It’s not uncommon for business owners to worry about paying creditors, especially during times of extended economic downturn. But when a business is struggling with debt to the point that it can barely stay afloat, it might be time to consider filing for bankruptcy.
Several different types of bankruptcy exist, according to the U.S. Bankruptcy Code. Chapter 11 bankruptcy is a special type that’s primarily used by businesses that are trying to remain open but need some time to reorganize.
Generally used by businesses, Chapter 11 can be an effective financial strategy. Before committing to this option, first understand some important facts. Here are 11 things business owners should know about Chapter 11 bankruptcy.
Bankruptcy Doesn’t Have to Be the End of the Business
Many people might think of a business declaring bankruptcy as the end of the line for that company — but it doesn’t have to be. The purpose of a Chapter 11 bankruptcy filing for a business is to have time to create a plan to repay some of its debts without having to deal with a constant barrage of debt collection efforts.
You Don’t Always Have to Close Shop During the Process
Filing Chapter 11 doesn’t mean that the company automatically must be shut down for a period of time or that you will lose control of the company. In many Chapter 11 cases, you will be a “debtor in possession,” which means you can remain in possession of the company and all of its assets and continue to operate your business during the bankruptcy proceeding.
In some cases, however, the court will appoint a bankruptcy trustee to oversee the business if it has a good reason, such as fraud or gross mismanagement of your business.
Court Approval Is Required for Major Decisions
As a debtor in possession, you don’t have quite the same level of control as you did before the bankruptcy filing: The bankruptcy court must approve all major decisions, such as selling assets, making or breaking leases and retaining outside professionals like lawyers.
To grant you more operating capital for your business, the court might approve a lender to make a loan and give that lender “superiority,” which means that new lender would be paid before other unsecured creditors.
Chapter 11 Bankruptcy Can Be Voluntary
A Chapter 11 filing can be voluntary or involuntary, depending on the circumstances. In a voluntary Chapter 11 bankruptcy filing, the debtor is the one who files the petition.
In an involuntary situation, three or more creditors file a petition. Although a debtor can contest an involuntary Chapter 11 bankruptcy filing, the proceeding will restrict the company’s ability to continue to do business as it has in the past.
You Don’t Create a Reorganization Plan
After filing for Chapter 11 bankruptcy, the debtor has the first chance to propose a plan of reorganization. Unless the court intervenes, the debtor typically has an exclusivity period of 120 days to propose a plan. The court can shorten or extend this period under special circumstances. The debtor is allowed longer than 18 months to file a plan and once the period of exclusivity is over a creditor or case trustee can file a competing plan.
To be confirmed, the reorganization plan must have a reasonable chance of success and be in the best interest of the creditors. Each creditor must receive as much or more as it would if the bankruptcy proceeding were converted to a Chapter 7 bankruptcy, which is when the company is immediately liquidated.
Creditors Are Treated Differently
Under a Chapter 11 bankruptcy, different types of creditors can be treated differently in the reorganization plan. Secured creditors — that is, creditors who have a security interest in collateral — must be paid at least the value of the collateral under any plan of reorganization, if not more.
For example, if the creditor is owed $60,000, but has a security interest in collateral valued at $50,000, the creditor must receive at least $50,000 from the business under the reorganization plan. Unsecured creditors have no collateral and take lower priority under the debt reorganization plan, which means that they might get much less than what they are owed, depending on what assets are left after the secured debts are paid.
Chapter 11 Doesn’t Require a Creditor’s Committee
When a debtor files a small business case they must be engaged in commercial or business activities and the total non-contingent liquidated secured and unsecured debts are $3,024,725 or less, or if they choose to file under subchapter V, the small business should have a combined total secured and unsecured debts of $7,500,000 or less, but not less than 50 percent of which arose from the commercial or business activities of the debtor, the court does not have to appoint a creditor’s committee.
However, debtors in small business cases will be assigned a U.S. Trustee to discuss debtor obligations, review the business plan and will monitor the activities of the debtor, among other things.
Declaring Chapter 11 Bankruptcy Doesn’t Guarantee Cash Flow
When you file bankruptcy, an automatic stay goes into effect that prevents almost all creditors from taking action against you for a limited period of time. The intent is that the business, as the debtor, will have a short period of time to create a plan of reorganization free from harassment and legal actions against it by creditors.
The stay remains in effect until the end of the proceeding or until the court modifies it. Although an automatic stay limits creditor actions against your business, it doesn’t mean creditors are required to continue to lend additional money to the company, which can create a cash flow problem.
Declaring Bankruptcy Costs Money
Courts are required to charge you a $1,167 case filing fee and a $571 miscellaneous administrative fee when you file for bankruptcy. The court can permit you to pay both the case filing fee and the miscellaneous administrative fee over time if you can’t pay them all at once. You’re limited to no more than four installments per fee, the last of which must be paid no later than 120 days after you file. Failure to pay will result in a dismissal of the case.
You Should Have a Lawyer, but One is Not Required
According to USCourts.gov, it is highly recommended to obtain a lawyer when filing for bankruptcy since the process has a long-term financial impact, and misconstruing the law can be costly. That being said, it is not a legal requirement to have a lawyer.
Owners Get Paid Last
Equity owners in the company cannot retain any assets or profits until all of the creditors, including unsecured creditors, are paid in full. For example, you can’t say that you’ll pay creditors 30 cents for every dollar you owe them and sell business assets to pay the debt — but then keep the $30,000 cash that’s in the company’s bank account. When you don’t pay your creditors, you can’t cash out, either.
More From GOBankingRates