Business Bankruptcy Seattle

Your business is a huge part of your life.  I know.  I am a business owner too.  I have represented businesses and business owners in bankruptcy.  However, I also have the experience of starting and running my own business – my law practice.  This gives me a unique perspective on what it is like to run a business and the role that your business plays in your life.  When most people think of business bankruptcies, they think of huge corporate chapter 11 cases like General Motors.  The reality is that most business bankruptcies are virtually indistinguishable from personal bankruptcy, because the business is so intertwined with the business owner.

Here are the considerations that I believe a core to a business bankruptcy, whether I am representing a sole proprietor, a corporation, a LLC, or a partnership.

Who Is The Client?

The first question is who am I representing?  This may seem like a strange question, but it is extremely important.  As an attorney, I have a fiduciary duty to my client.  Part of that fiduciary duty includes the rule that I cannot represent two clients who have adverse interests.  So I need to know what type of business you have: sole proprietorship, partnership, corporation, or LLC.

  • A sole proprietorship is an unincorporated business with only one owner.  If there is more than one owner, it is a partnership.  In fact it is a partnership even if you don’t have a partnership agreement.
  • Did you know that a corporation or LLC – even a corporation or LLC with just one shareholder or member – is a legally separate entity from the members and shareholders?  A corporation or LLC is a fictional entity that is legally distinct from its owners, shareholders, members, officers, and directors.  Even though a corporation or LLC can only act through a natural person (you), it is separate from you.

This means that unless you are a sole proprietorship, I can either represent you or I can represent the business; but, I can’t represent both.  This is true even if there is only one shareholder or one member.  The identity of the client will be determined based on how we answer the other questions.

What Kind Of Problem Do You Have?

A bankruptcy can fix financial problems, but it cannot fix business problems.  A financial problem is too much debt and not enough income.  A business problem is something about your business that is fundamentally unsound such as offering a product that is no longer in demand or not being able to offer a competitive price.  If your business is making and selling horse drawn carriages, you have a business problem that bankruptcy cannot fix.

However, if your business is in trouble because you got behind on your taxes, expanded too quickly, or something of that nature then it is a financial problem.  A financial problem is solvable.  You can use bankruptcy to downsize the business, to cut costs, get rid of unserviceable debt, and repay key creditors.

Are You Staying In Business?

If you are staying in business, your bankruptcy will be structured very differently than if you are going out of business.

  • Staying In Business:  When you plan to continue operations, the purpose of the bankruptcy is twofold: restructure your debt and preserve your ability to operate.
  • Going Out Of Business:  When you plan to shut down the business, the goal is to protect the owners from liability for the business’ debts.

One question that I get fairly frequently is “why can’t I just shut this business down and just start an identical business?”  The answer is successor liability.  Successor liability means that even though the old entity is gone, that old entity’s debts will flow into any new entity that the owners create.  This is why you need an experienced business bankruptcy attorney.  The goal is to cutoff liability once and for all, and not to create debts that will follow the owners into future business ventures.

What Is Your Debt Structure?

Debt structure means two things: 1) is it personally guaranteed, and 2) what type of debt is it.

Personally Guaranteed Debt

Many people think that by forming a corporation or LLC they are protecting themselves from personal liability on business debts.  That is only partially true.  A corporation or LLC does protect you from the entity’s debts; however, you can waive that protection by signing a personal guarantee.

Two debts that are most commonly personally guaranteed without the business owner knowing it: credit cards and taxes.  When a business gets a credit card, typically the credit card is guaranteed by whoever applied for the card.  The business is just an authorized user.  This is true even if you get a so-called “business credit card.”  Taxes are in the name of the corporation or LLC, but at least one person signs every tax return as the “person most responsible.”  Basically, this means that if the business fails to pay its taxes, the person most responsible is liable for them.

The Types of Debt

There are basically two types of debt: secured and unsecured.  In bankruptcy unsecured debt is broken down further into priority unsecured debt and general unsecured debt.

Secured Debt

Secured debt means that the creditor has a lien on the borrower’s property.  The most common example is a car loan.  The lender has a lien on the car.  If the borrower fails to pay the debt on time, the lender can repossess the car.

If you plan to continue your business’ operations, you must either be prepared to give back the collateral or repay the secured creditors.  Depending on how you are restructuring your business, it may make sense to give back some collateral.  For example, if you bought too much equipment.

In addition, bankruptcy allows you to “cram-down” on secured creditors.  A cram-down allows you to pay back the value of the collateral, instead of paying back the balance of the loan.  You still pay interest, but you can typically get a discounted interest rate through cram down as well.  This is a good option if the collateral is underwater, i.e. worth less than what you owe.

Unsecured Debt

Unsecured debt means that the creditor does not have the right to repossess collateral.  Typically, unsecured debt is for things like lines of credit, trade debt, and credit cards.  Taxes are also usually unsecured debt, but they are not your typical unsecured debt and are dealt with separately.  An unsecured creditor can make itself secured by getting a judgment against your business.

In bankruptcy, you can discharge unsecured business debts provided that it is a chapter 11 case and the entity will continue operation.  In a liquidating chapter 11 or a chapter 7, business entities cannot get a discharge.  In addition, you cannot simply get rid of unsecured debts in a chapter 11 bankruptcy and plan to continue operation.  This is because of the law known as the new equity exception to the absolute priority rule.

Priority Unsecured Debt

The term priority unsecured debt only exists in bankruptcy, but it is a useful concept when you are thinking about your business’ finances.  The most common priority unsecured debt for a business is tax debt.  Tax debts are unsecured, but because of state and federal tax laws you cannot simply walk away from tax debts.  This is true regardless of whether you file bankruptcy.  The IRS or WA DOR has the power to shut down your business, seize your assets, and auction them off if you fail to pay your taxes.

Accordingly, tax debts must be paid in full if you plan to keep your business in operation.  Even if you do not plan to continue the business operations, tax debts must be addressed because you may be the person most responsible and because of successor liability issues.

What Resources Are Available?

If your business is facing insolvency, you need to think about the resources available to either turn it around or to protect yourself.

Assets Available For Turnaround

For example, if you are going to propose a chapter 11 bankruptcy and keep the business running you must either 1) pay all claims in full, or 2) meet the new value exception to the absolute priority rule.

In bankruptcy, creditors are given priorities.  The priorities are as follows: 1) secured creditors, in order of perfection; 2) priority unsecured creditors; 3) general unsecured creditors or subgroups of general unsecured creditors; and 4) equity.  The owners, shareholders, or members make up the equity class.

The absolute priority rule says that if one class of creditors will not be paid in full, no lower class of creditors may receive anything through the bankruptcy, unless 1) the creditor consents to receiving less than their full amount, and 2) there is new value being brought into the business.

Since you are the owner of the business, you are in the equity class of creditors.  You cannot keep your ownership interest in the business or receive anything for your ownership interest, unless all classes of creditors are paid in full or you can bring new value to the business.  New value means either money or capital assets.  Most successful reorganization chapter 11 cases involve the owners bringing their own money into the case or finding new investors.

Assets Available To Protect Yourself

The term available resources means new investors or a new cash infusion when you are reorganizing your business, but it means something entirely different if you are going to wind down your business.  If the business has valuable assets, it makes the most sense to liquidate them in an orderly manner and try to pay off the creditors who are most likely to pursue you on your personal guarantee.

For example, if your business has assets and it has tax liabilities then you should try to setup an orderly liquidation of the business; so that the tax liabilities can be paid.  If you don’t engage in an orderly liquidation, the fastest creditor will get the assets.  If the tax creditor isn’t the fastest creditor, then the business will end up still owing a tax debt; and you may end up being held liable as the person most responsible.  Orderly liquidation through a bankruptcy or receivership minimizes your risk of being held responsible for the business’ taxes.

Conclusion

I started this article with the question, who is the client.  The answer is it depends.  Business bankruptcy is a complicated and fact specific area of law.  In some cases, it will make the most sense for the business owner to file bankruptcy, because that it is the best way to get back on your feet, cut off successor liability, and take care of taxes.  In other cases, it makes the most sense for the business to file bankruptcy to either engage in an orderly liquidation or a reorganization.

Ultimately, the issue is whether the business can get back on its feet or whether the business is destined to fail regardless of what you do.  It is never easy to recognize the best course for your business.  You spend years working on it.  You put countless hours into it.  Sometimes the truth hurts, and you need to cut your losses.  Other times, the business can be saved.  Regardless of what happens to the business, you need the counsel of an experienced bankruptcy attorney to help you navigate the next phase in your business life, whatever it may be.

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