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Surviving the Big, Bad B: Confronting Bankruptcy

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Bankruptcy looms in your future. If not for you, personally, then for one of your customers, employees or vendors. Chances are good at least one of you will end up in bankruptcy court.

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Nobody wants to think about bankruptcy. That’s understandable. However, now is the time to give it some serious attention. In April, the first bankruptcy reform in 20 years was signed into law, and it takes effect in October. Experts predict a mad rush of consumer bankruptcy filings before then.

Add to that the fact that, each day, more than 150 businesses go “belly up.” So, what can you do to prevent becoming a statistic? What do you do when there’s too much month left at the end of the money?

First, we’ll explore the reasons for failure, learn how to strategize in the event of bankruptcy (yours or your customer’s) and, finally, examine the types of bankruptcies.

Early Signs

Let’s start at the most logical place – the beginning. What are the early signs of pending bankruptcy? How does bankruptcy occur in the first place?

Usually, the first symptom of a pending bankruptcy is slow payment of accounts. Other signs, sometimes overlooked, include defections of salespeople or problems with bill collecting.

Incidentally, the people most likely to spot trouble early are those employees in your lower echelons. They will be first to see production slowdowns, returns of defective merchandise and angry customers.

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Sudden changes in payment history can also indicate problems. For example, if one of your commercial customers always pays within 15 days net and then suddenly moves to 45 or even 60 days, that may be a red flag.

Bottom line: You must stay proactive and in contact with customers. Don’t be afraid to get on the phone and try to find out what is going on.

Why So Many Fail

So, why do businesses fail in the first place? Is it lack of money, lousy locations or poor distribution? Nope. None of the above. Those are only symptoms of a bigger problem.

According to many analysts, small business failure is first prompted by isolation. To prevent isolation, independent tire dealers should constantly educate themselves. They should act like sponges, soaking up as much information as they can from books, magazines and trade associations. Other options include finding a mentor or business partner or forming a board of advisors. Networking with peers is an effective way to gain valuable insights and advice.

Interestingly, when asked why they fail, entrepreneurs tend to state reasons that differ from those of the experts. Entrepreneurs say they fail primarily because of undercapitalization (32%), a slow economy (30%) or creditor problems, slow receivables, tax problems, loss of a major customer or partner, overexpansion and poor management (8%).

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Demystifying 7, 11, 13

So, what are the types of bankruptcies? And what are their options?

First, there’s Chapter 7. This type of bankruptcy indicates liquidation often forced by a creditor. In some instances, it can result from a decision by the debtor. Chapter 7 dissolves the company and uses its assets to cover a portion of debts. The court determines how much, in assets, will be available to pay creditors. Secured creditors are paid before unsecured ones.

In a Chapter 7 bankruptcy, debtors give up property that they own at the time they file. This property is then sold by a trustee who uses the proceeds to pay creditors. Chapter 7 debtors are allowed to keep the money they earn after filing the bankruptcy as well as most other property they obtain after the filing.

In October, the rules change. For many people, the Chapter 7 option will be gone. The new law requires debtors to pass certain “means testing” that will determine whether they are eligible for Chapter 7. If a debtor’s income is above minimum prescribed standards, the debtor must proceed under Chapter 13 and repay at least a portion of unsecured debts. As a business owner, this should be more helpful in collecting debt, as it will be more difficult for individuals with higher income to discharge their debt.

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Next is Chapter 11 bankruptcy. This type of bankruptcy, which requires the agreement of creditors and approval of the courts, lets a firm restructure its debts and stay in business. Under court supervision, debts may be restructured, unprofitable divisions or stores closed, work force reduced and even labor contracts renegotiated.

Chapter 11 has three possible outcomes. First is a successful reorganization of the firm under protection of the court. Second is liquidation to satisfy some claims. The third eventuality is a merger or acquisition.

In its broadest sense, Chapter 11 is a complete reorganization. A business gets to operate for a period of time while it creates a reorganization plan voted on by creditors with court approval.

Because companies often emerge from Chapter 11 undercapitalized, many reorganized companies will eventually slip back into bankruptcy. Once this happens, these companies are frequently liquidated or sold.

Chapter 13, the third type of bankruptcy, is intended for small, sole proprietors with unsecured debts of less than $250,000 and secured debts totaling less than $750,000. Debtors keep all of their property (exempt or not), but they make regular payments to creditors using the money they earn after filing the bankruptcy case.

These payments must be at least as much as would have been paid to creditors in a Chapter 7 case. The payments are made to a trustee who then distributes the payments to creditors. The payments are made in regular installments, according to a plan that the debtor draws up. The plan lasts either until the debts are paid in full or until the end of a three- to five-year period. The debtor receives a discharge at the end of the plan.

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A Chapter 13 case can be filed by most consumer debtors. There are two principal requirements: First, the debtor must have regular income, although it need not be from a job; regular benefit payments or rental income qualifies as income. Second, the debtor must not have excessive debt.

Chapter 13 would be applicable to a retailer only if it was operating as a sole proprietorship or a partnership between husband and wife. Chapter 13 is only for individuals with debts totaling less than $1.2 million.

Three Cs of Prevention

A tire dealer’s prevention guidelines should be based on what Bob Bernstein of Bernstein Law Firm calls the Three Cs of Credit: Character, Capacity and Capital.

• Character: Character is determined by how a person has handled past debt obligations. Credit history and personal background come into play.

• Capacity: This means how much debt a borrower can comfortably handle. Analyze all of the borrower’s income streams, and look into any legal obligations that could potentially interfere with repayment.

• Capital: You must have a firm grasp on the current available assets of the borrower. These assets can include real estate holdings, savings, or investments that could be used to repay debt if income is unavailable.

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To prevent having to deal with the bankruptcy of a vendor, tire dealers should always pull credit reports early, just as they would for customers. One source of these reports is Dun & Bradstreet. So, when ordering from a supplier for the first time, be sure to obtain a credit report.

When an employee goes bankrupt, it may involve Chapter 7 (straight liquidation) or Chapter 13 (a court-supervised payment plan). In either case, a tire dealer can’t use future wages to secure payment outside the court on a debt that has been designated as part of a bankruptcy action.

Bankruptcy Reform and You

It’s easy to see how consumers will be affected by the impending bankruptcy reform. But how will businesses – particularly tire dealerships – be affected?

The answer’s not all bad. It will be harder for individuals to walk away from their debts, which is good news for dealers. Presently, retailers lose about $1 billion a year to consumer bankruptcies, according to the National Retail Federation.

However, the law that takes effect in October also forces retailers to make decisions on leases they have much more quickly. It also moves landlords into a preferred class of creditors. This means that, after filing for bankruptcy protection, a retailer will have seven months to decide whether to assume or reject an existing lease. If the retailer rejects it, the retailer’s landlord goes to the back of the line with unsecured creditors for claims of any unpaid rent. Some say this will force some struggling retailers to liquidate instead of restructure.

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More good news for tire dealers that find themselves confronted with a customer’s bankruptcy: The rules expand the reclamation period (recovering goods sold) from 20 to 45 days. And, if a dealer ships the goods within 20 days before the customer files bankruptcy, that dealer is entitled to an administrative claim (instead of a general one). That means the dealer’s claim moves way up the priority list.

The reform also strengthens protection from preference claims. It limits preference claims to those in excess of $5,000. In addition, any claims less than $10,000 must be filed in the court where the creditor is located, rather than where the bankruptcy is located. This is supposed to reduce the number of “nuisance” claims against creditors.

When You Go Bust

If you think your business is heading for bankruptcy, your first step should be consulting with experienced bankruptcy lawyers. Because bankruptcy and creditors’ rights law requires highly specialized skills, it would be wise to select a lawyer who is certified by the American Board of Certification in this area.

Deciding which chapter to file – and whether to file at all – is a task that has to be made by you and your lawyer. Many factors – including creditors, assets and prospects of business reorganization – need to be carefully considered.

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Once you’ve filed, there are some specific steps you should take. First, admit you have a big problem and seek input from professionals, such as your accountant or CPA and your banker. Trade suppliers also can help, although there is a chance they may become alarmed and put you on COD status.

Secondly, shop for better suppliers. Consider paying more for better terms. Try to extend terms from 30 to 45 days, for example. Keep taxes current, especially those for payroll. Seek and obtain outside capital; sources could include investors, the bank or your personal resources.

Another change imposed by the newly enacted bankruptcy reform concerns commercial lease laws. They have been tightened in favor of lessors of non-residential properties. Come October, a debtor must immediately surrender the property to a lessor if an unexpired lease is not assumed or rejected within 120 days of bankruptcy filing.

Costs to Consider

Of course, before filing for bankruptcy, you must be aware of the cost – including attorney and court fees. One caution here: Don’t be misled by the ads sprinkled throughout the newspaper classifieds that promise bankruptcies for $99 or $100.

Many of these ads promise a free consultation, and some proclaim that no office visit is required since all forms are handled by phone and mail. Others press your urgency button with the statement: “Hurry! Laws Changing!” Often, these ads have a friendly name – like Candace or Cindy Lee – listed as a contact. But don’t take this route.

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As far as cost goes, Chapter 7 cases are generally the least expensive because they are the simplest. The business closes and hands over the assets to a trustee. The only fees and costs are for the preparation and filing. The cost varies by locale and can run from $250 up to $1,500.

Keep in mind that finding the cheapest price isn’t always the best strategy; there may be some amount of personal attention required as the case gets more complicated. Even a simple Chapter 7 for an individual may have a long-term impact on that individual. While individuals can file their own Chapter 7 or 13 cases, this is extremely risky.

Chapter 13 filings are more expensive because they require ongoing services by attorneys. Why? Because Chapter 13 is a repayment program that requires monitoring and additional expense. In some cases, however, you may be able to delay fees.

Chapter 11 is the most expensive type of bankruptcy. This type tends to be used by individuals and businesses with more complicated situations and more valuable assets or future prospects. It means ongoing monitoring and active participation by attorneys and, therefore, requires ongoing expense.

The best way to save costs in all cases is to prepare for the filing long in advance. In other words, don’t wait until the last minute. Cases done hurriedly often require more clean up after the fact.

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For a business, the process of exiting bankruptcy through reorganization can take months or even years. While you may technically be out of the bankruptcy in a matter of months, it may take years for the debtor to repay what is owed.

And, the Big B stays on your record for 10 years. You can’t use Chapter 7 liquidation again for six years.

When a Customer Goes Bust

Maybe you’ve been paid ahead. Sounds good, right? Well, not really. There’s a problem with payments received shortly before a customer goes bust. Bankruptcy lawyers are targeting smaller companies for so-called “preference actions.” These suits seek to recover payments made just before filing for bankruptcy.

However, the bankruptcy code says no creditor is entitled to preferential treatment. So, anyone paid in the 90 days prior to filing is considered “preferred.” Most businesses would be wise to settle such suits.

U.S. Chamber of Commerce believes the bill has more benefits than minuses for businesses. However, bankruptcy lawyers are concerned that the new procedures will lead to earlier closures of businesses, especially smaller ones.

Attitude Shift

Bankruptcy used to mean hurrying off the retail scene with your tail between your legs and copies of creditor notes in hand. It carried a stigma, which often led to financial death. But not anymore. There’s no shame in bankruptcy, says Craig Jarrell of Pulaski Mortgage Co. “They just do it and don’t look back, ready to rock and roll again with a bundle of new debt.”

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The attitudinal shift about bankruptcy has the younger people saying “ahhhh, whatever” as the credit culture changes. Critics cite easy credit money and bankruptcy attorneys who push their services. And, lenders have lowered their standards.

So, all in all, it’s bankruptcy season year round. And you would be wise to prepare for bankruptcy – whether your customer’s, your vendor’s, your employee’s or your own.

Bob Bernstein, managing partner of Bernstein Law Firm in Pittsburgh, provided extensive input for this article. The firm is renowned for its expertise in bankruptcy, retailer and commercial collections, lease enforcement, creditors’ rights and mortgage foreclosure. Bernstein writes and lectures for local and national groups and is certified by the American Board of Certification.

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