State courts offer a way to beat business bankruptcy

Bankruptcy filings last year exceeded 1998's record of 1,442,549. While individuals accounted for the bulk of bankruptcies, business filings jumped by 7 percent, reaching almost 40,000.

The reason for the increase? An unprecedented confluence last year of social, economic and political events: recession, dot-com bust, terrorist attacks and proposed federal bankruptcy reforms. The combination sent a significant financial wave across the country, and the ripples are expected to continue well into 2002.

"I guess you could say it's been a landmark year in terms of some of the large type of filings we've had, certainly punctuated by the recent filing by Enron," says Debra Crabbe, bankruptcy attorney with Foster Pepper & Shefelman in Seattle. "But given the fact that we're expecting record numbers of filings in January and February because of the trickle-down effect and because of retail and hotel industry problems, we may be only seeing the tip of the iceberg at this point."

Elliot Abrams, a bankruptcy attorney in Silicon Valley, agrees.

"I see more bankruptcies, and I see more people out of work," says Abrams. "It doesn't surprise me. The economy is going down, the dot-com thing takes a while to filter through, and there's more business and personal filings."

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Small businesses may be particularly vulnerable during turbulent economic times. If your major customer cuts production or files for protection, they could take you down with them. You may have greater debt and fewer reserves than the big guys with which to ride out the lean times. And if the major manufacturer lays off your customers, who's going to buy your products?

Sure, filing bankruptcy is an option. But not filing may be a better one. Here's why.

Chapters and curse
Bankruptcy is your right, guaranteed by the U.S. Constitution, to have your debts canceled or modified by the federal courts. It is not necessarily a mortal blow. Donald Trump, Wayne Newton, Mark Twain and countless others have survived and even thrived after bankruptcy.

That said, it's important to bear in mind that no one wants you to file for bankruptcy: not your customers, not your creditors, not your bank, not your partners, not your attorney, and certainly not you and your family. It is a costly, time-gobbling, unsatisfying last act with considerable personal and professional stigma attached that will dog your credit rating like a pit bull.

Bankruptcy offers you three largely unpleasant alternatives:

Chapter 7, also known as a straight bankruptcy, is the most widely-used form of bankruptcy. It provides for the liquidation of your nonexempt assets and the orderly disbursement of the proceeds to your creditors on a pro rata basis (usually less than your owe them). Chapter 7 results in the elimination of your debts and prevents your creditors from garnishing your wages or repossessing your property, but you'll still be liable for student loans, alimony, child support and some taxes. (Bankruptcy cannot erase non-income taxes, such as payroll taxes, Trust Fund Recovery Penalty or fraud penalties. Income taxes can be eliminated, but only if you meet certain conditions.) Your creditors can force you into Chapter 7 involuntarily.
Chapter 11, also called reorganization, allows your business to develop a reorganization plan, buying it breathing room from legal actions by your creditors on the promise that it can return to profitability and repay them in time. Chapter 11 can be voluntary or involuntary. Creditors also can concurrently force your business into Chapter 7 liquidation.
Chapter 13, also called the wage earner's plan, allows you to pay off your debts by turning your disposable income over to a trustee who distributes it to your debtors. Chapter 13 often involves paying off most or all of your debts, but over a longer period or at more liberal interest rates. You must initiate a Chapter 13 hearing; your creditors cannot force you into it.

A cleaner resolution
OK, so you can't avoid shutting down the business. But don't automatically opt for a federal court disposition. Many small businesses have found that state legal systems offer a far more palatable way to toss in the towel without the residue of a bankruptcy record.

For directions, consult a former dot-commer.

"Dot-coms really didn't enter the bankruptcy arena to the extent that you might expect. A lot of dot-coms went by the wayside, and a lot of attorneys started resorting to state court law to wind them up," says Crabbe. "It was a lot easier and more economical process."

She explains that, in most states, corporate statutes allow you to have a board meeting in which there is a vote to dissolve the company, liquidate the assets and distribute the proceeds to creditors. At that point, you would typically hire counsel or assign all of your company assets to an independent third party for the benefit of creditors.

Company assets are then liquidated, the proceeds are put in a trust account, and claims are paid, usually on a pro-rata basis. Creditors have a certain period to file their claims, and if they don't file by that date, they don't get paid. Then you distribute the pro rata amounts to creditors, file articles of dissolution and hang up the closed sign.

"Contrary to what a lot of people believe, most people who run these companies do have a conscience, and they feel very badly that they're stiffing people," says Crabbe. "When they see that they are able to get money to creditors, it makes them feel better, it makes them sleep better at night, and most importantly, it assures the board of directors that they're fulfilling their fiduciary duties."

Board members also tend to prefer a state court dissolution.

"It certainly helps any board member because when you wind up under state court law, you don't have to do the reporting requirements to the SEC like you would with a bankruptcy. There are certain forms that every board member in any company has to file, and those disclosures have to include whether they've been involved in a company that filed bankruptcy. If you wind out outside of bankruptcy, that's not something you have to disclose," Crabbe says.

Not for everyone
Sounds too easy? Well, Crabbe admits it won't work for every company.

"It really only works with smaller types of companies where you don't have creditors pounding at your door and you don't have a hostile environment. Sometimes creditors don't care if it costs them a bit of money, they want their pound of flesh," she says.

"But I wound up a number of dot-com companies, and I didn't really have any problem. We were able to show creditors that if you cooperate with us, here's what you're going to get and it would be a lot more than you would receive in a bankruptcy."

Bottom line: Before you head for bankruptcy court, consult your lawyer about dissolving your company through state court law.

Jay MacDonald is a contributing editor based in Florida.

-- Posted: Jan. 30, 2002