Bankruptcy Basics for Frontline Industries: FAQs

As the impacts of the pandemic continue to wreak havoc across businesses across all industries, the hardest hit businesses have been front-line industries such as those in hospitality and lodging. As the economy continues to cause future uncertainty, many businesses have begun to consider all their options, including the possibility of bankruptcy. Bankruptcy is a legal process than can be complicated and lengthy and have unintended consequences . The decision to file for liquidation or reorganization can be a difficult one, but it is important to conduct due diligence and be prepared with a strategy. Following are several frequently asked questions in relation to bankruptcy options and the basics of what businesses should be aware of.

Q: What are the differences between the bankruptcy chapters?

A: Title 11 of the US Code has a number of Chapters available for businesses and individuals to file under for protection from creditors.

• Chapter 7 is a liquidation and is available to both individuals and businesses. In this instance a trustee is appointed who will liquidate the assets of the bankruptcy estate and distribute the proceeds to creditors according to the statutory priorities.
• Chapter 9 is for municipalities and is a reorganization. The largest recent filing was the City of Detroit.
• Chapter 11 is a reorganization typically for businesses, however certain individuals with debt above certain thresholds will also file under Chapter 11. Under Chapter 11, the debtor retains control and moves to preparing a plan of reorganization which will be voted on by the creditor body.  The plan lays out how the business will restructure and how the creditors will be paid.
• Chapter 12 is available to family farmers and fisherman and is also a reorganization.
• Chapter 13 is exclusively for individuals with regular income. Under Chapter 13, the individual will repay their debts over a 3 to 5 year period.
• Chapter 15 is exclusively for international businesses with US assets.

Q: I have heard of a “Subchapter V”. What should a business know about it, and what is the difference between a Chapter 11 Subchapter V and Chapter 11?

A: The Small Business Reorganization Act (SBRA) established a subchapter to Chapter 11, and the CARES Act expanded upon it.  This subchapter allows businesses with debt not greater than $7.5m to file for protection.  The difference between this and a regular Chapter 11 is that there is no creditor committee which tends to drive up costs.  There is also a compressed time frame for the debtor to file a plan within 90 days thereby substantially shortening the time in bankruptcy.  Both of these issues have historically been barriers to small businesses filing for reorganization.

Q: Are most bankruptcies voluntary or involuntary?

A: Most bankruptcy filings are voluntary. However, in certain circumstances, a bankruptcy can be involuntary. In those cases, the creditors will force the debtor into bankruptcy. When a petition is filed, a fictional entity is created which in turn creates a bankruptcy estate.

Q: What parties are part of a bankruptcy estate filing?

A: Upon filing, there are multiple parties. There’s the debtor themselves and in some cases, there’s a trustee. Depending upon what chapter you file under will dictate the level of participation by the trustee. The trustee is generally either a practicing attorney or a CPA.  The office of the United States of Trustees, which is a part of the Department of Justice, has a supervisory role. Additionally, you have advisors,  financial advisors, investment bankers and attorneys. Financial advisors assist the case from an accounting perspective and can assist in restructuring the company. Those can be very important roles in helping the company succeed through bankruptcy. Finally, there are the creditors.

Q: Is a communication plan important when considering a bankruptcy filing?

A: One of the most overlooked pieces  to consider during the filing process is a communication plan. For frontline industries, businesses have three constituents to consider: customers or guests, vendors and employees. A bankruptcy filing can be disruptive; employees are worried about losing their jobs, customers are worried if they will receive their service or product, and vendors are worried about money owed and if there is a continuing business relationship. Customers who placed deposits for future events will be acutely concerned about the status of the business.  How is your business going to communicate with each of these constituents moving forward? It can be helpful to have an attorney and/or financial advisor at the table with you to make sure your business has a successful communication and reorganization plan.

Q: What are the major differences between a Chapter 11 filing vs a Chapter 7 filing?

A: During a Chapter 11 filing, the ultimate goal is to emerge and continue on as a successful business. Under a Chapter 11 filing, an owner-operator can stay in control of the business, it’s assets, and continue operations as a “debtor-in-possession”. The business owner will have the ability to refinance debt, but the downside is that almost every action outside of the ordinary course related to the business is going to require court approval. By contrast, during a Chapter 7 filing the business will close, its assets sold and the proceeds distributed to creditors.

Q: How do businesses continue operating under Chapter 11?

A: Once an automatic stay comes into effect (which occurs upon the filing of the bankruptcy petition), “first-day” orders will acted upon by the Court, essentially giving the owner-operator the permissions necessary to operate the business.  Generally, a lender will have a blanket lien on all of the business’ assets so permission is necessary to use the lenders assets. Some of those orders may be to give permission to utilize collateral, including cash; others might be to continue paying payroll, paying payroll taxes, sales taxes, and expenses to continue operations.

Q: Once the owner-operator of the business is considered the “debtor-in-possession”, what bank accounts can be used for business purposes?

A: As the owner-operator is now considered the “debtor-in-possession”, existing bank accounts cannot be used. One of the items that may be overlooked by the debtor-in-possession is the need to go to the bank and open up new bank accounts called debtor-in-possession accounts.

Q: What else does the business need to consider after filing its petition?

A: Creditors may be owed a significant amount of money, and they may now want to change their terms because they don’t want to be at risk for any further loss of cash. Anything that the debtor wants to do, within the ordinary course of business, the owner-operator can continue to do without any interference. Should the owner-operator want to do something that is outside of those terms, such as take out a loan or sell all assets, court approval prior to the transaction will need to occur. Additionally, each month the debtor is going to be required to file a monthly operating report – a typical monthly close for sizable businesses that goes through the balance sheet and income statement, cash balances,  receivables, accounts payable, and tax issues that is filed as public information on the court’s website.

Q: What is considered an “ordinary course of business”? If a business is doing something systematically or infrequently, would that be considered normal business operations?  For example, consider a business that purchases franchises or hotels as it becomes available, but occurs infrequently and only as the opportunity arises.

A: There would not be a limitation to regular transactions. Acquisitions as described would require approval as they potentially are changing the normal flow of business.  Certainly incurring debt to finance the acquisitions would require approval. Lastly, if the business has the unencumbered cash flow to make the acquisition it brings the purpose for the bankruptcy into question.

Q: What happens to debts incurred prior to the Chapter 11 filing?

A: Debt incurred prior to the Chapter 11 filing are set aside pending resolution of the bankruptcy proceeding. The business is able to collect on receivables and use that cash, without any existing debt that needs to be paid. The business is essentially able to move forward with a clean slate for a period of time by receiving cash flow, allowing the business to get back up on their feet, and be positioned to be able to move forward. Some vendors are going to require payment as you go, and terms will need to be arranged with the creditors.

Q: What options are available for businesses to consider, outside of a bankruptcy filing?

A:  Try to settle or negotiate with your creditors prior to going into bankruptcy. There is also a State level liquidation called an Assignment for the Benefit of Creditors.

Q: Are creditors likely to work with the debtor for a reorganization plan?

A: It is generally in the best interest of the creditor to work with the debtor for a successful plan of reorganization. The goal after all if for the debtor to resolve the issues that brought about the need to file for protection and emerge as a stronger company. If there’s likelihood that the business will continue, creditors might be more apt to give the debtor more time to develop their reorganization plan.,  In addition creditors are apt to work with the debtor because they want the company to be successful and ultimately, want to maximize the amount of money they get paid on their old obligations.

Resources Available for Your Business

View Withum’s on-demand webinar on Navigating Bankruptcy for Businesses as the panel of thought leaders address bankruptcy business strategies for frontline industries.