Alternatives to Bankruptcy for Small Business

An owner of a business in financial distress may seek options to bankruptcy to liquidate or reorganize the business.   Non-bankruptcy alternatives for either restructuring or liquidation may be less costly and more efficient for the business owner.  Similarly, secured lenders seeking to foreclose on their collateral may find that non-bankruptcy alternatives provide the most cost-effective and flexible means to obtain control over a borrower’s collateral upon default.  Some of the alternatives to bankruptcy are summarized below.

Out-of-Court Workout

The first option is an out-of-court workout, in which a debtor attempts to solve its financial problems by negotiating repayment terms with creditors outside of court.

In many instances, the business may be in default with its secured lender but generally paying other debts as they come due.  The secured lender will typically have security for its debt such as a mortgage on real property or an interest in inventory and equipment.  A borrower’s secured lender may be willing to negotiate a forbearance agreement pursuant to which the secured lender agrees not to sue the debtor provided the debtor meets the requirements of the forbearance agreement.  The terms of a forbearance agreement may vary depending on the borrower’s situation, but may include modified payment terms or a breathing period to allow the borrower to obtain refinancing or a buyer for the business or property.  The lender may also ask for additional protections under the forbearance agreement such as additional security or guarantees.

In other cases, the debtor may also need to approach constituents such as vendors or landlords and separately negotiate new payment terms.  If the debtor can successfully propose and negotiate a restructuring plan with each of its constituents, the debtor may reorganize its business without filing for bankruptcy relief.

Assignment for the Benefit of Creditors

The second option is an assignment for the benefit of creditors (“ABC”). Under this alternative to bankruptcy, a business owner liquidates its business under the supervision of a third party assignee and state court. Although this option is similar to chapter 7 bankruptcy, an ABC is less expensive, takes less time, and allows for the liquidation to occur with less oversight and more flexibility. An ABC is also less public than a chapter 7 bankruptcy.

Under an ABC, a company will assign all of its assets to the third party assignee.  After the assignment the assignee holds legal and equitable title to those assets in trust. In turn, the assignee will sell the company’s assets, the proceeds of which will be used to repay the company’s creditors.

An assignee is usually selected by the company, however, it is important to consult key creditors when selecting an assignee as the assignment process will likely be completed more efficiently if creditors are confident in the assignee selected. After the assignee has been selected and the assets of the company have been assigned, the company will need to provide the assignee with a list of all its creditors so that the assignee may begin the process of notifying the creditors and establishing a bar date by which the creditors will need to file a claim.

Although there are advantages to using an ABC as an alternative to filing bankruptcy, there are several disadvantages to using this process.  One disadvantage is that the bankruptcy process allows a flexible sale process to provide the buyer of a debtor’s assets with significant protections from claims of existing creditors and free of existing liens.  The ABC does not allow for the same buyer protections and may be less desirable to potential purchasers.  A second disadvantage is that a business may not receive a discharge of its debts in an ABC, although it may in certain instances in a liquidating chapter 11 bankruptcy case.  Additionally, the ABC does not cause an automatic stay to preclude continued litigation or foreclosure of assets, although the ABC does provide some protection from unsecured creditors by transferring assets to the assignee.

Receivership

A bankruptcy alternative which is beneficial not only to owners of a debtor company, but also to creditors is a receivership under state or federal law. A receiver is an officer of the court and has broad powers to manage the assets of a small business, collect the assets of the small business and distribute the proceeds to creditors.  A receivership is less costly than a bankruptcy liquidation.

Creditors of the debtor are the parties typically seeking to have a receiver appointed as a receiver is able to impartially market the company and its assets for sale, thus obtaining the best price possible. Creditors also favor a receivership due to the potentially lower costs associated with a receiver. Additionally, since a receiver handles most of the aspects of the liquidation of a debtor company, the sale and distribution process is done quickly and without additional expenses. The receiver may, however, hire professionals to assist with the liquidation such as real estate brokers or attorneys.

One disadvantage of a receivership is that a disgruntled party may file for voluntary or involuntary bankruptcy in order to remove the receiver.

Dissolution

One of the least expensive alternatives to filing for bankruptcy is a dissolution, which allows for the voluntary closure of an incorporated company by its leadership. Dissolution is only practical if there is no litigation against the company and the assets and debts are minimal.  Dissolution may be the final step after liquidation by another method.

The dissolution process differs based on the state of incorporation, the company’s articles of incorporation and whether or not the company has shareholders. However, a general dissolution contains the following steps:

  1. Approval from the Board of Directors to begin the dissolution process;
  2. Approval from shareholders (if necessary) of the dissolution;
  3. File a Certificate of Dissolution with the Secretary of State in the state of formation;
  4. Report the dissolution to the IRS; and
  5. “Wind up” the company, including:
    • Valuing and liquidating the assets of the company
    • Initiating a formal claims process for creditors of the company and providing proper notice
    • Paying the debts and other liabilities of the company, including all final state and federal taxes.

Dissolution is distinct from the other alternatives to bankruptcy in that once dissolution is approved all business activities stop and the company only continues to settle the dissolution and close the business. In an out-of-court workout, ABC or receivership, the company may continue its business operations for a short period of time while closing down if continued operation is in the best interest of the company.  If the business is not incorporated, but rather a limited liability company or partnership, other forms of liquidation may be relevant.

Each of the above alternatives to bankruptcy involve detailed legal and procedural issues.  Hiring the right professionals to assist in the above processes is key to success.