The Myth of Chapter 11

Debtor attorney Jerrold Guben
Photo by David Croxford
“Capitalism without bankruptcy,” goes the old saw, “is like Christianity without hell.”

This maxim captures the dread that surrounds a business failure, but misses another point. Bankruptcy is not a punishment but an absolution that relieves the individual of his sin — oppressive debt — through a legal sacrament known as “discharge.” Even so, if capitalism is a religion, bankruptcy is hardly a central rite. That’s because most of the advantages of bankruptcy apply only to individuals. For Hawaii businesses, those advantages barely exist at all.

Huge legal fees for Chapter 11

Legally, there are several kinds of bankruptcy, each named for a chapter in the federal Bankruptcy Code. The most common, Chapter 7, is a simple dissolution. The debtor throws in the towel, turns nonexempt assets over to a trustee to distribute to creditors and walks away. For the individual, a Chapter 7 bankruptcy provides a fresh start. Even individuals with too much income or too many assets to qualify under Chapter 7 can file under Chapter 13, which allows them to renegotiate debts with their unsecured creditors.

What causes most confusion is Chapter 11. Sometimes called reorganization, a Chapter 11 bankruptcy gives a company a chance to renegotiate its debts with unsecured creditors, including leases, union contracts and pension plans. This holds out hope for survival. Unlike in a Chapter 7, the owner retains control of the company as a “debtor in possession.” To the owner of a failing business, a Chapter 11 can seem like an attractive answer. The problem is that it’s largely a myth.

Most well-known bankruptcies — both locally (Hawaiian Airlines, Hilo Hattie, Hawaiian Telcom) and nationally (Lehman Brothers, Macy’s, Enron) — were originally filed under Chapter 11. But this is misleading. As Jerrold Guben, a prominent debtor attorney with Reinwald O’Connor & Playdon, emphatically points out, “We have virtually no Chapter 11s in this town.” Out of the thousands of cases now on the docket at the Bankruptcy Court for Hawaii District, just a handful are in Chapter 11, most of them large corporations. Moreover, even these sophisticated companies often fail in Chapter 11 and are converted to Chapter 7 (Aloha Airlines and Circuit City). “Maybe one in 20 Chapter 11s is successful,” Guben says.

A Chapter 11 favors large companies because it’s a long and expensive process. “It’s a $25,000 to $50,000 retainer. Minimum,” says Guben. That’s just to start. According to Robert Faris, chief judge of Bankruptcy Court for Hawaii District, most small companies don’t have the wherewithal to get through it. “You need several things to survive,” he says, including cash and organizational resources. “But more important,” he says, is “What’s the plan? What are you going to do to solve the problem? What’s the business problem that you’re facing, and what are the business solutions to that problem? A lot of the time, I don’t get straight answers to these questions.” For your Chapter 11 to be confirmed, you have to persuade both the judge and a committee of your creditors that your plan can succeed.

Not all businesses are equally suited to Chapter 11. “Some real estate concerns have made it through,” Faris says, “and some retail companies come through — usually by getting smaller and retrenching. Construction companies almost never make it. They need to get bonding, and surety companies just won’t do it.” Frequently, even promising Chapter 11s fail. “Often, there’s a divorce lurking in the background,” Faris says. “Other times, it’s simply an unwillingness to part with assets. Occasionally, there are buried tax problems — assets that they need to sell, and have a willing buyer for, but their tax basis is very low, so they’ll end up owing too much capital gains. There’s sort of no way out in those cases.” In the end, these cases are either dismissed or converted to Chapter 7s. Which, as Guben points out, is of little advantage to the business owner.

Owners Left Holding the Bag

Which brings us back to the principle of discharge. “In a corporate Chapter 7, there is no discharge,” Guben says, his voice rising for emphasis. “Discharge is available only to Chapter 11 debtors and personal Chapter 7 debtors. But not for corporate Chapter 7 debtors.”

That’s the crux of the bankruptcy dilemma for the owner of the small- or medium-size business. Without the sacrament of discharge, bankruptcy simply doesn’t provide the same protection for business owners that it does for individuals. Even though the company may use Chapter 11 to get out from under some of its unsecured debt, the owner usually remains vulnerable. According to Guben, that’s because, for most small businesses, the landlord and the bank have probably extracted a personal guarantee from the owner, often in the form of a lien or a second mortgage on their home.

Even in a personal bankruptcy, these kinds of secured debts cannot be discharged. “So, the problem is not that the corporation isn’t discharged from its debts in Chapter 7,” Guben says. “But, what do I do with the owner of that corporation? He’s the real problem.” It’s this personal exposure that makes corporate bankruptcy largely meaningless. In fact, business owners frequently come to Guben looking for a corporate Chapter 11, and leave, instead, with a personal Chapter 7. Corporate bankruptcy simply doesn’t offer any protection for the owner. The problem, Guben says, “is not who you may owe at the corporate level, but who you may owe at a personal level.”

“That’s why I tell people, ‘Forget it,’” he says. “‘Don’t pay me my retainer — $5,000 to $10,000 minimum in a corporate Chapter 7 — because it’s a waste of your time and money.’”

Instead, he says, the best strategy is frequently to simply close the business and walk away. “I say, ‘Wait a minute. Don’t immediately file for bankruptcy for yourself. Let’s see who’s going to go after you.’ Sometimes, credit-card companies may not come after you for years, even though you used your credit card to pay for business expenses. And the landlord may say, ‘Ah, forget it. It’s not worth my time.’ That’s why I always say, ‘Let’s take a cooling off period here.’ Close the business. Lock the doors. Turn the keys back to the landlord. And let’s see if anybody’s really going to go after you on your guarantee. If they do, then we’ll file for bankruptcy to possibly discharge it.”

Even in the cases where creditors do come after you, waiting may be the most efficient option. “You may find out in a few months or a year or two that there are just one or two ‘squeaky-wheel’ creditors who are after you,” Guben says. “Pay them!” That’s because, unlike in bankruptcy, “you can prefer these ‘squeaky wheel’ creditors to other creditors — Mainland creditors and the like.” In this way, sometimes doing nothing is the best course.

Preparing for Bankruptcy

The best approach is to plan ahead. Nevertheless, Guben notes, most of his clients — even sophisticated business people — come to him at the last minute, often prompted by an eviction or foreclosure notice. “So we’ll file and see how things turn out in the next couple of hours,” he says. “Because I’ve got to be in court within 24 to 48 hours on something called ‘first-day motions.’” It’s this rush that’s one of the biggest differences between the bankruptcies of small companies and large corporations.

“Take a look at the Hawaiian Telcom case,” Guben says. “They must have filed 60 or 70 motions on the first day.” That’s because they began planning months earlier. “They knew that, on Nov. 30, they would not be able to make their debt-service payment, and they started to prepare their first-day motions. I haven’t got that luxury in local bankruptcy cases. So, it’s a real scramble. That’s why, without advance preparation, they’re not as successful.” That doesn’t mean you can’t negotiate with your creditors— ideally long before you declare bankruptcy. “The creditors are willing,” Guben says. “In this day and age, they’re being squeezed, too. That’s why General Growth is negotiating ‘give-ups’ with most of its tenants now. It’s better to cover something than nothing.”

Signs that can alert creditors

Of course, most of the people affected by bankruptcies aren’t debtors; they’re creditors. Just like the business owner, creditors are much better off planning ahead, says Tina Colman, a creditor attorney with Alston Hunt Floyd & Ing. That means keeping your eyes open for telltale signs of trouble. Some, like late payments, are obvious. Others are subtler. “Lot of times, you have problems when the generations change,” says Colman, pointing out that the children of founders may not have the same work ethic or business acumen as their parents. One of the best bankruptcy watches is well-trained sales people. “Because sales people are on the front line with the customer, they’re the ones who will notice changes in the company,” Colman says. “If you chat with the owners and they tell you that they’re thinking of retirement: red flag. The wife says, ‘My husband’s real sick:’ red flag.”

What do you do with that information? “Start watching how you get paid,” Colman says. “Put them on C.O.D. Try to get some collateral.” The important thing is for the creditor to initiate a discussion, Colman says, because the debtor, in all likeli-hood, won’t. “There are embarrassment issues. Loss-of-face issues. Honor issues. You’ve got a lot of delicate things that mitigate against people being forthcoming about their problems.”
Thinking ahead

According to Ken Gilbert, senior consultant and partner at Business Consulting Resources Inc., proper planning for failure begins even earlier. Gilbert has a more than academic appreciation of bankruptcy. Thirty years ago, after flirting briefly with big success, his first company in Hawaii failed spectacularly. (Full disclosure: This writer’s father was a partner in that business.) “What I learned through that whole process,” Gilbert says, “is that you have to plan, protect and insure against the potential downfall of the business.”

Some of that planning is preventive. For example, any bankruptcy attorney can advise you about assets that are exempt in a bankruptcy proceeding. Faris points out, “Retirement plans are pretty much protected. Life insurance is basically exempt. And then there’s tenancy-by-the-entirety.” The latter is a way to structure the ownership of your home so that it can’t be used to secure a business loan without a spouse’s express approval. But these assets should all be in place years in advance.

Like Colman, Gilbert also recommends being more vigilant — preplanning for critical thresholds. “Let’s say you have $150,000 of corporate money in the bank and you start to see some of these trends. If you had planned and preplanned for financial distress, you might have decided that the maximum of that $150,000 that you’re prepared to lose is $75,000.”

“At some point,” Gilbert says, “you have to make these difficult decisions: to downsize; maybe to move the company into the second bedroom of your house; to go from 15 employees down to six. To protect what you have.” Noting that this goes against the basic optimism of most entrepreneurs, he adds, “I would rather be in the situation where I have to rebuild than be up against the wall with no options.” This planning should happen in good times, not bad. “That’s when you go to see a bankruptcy lawyer,” Gilbert says.

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