners to suit by the trustee (like if they have unpaid debts to the business), but it sometimes is the best way to clear the assets in a transparent fashion so that creditors get their satisfaction and stop pursuing the business and its owners for the unpaid debts. Once this bankruptcy process is finished, the business can be formally dissolved with the Secretary of the Commonwealth and the matter can be put to bed. The cost of bankruptcy usually comes from the business assets.

3. What if there are no business assets?

If the business has not assets, you still need to make sure you deal with personally-guaranteed debt and any priority debts, like taxes and wages. Once you do this, an old legal maxim comes into play: you can't get blood from a stone. Creditors will try, however, and many an asset-less business winds up in bankruptcy just to satisfy the creditors that there are indeed no assets to be found. However, this is not always necessary. Blood can truly not come from stones and so, although annoying and time-consuming, dunning efforts by angry business creditors will come to naught if the business has nothing. In this case, letting the business die a natural death (non-payment of debts and administrative dissolution by the Secretary of the Commonwealth) should be considered.

It's probably obvious, but it makes a lot of sense to retain an attorney to guide you through the process of winding down a business in Massachusetts. There are several strategic options to consider that will affect the speed of the process and the overall cost to the business owners.