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The Myth of Chapter 11

Want to use bankruptcy to renegotiate with your company's lenders? Sorry, only big boys play that game

(page 1 of 2)

Debtor attorney Jerrold Guben says the smartest tactic
is often to simply close a failing business and hold
off on filing for bankruptcy.
Photo: 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.


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