Nellor Law Office—Reorganization

Alternatives For Debt Relief

The Nellor Law Office provides legal services to businesses, corporations, partnerships and ventures, limited liablity companies and individuals seeking to reorganize their busines or financial affairs.

There are many methods, or systems, available to persons and businees suffering from financial distress. Each has advantages and disadvantages. They include:

Chapter 11 Bankruptcy

Chapter 11 bankruptcy is typically a rehabilitation proceeding. Most people refer to chapter 11 cases as reorganizations. It is available to all types of businesses and to individuals who reside, have property, or engage in business in the United States.

Chapter 11 is the most comprehensive and flexible set of tools available to reorganize. This makes it difficult to describe. It also makes it a good place to start to determine what things a debtor may do to get out of a financial crisis. The options available to a debtor in chapter 11 include all of the options available under any other system of financial relief plus all options available to a business outside of bankruptcy: they run the gamut from rewriting the terms of every debt, rejecting unnecessary leases, curing defaults, substituting new lenders for old, rearranging liens, to complete liquidations.

When a chapter 11 case is filed, a stay automatically takes affect that prohibits creditors from taking any action to enforce or collect a debt. The debtor continues to operate its business. A trustee is normally not appointed.

One purpose of chapter 11 is to preserve the going concern value of a business. Chapter 11 operates under the concept that property brings a higher price if it is generating income, or if it can be held until a fair market price can be obtained from an orderly sale, as opposed to a rapid liquidation.

A business reorganizes in chapter 11 under a plan. Usually, the debtor creates the plan, but almost any party in interest is entitled to submit a plan. A chapter 11 plan can use almost any method to pay debt. In order to be binding, however, a chapter 11 plan must be confirmed by the bankruptcy court. In order to be confirmed, creditors must vote to accept the plan or it must be fair and equitable, and feasible.

Whoever proposes the plan must also prepare a disclosure statement that contains adequate information about the debtor and the plan before creditors may approve or reject the plan. The disclosure statement must be approved by the court before it is given to creditors and before a debtor may solicit any acceptance of a plan.

Creditors are classified by the plan and are paid at different times, in different amounts, and with different protections depending on their class. Any classification is acceptable so long as all members of a class are similar. All members of a class must be treated in the same way.

Creditors accept or reject a plan by voting on it. Voting is done both individually and by classes of claims. Not all creditors get to vote on the plan. Only claimants that hold impaired claims vote. A claim is impaired if the plan alters payment terms, does not cure any default that exists, or does not pay the fair market value of the claim, in cash. Unimpaired claims are deemed to have accepted the plan. An impaired class of claims accepts the plan only if the holders of at least 2/3 in amount and more than 1/2 in number of the allowed claims in that class vote in favor of the plan.

A chapter 11 plan must comply with a distribution scheme called the “absolute priority rule” if any class of claims voted to reject it. In general, debts and obligations are given a rank or priority by the Bankruptcy Code. The absolute priority rule requires that higher ranking claims be paid in full before any payment may be made to junior ranking claims. If there is not enough money to pay all claims of the same rank, they all share pro rata.

The bankruptcy court will not automatically confirm a plan even if all classes of claims accept a plan. The court must still determine that the plan is “in the best interest of creditors.” This means creditors may not be paid less under the plan than they would receive if the debtor was liquidated under chapter 7.

The advantages of Chapter 11:

The business continues to operate while a plan is formulated
Creditors receive full disclosure of the debtors financial affairs before a plan is approved
It provides a vehicle to recover preferential transfers and fraudulent conveyances
It provides a debtor with a discharge (it is the only bankruptcy that can provide discharges for corporations and partnerships).

The disadvantages of Chapter 11:

It is expensive and time consuming
It does not solve the underlying problem that brings the business to chapter 11
Although there are no time limits in chapter 11, filing a case has a practical effedt of starting the clock ticking for the debtor to resurrect the business.

Chapter 13 Bankruptcy

Chapter 13 is, like chapter 11, a rehabilitation proceeding. It is available to both individuals and individual small businesses— it is not available to corporations or partnerships. Chapter 13 is also restricted to smaller cases— the debtor must owe less than $465,275⁰⁰ in unsecured debt and $1,395,875⁰⁰ in secured debt.

Chapter 13 debtors do not, typically, sell their property to repay creditors. Instead, creditors are repaid over time according to a court approved plan. The debtor makes periodic installment payments to a trustee who then distributes those payments to creditors according to the plan. The time period is typically 36 months but can be a maximum of 60 months. All debts can be adjusted or modified by a chapter 13 plan (except there are limitations on modification of a debt secured by a lien on the debtor's principal residence (for example, a mortgage) and certain motor vehicle loans).

A chapter 13 plan is commonly either an extension or a composition (although various permutations of either of these basic plans are not unusual). An extension plan simply extends the time a person normally has to pay current debt. A composition plan is similar to an extension, except that only a portion of the debts are paid. A debtor must pledge all of his or her “disposable income” to a trustee for an “applicable commitment period” of between 36 and 60 months in order to have a composition plan confirmed.

Once a plan is confirmed, all creditors are bound by its terms (even if they object) and are prohibited from taking any action to enforce or collect their debt while the plan is in effect. A plan will be confirmed if it was proposed in good faith, is fair and equitable, and if it provides that each unsecured creditor will receive at least what that creditor would receive if the debtor was liquidated in a chapter 7 case.

Creditors do not get to vote on chapter 13 plans.

A person receives a discharge after the plan is performed even if his or her debts have not been repaid. The only exceptions include alimony, support, restitution, judgments for injuries sustained while driving under the influence of alcohol, and some student loans.

If a chapter 13 case is dismissed, creditors can collect their debts. If the case is converted to chapter 7, then chapter 7 rules and laws apply to the entire case. A hardship discharge is available if the debtor can not perform the plan due to circumstances beyond the debtor's control, the plan cannot be modified to work, and the trustee has distributed at least what would have been distributed in a chapter 7 case. A chapter 13 hardship discharge is the same kind of discharge a chapter 7 debtor receives, and the same exceptions apply.

There is no statutory prohibition to filing a chapter 13 case immediately after a chapter 7 case, or for repeated chapter 13 cases, but there are or can be limitations to repeated bankruptcy filings by the same debtor.

The advantages of Chapter 13:

The business continues to operate during the case
It provides a vehicle to recover preferential transfers and fraudulent conveyances
It provides a debtor with a discharge broader than the chapter 7 discharge
Relatively inexpensive
Creditors do not get to vote.

The disadvantages of Chapter 13:

Limited (“canned”) methods of rehabilitation
It does not solve the underlying problem that brings the business to chapter 13
Limited time to rehabilitate
Not available to partnerships and corporations.

Chapter 7 Bankruptcy

Chapter 7 is a liquidation proceeding. It provides a comprehensive set of rules to sell a debtors assets and distribute the proceeds of the sales to creditors. Almost any individual or business entity is eligible for chapter 7 relief. Only individuals, however, may receive a chapter 7 discharge.

A person who files a chapter 7 bankruptcy case turns his or her non–exempt property over to a trustee. The trustee sells that property and distributes cash from the sales to creditors. If there is not enough money to pay everyone in full, creditors share distributions from the trustee by rank, and then pro rata to other creditors of the same rank. If there is no property for the trustee to sell, no distribution is made to creditors.

A trustee does not sell all of a debtor's property. In the case of individual debtors, some property is exempt from the trustee and creditors. If property is exempt, a person gets to keep it even if they file chapter 7 bankruptcy. The kind, and amount, of property that is exempt varies by state.

An individual chapter 7 debtor normally receives a discharge of his or her debts even if there is no distribution to creditors. If a debt is discharged the person who owes the debt is no longer legally obligated to pay it. The discharge serves is an injunction against a creditor that prohibits any attempt to collect a discharged debt in the future.

In some circumstances a debt may not be discharged, even for individual debtors. If a debt is not discharged the debtor remains legally obligated to pay it even if a bankruptcy case is filed. Some debts are automatically excepted from discharge. Other debts may be excepted from discharge only on the order of the bankruptcy court. In situations of fraud or similar misconduct, the bankruptcy court can deny a debtor a discharge from all debts.

The advantages of Chapter 7:

A well defined and recognized liquidation proceeding
It provides a vehicle to recover preferential transfers and fraudulent conveyances
It provides an independent person to sell property
It provides individual debtors with a discharge
It is fairly quick and inexpensive.

The disadvantages of Chapter 7:

The business is closed
The debtor has no control over the liquidation process
Costs of administering the case cut into the amounts creditors may realize from the sale of the debtors property
Corporations and partnerships do not receive a discharge.

Voluntary Asset Sales

Converting assets to cash is an obvious, potential solution to liquidity problems. A business can sell assets and use the proceeds to infuse cash into business operations, or to pay off creditors.

There are really two kinds of asset sales to consider: those done to help rehabilitate the business (a sale of some assets), and those done as part of a self–help liquidation (a sale of all or substantially all assets).

A sale or some assets works if: (1) There are excess assets not needed for daily operations, or; (2) The sale of encumbered assets will cover all or most of the liens affecting the assets and relieve the debtor of its payment obligations.

A sale of all assets, or the business as a whole, works if: (1) The value of the assets or the business exceed liabilities, or; (2) The purchaser agrees to assume liabilities.

The advantage of an asset sale:

The liquidation of assets is under the debtors control
No bankruptcy stigma

The disadvantages of asset sales:

Finding a willing buyer in time for it to do any good
Losing the use of the sold assets
It does not solve the underlying problem that leads to the sale
No discharge if the debt is not paid in full.

Sale And Leaseback

A sale and leaseback is an offshoot of an asset sale. It involves selling some or all of a debtor's assets to a third party who then leases the property back to the debtor. Its purpose is to provide an infusion of capital (proceeds from the sale) and permit the debtor to continue to use the property necessary for operations (the lease).

It is usually more difficult to find a buyer/lessor than it is to find a buyer in a straight asset sale. Leases are subject to re–characterization as a sale or even as a partnership arrangement in a subsequent bankruptcy case. This can result in the lease being avoided or the buyer/lessor's assets becoming subject to liquidation to satisfy the debtors debts. Obviously, these risks have a chilling affect on finding a willing buyer/lessor.

Merger

We usually think of mergers as large corporate acquisitions or takeovers. But small businesses can merge, too. Merging with or being consumed by a similar or competing business is an option for some businesses.

Mergers may be attractive to other parties if the debtor has tax losses that can be used by the acquiring business.

The advantages of a merger include:

It usually provides a method for the debtor's owners to retain a job, and some equity interest in the merged business
No bankruptcy stigma.

The disadvantages of a merger are:

Adverse tax consequences to the acquiring company unless equity interests are given to the owners of the debtor
The acquiring company probably takes on successor liability to the debtors debts
Finding a willing merger partner
There is no debt discharge.

Syndication

A syndication consists of a debtor transferring assets to a limited partnership which is funded by private investors. The advantage to the debtor is that it retains control of the assets (usually as a general partner) and receives an infusion of cash (from the investors).

Syndications may be available if the business' primary asset generates tax benefits. The primary investment incentive is the possibility of limited partners using various tax losses, deductions and benefits to offset income from other sources. The most common businesses where syndications may work involve real estate, farming, and similar businesses.

Syndications are fraught with risks. Creating a syndication involves the sale of a security, governed by State and Federal securities laws. Even if registration with the Securities Exchange Commission is not required, the exemption does not exclude the transaction from disclosure requirements or remove the limited partnership from the anti fraud provisions of federal law.

Investors

Private persons may be willing to provide capital to fund business operations or to fund a business out of its current crisis. The problems with private investment, however, are the same as the problems with syndications.

Out Of Court Workouts

A workout is an agreement between a debtor and its creditors to achieve an extension or composition of debt. Think of a workout as a Chapter 11 reorganization by private agreement. Anything that can be done in a chapter 11 bankruptcy can also be done through a workout, it just requires creditor assent.

The advantages of a workout:

It avoids the expense of a Chapter 11 case
It avoids the general stigma of bankruptcy

The disadvantage of workouts:

They are entirely consensual. It almost requires unanimous consent of creditors to succeed—one or two dissenting creditors can scuttle an entire plan.
It is almost impossible to attain unanimous consent when there are a lot of creditors—the larger the case the less chance a workout has to succeed.
There are no controls other than the word of the debtor
There is no way to uncover or recover preferential transfers of fraudulent conveyances.
There is no debt discharge.

State Court Liquidations

Washington provides several statutory vehicles to liquidate a business. The dissolution, and distribution of partnership assets, is governed by R.C.W. 25.40.290 to .420; For limited partnerships, the relevant statutes are R.C.W. 25.10.440 to .470, and; For limited liability companies, see R.C.W. 25.15.270 to .300. Corporations can be dissolved and its assets liquidated pursuant to shareholder or director action, judicial action, or receiverships. See, Chapter 23B.14 R.C.W.

Think of State Court liquidations as miniature chapter 7 bankruptcies. Each statute provides a method for gathering and liquidating business property, and a priority scheme for distributing the proceeds from liquidation to creditors. They do not, however, stay actions against a debtor, control creditors outside the state, nor do they provide the debtor with a discharge.

Assignments For The Benefit Of Creditors

An assignment for the benefit of creditors is a hybrid liquidation process, recognized at common law and by statute that involves a debtor transferring all of substantially all of the debtor's assets to a third person who liquidates the property and distributes the proceeds to creditors. The Superior Court (in the state of Washington) supervises statutory assignments for the benefit of creditors and has the power to enter orders affecting collection actions, determine claims and to supervise the liquidation process.

The only benefit of an assignment for the benefit of creditors over a chapter 7 bankruptcy case appears if the debtor has enough property to satisfy all of its debts and to operate its business. In other words, the debtor can assign the property it does not need for liquidation and remain in business while the liquidation and satisfaction of debt takes place. There is, however, no discharge, and the act of creating the assignment is itself an act that can trigger an involuntary bankruptcy case against the debtor.