Receivership, Chapter 7 or Chapter 11?

The owners of a company who seek to retain control of a troubled business by using Chapter 11 and hope they can propose a reorganization plan that will be confirmed by the courts often forget the difficulties and true cost of such an effort.

7-11-or-receivershipThere are pitfalls for debtors who seek merely to maintain control of their business rather than execute a true restructuring; the most serious being the potential impact on their personal assets.

We have recently become involved in several cases where the bank or lender has proposed a state receivership in order to protect its collateral and preserve the company’s assets.

In one case, while a receivership was not proposed, there was the fear that the state intended to seize assets due to a large amount of trust fund taxes due.

Since the owners of a company in receivership, or even Chapter 7, lose control of the firm’s assets, they often choose to file a Chapter 11, thus retaining control of the business as a debtor in possession, albeit under the watchful eye of the U.S. Trustee, and many creditors.

A clever debtor, who has frustrated a lender, often for years, believes he can maintain control by proposing a reorganization plan that will be confirmed by the courts, allowing the business to go forward even while knowing that they may not pass the minimum criteria for the success of such a plan..

There are two important tests required …

There are two important tests required to make this strategy successful.

  1. One is that there is a reasonable likelihood that a rehabilitation of the business will be achieved and
  2. The other is whether or not the bankruptcy estate is continuing to shrink due to continuing financial losses or other causes.

Under the first test, the court will look at the entire financial picture of the debtor, including its actual prospective income, its assets and the liens on those assets.   It will determine if, after proceeding through the reorganization process, a viable company is likely to emerge. If the debtor has little income or profit or the ability to generate income, there is little to reorganize.

The court will also look at the actual cash flow from the business and the potential depreciation of assets. Post filing negative cash flow is the principle evidence of continuing losses. Likewise, where the current cash flow is insufficient to service accruing interest, taxes, insurance and other costs, the creditor’s position would weaken as the Chapter11 continued. Items such as deferred maintenance are also evidence of continued shrinkage of the estate.

Chapter 11 is only for debtors who have …

While not actually addressed in the bankruptcy code, the courts have held that Chapter11 is only for debtors who have a legitimate reorganization purpose and have the ability to execute on a plan.  It is not meant to be used by a debtor whose sole purpose is to avoid foreclosure on assets or to prevent a receivership.  In such a case, the court may well find that the Chapter 11 filing is in bad faith and order a conversion to Chapter 7.  When such cases occur, creditors are often quick to point out to the court why the Chapter11 filing is not viable.

In one case we know of, the company, having realized that it could not make a major trust tax payment due to the state, decided to file Chapter 11 two days before Thanksgiving, giving their law firm little time to prepare.  As discussed above, the business has to demonstrate that it has the resources to reorganize or can get them and it has to have a plan that can be “sold” to the court, its financial institution and other creditors.

money-2The Chapter 11 filing was followed by a flood of objections to almost everything proposed by the company.  The state wanted its tax money, the bank wanted its money and creditors wanted to be paid. In the end, it was determined that the entire process was indeed too little, too late and the filing was converted to Chapter 7 liquidation.

In yet another case, the lender proposed a state receivership to liquidate the assets of the company and maximize the return to the lender from the collateral.  Upon notice of the receivership, the company has stated its intent to file Chapter11 as soon as notice of the receivership reaches the court.

While debtors use numerous ploys …

While debtors use numerous ploys in the courts to delay a lenders realization on collateral, in their efforts to maintain control of their business they often forget the potential effect of any personal guarantees they may have executed.

A Chapter 11 filing that fails to realize a successful reorganization will prove to be very expensive and debilitating to the estate, reducing the return to the lender from the collateral.  The lender will, in many cases, look to the personal assets of the debtor under the guarantee, often leading to a personal bankruptcy as well as a business one.