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Early Chapter 11 Planning Can Help Owners Retain Their Businesses

Many small businesses are experiencing cash flow difficulties in today’s economy. In many instances, additional bank lending is not a viable option to address cash flow needs. Nevertheless, there are a number of other ways to fund a business during a cash crisis, most notably by stretching out suppliers, and occasionally by failing to pay withholding taxes. Of course, suppliers can only be stretched so far before demanding COD, which only exacerbates the situation. Financing cash flow with taxes is even worse, as the IRS may both close down the business and pursue the owner personally for any deficiency.

Faced with mounting pressure from banks and from suppliers, business owners often have nowhere to look but their own pocketbook for financing. Whether to invest additional funds in a business is one issue. An equally important issue that is often overlooked is the timing of that investment.

If an owner has the personal resources to do so, and the business rebounds before the personal resources are sapped, further investment in the company may make sense. There is nothing worse, however, than a business owner who has invested all of his or her personal resources into a business, only to find that the business is not able to recover sufficiently to continue in operations. Unfortunately, it is only at that point that many business owners think of bankruptcy.

As a practical matter, most business bankruptcy filings are a reaction to some creditor action – the bank sues to foreclose and on the day of the sheriff’s sale a bankruptcy is filed. If the owner has exhausted his or her personal resources, retaining the company after a reactive bankruptcy filing can be difficult. One reason is that the Bankruptcy Code generally requires that an owner contribute new capital in order to maintain an equity position. After exhausting his or her personal resources prior to a bankruptcy filing, an owner may no longer have the ability to invest the additional capital generally required to retain ownership of the reorganized company.

As an alternative, an owner with the personal resources to make additional investment in the company might consider using his or her funds to recapitalize the company through a Chapter 11 bankruptcy proceeding. This strategy works particularly well for a company that can operate profitably on a current basis but as a practical matter will be unable to satisfy all of the debt accumulated. Bankruptcy is not a viable alternative for every business in financial distress. In particular, bankruptcy is not designed as a resting place to work out business problems. The Bankruptcy Code anticipates, and the creditors generally demand, that a debtor operate profitably. If a company cannot operate profitably outside of bankruptcy, it is almost certain not to operate profitably in bankruptcy.

If the company is able to operate profitably, however, and the owner has funds to invest, a pro-active Chapter 11 bankruptcy filing often serves the dual purpose of restoring the company to profitability and maintaining current ownership. With proper planning, some of the most difficult issues faced by companies filing bankruptcy (principally access to cash and continued financing) can be addressed in advance rather than in the crucial few days after a filing. Similarly, with proper planning, supply sources can be obtained and customer relationships maintained. With sufficient time and planning, a company can even file for bankruptcy protection with a plan of reorganization already in place.

Small business owners often will go to great lengths to save their companies. As the economy emerges from the current downturn, small business owners may do well to consider Chapter 11 bankruptcy planning as a tool for the continued viability of the company rather than as the last gasps in a slow economic death. Before succumbing to pressure from a bank or from suppliers to invest additional funds, a small business owner should evaluate whether the timing and nature of the investment achieves his or her goals.

Robert Nicholson




This advisory has been prepared by Carson LLP for informational purposes only and does not constitute legal advice. Copyright 2020, Carson LLP, 301 W. Jefferson Blvd. STE 200, Fort Wayne, Indiana, 46802. All rights reserved. Date of Advisory 3/26/2020.