It’s late Friday afternoon and your mind is wandering. For the moment, the trials and tribulations of your past week and the challenges of the week ahead have faded away. Perhaps you’re dreaming of a day on the golf course, a weekend shopping downtown or simply quality time with family and friends. Then the phone rings…
It’s I.M. Wealthy on the line, a long-time client. In the past you’ve handled his corporate matters, real estate transactions and estate planning. Your partner even handled his divorce. Reflexively your mind snaps back into lawyer mode. This time there are no customary salutations and niceties. Wealthy cuts right to the chase.
He relates a sad tale told too often in our current economy. His once formidable business is sick and fading fast. How can this be? Wealthy has…or had….a great business. He had lots of clients, sold millions of widgets and made a fortune. Now he’s nearly broke and worse, he’s pledged all his personal assets to cover his failing business. Creditors are nipping at his heels and he can’t see any solution. He’s come to you to sort it out.
You listen carefully to his sordid tale of declining sales, market fluctuations, a risky takeover and intense competition from overseas. For the last two years he’s poured every cent of his savings into the company. He’s even mortgaged every asset he owned just to keep the doors open. And it still wasn’t enough. The business continued to spiral downward. Now Wealthy is facing lawsuits, judgments, citations and IRS levies. He is effectively out of business.
The unfortunate scenario of I.M. Wealthy is common today, but it is also avoidable. While economic changes happen quickly, leaving even well-heeled businesses in permanent trouble, there are usually some distinct warning signs. By heeding the signals of impending business failure, business owners can manage the outcome to their advantage. Title 11 of the United States Code (the "Bankruptcy Code") provides at least three possible solutions to business problems: Chapter 11, Chapter 7 and Chapter 13. More solutions exist outside of bankruptcy court, such as out of court workouts, asset or business sales, and assignments for the benefit of creditors. However, the first step to recovery or a soft landing is to identify and heed the common warning signs.
Warning Signs that Your Client’s Business is in Trouble: The signs of a failing business can take many shapes. While not exhaustive, the list below can be a starting point for an honest assessment of future business prospects.
Is your client’s industry in recession? The most recent example of this phenomenon is homebuilders and developers. However, there has also been significant damage to related businesses such as plumbers, electricians and other various construction contractors. Paying attention to business trends and cycles can help you identify a potential problem for your client.
Is your client utilizing old methods in an industry changed by technology? Perhaps Mr. Wealthy didn’t see the handwriting on the wall in the widget industry. The classic example is buggy whip manufacturers at the turn of the last century. Technology changed and demand for buggy whips fell. More recent examples are large scale printing press manufacturers (replaced by computer generated graphics and printing) and makers of VHS tape (replaced by CDs and DVDs).
Has your client undergone rapid expansion or growth? Ironically, too much business can actually cause problems. When business is good and plans are made to expand, sometimes the expansion outstrips demand or dips in the economy cause problems that were unforeseen. One recent example would be Starbucks and its current retreat in store numbers. While lattes and espressos may be a billion dollar industry, the principle holds true for small businesses too; whether it be a custom office furniture maker in Berwyn or a computer consulting firm in Naperville. Rapid growth can deplete vital cash and management resources, increasing financial volatility and the probability of business failure.
Is your client having cash flow problems? Cash flow encompasses several concepts. Primarily it refers to whether a business generates enough income to service its operations and obligations. It can also mean the timing of income in businesses that operate in industries with highly defined seasonality (think of Christmas tree growers). Signs of cash flow problems are excessive borrowing to meet monthly operating expenses, litigation with creditors, bounced checks, vendors who will only accept cash payments, and not paying bills in a timely manner.
Is your client paying taxes as they come due? One sure sign of problems is when the business cannot pay its tax obligations. What it means is that the business is using money that should be set aside for withholding taxes and other tax obligations to fund operations. In essence, the Internal Revenue Service, Illinois Department of Revenue (or other taxing authority), have become de facto lenders of last resort to your client. Using a taxing agency as a lender is an extremely slippery slope and usually means that all other sources of capital have been depleted.
Has your client’s bank declined to renew a line of credit or asked for additional collateral and personal guarantees? Bank loan officers perform due diligence on their customers regularly. They also know when a certain industry is in decline. A sure sign of trouble is when the bank won’t renew the credit line or is asking for additional assets to secure the line. If your client is experiencing this warning sign, it is time for a sober assessment of the business’ prospects.
Has your client’s business recently changed management or other key staff members? Losing a great salesman or other key person has been the trigger for many a business failure. In theory, no one is irreplaceable, but in practice they often are. In some cases, a key employee leaves because he or she knows the inside scoop on the company and takes flight before the real problems come to light. Another classic example is the death or retirement of a certain maverick manager (e.g. the founder) whose replacement just isn’t up to the task.
Does your client draw a salary from the business? One of my esteemed colleagues is fond of saying that if you don’t get paid by your business, you don’t have a business – you have a hobby. That wisdom is spot on and is a sure sign of possible business failure ahead. It is really a symptom of cash flow problems, but one that is easily disguised by a prideful business owner who has outside wealth and other assets to provide for usual living expenses.
If you recognize that your client may have a failing business, what do you do? Taking action earlier rather than later is paramount. The palatable options and choices of a business owner facing trouble typically become fewer with the passage of time. Fortunately, there is help in the form of both bankruptcy and out of court solutions.
Bankruptcy Solutions to Business Problems:
Chapter 11 The Bankruptcy Code provides for several possible solutions to business problems. Chapter 11 of the Code allows for a business to reorganize while under court supervision and protection from creditors. Chapter 11 takes many forms, but essentially the company management proposes and executes a Chapter 11 Plan which may be used to compromise or even eliminate certain classes of debt. The plan can also be used to reject leases and other executory contracts that are not favorable to the debtor. Typically a Chapter 11 debtor is attempting to continue in business. A "liquidating Chapter 11" is a debtor that sells assets in an orderly manner to pay creditors.
The largest Chapter 11 case of all time was filed in September, 2008 by Lehman Brothers who listed over $639 billion dollars in assets. Chapter 11 can be used by a troubled business of any size that wants to continue operations or conduct an orderly wind down.
Chapter 7 In filing a Chapter 7 case, the owners of a troubled business have decided to "raise the white flag", shut down and walk away. In the typical scenario, a Chapter 7 Trustee is appointed who collects and liquidates assets of the bankrupt company. Proceeds of the assets are used to pay creditors. While potentially costly to owners of the company through the loss of their equity (if any was left), the old adage that "your first loss is your best loss" applies. When a business is unprofitable and the long term prognosis is not, shutting down to cut losses becomes a reasonable alternative. Perhaps I. M. Wealthy would still be on solid financial ground had he chosen to file a Chapter 7 case instead of investing all of his personal assets in the failing business.
Chapter 13 Business Chapter 13 cases are somewhat limited in their application. A corporation, limited liability company, partnership or other similar business entity cannot file a Chapter 13 case. Typically a business Chapter 13 is a sole proprietor operating a small business. In Chapter 13 the debtor proposes a plan that is overseen by the court and a Chapter 13 Trustee. The terms of the plan can compromise certain debts, reject leases and executory contracts and abandon costly unprofitable assets. Since debts of the business are debts of the individual a successful Chapter 13 Plan will benefit the sole proprietor’s business.
Non-bankruptcy alternatives: There are many non-bankruptcy alternatives for aiding a failing business. The short list of popular choices includes, out of court workouts with creditors, asset or business sales and assignments for the benefit of creditors.
A workout with creditors is simply a negotiation with company creditors for favorable terms of repayment of debt or outright forgiveness of debt. One problem with an out of court workout is that it requires that the owners of the company be committed to continuing the business. It may also require further capital infusions or pledging of assets. Remember our friend I. M. Wealthy?
Asset or business sales are popular when the selling price will exceed liabilities. Often an outside consulting company is hired to find a suitable purchaser. However, when a company is "upside down" and has no equity, an asset or business sale becomes more difficult due to the concerns of competing creditors. In these cases an Assignment for the Benefit of Creditors is a possible solution.
Using the assignment for the benefit of creditors, the owners of the business debtor relinquish control to an independent assignee who liquidates the assets and uses the proceeds to pay creditors. The assignment is like an out of court Chapter 7 case. One drawback is that an assignment will not stop certain legal and or collection actions against the debtor like a bankruptcy case would. Creditors generally need to agree to stop their actions. Therefore, an assignment for a business facing such actions is a somewhat limited tool.
Summary: Bad things sometimes happen to good clients and their businesses. When they do, you will want to recognize the warning signs that a business is in trouble. Even if your practice does not include commercial, business or bankruptcy law, you should know the common signs of a failing business. Alerting your clients to potential pitfalls – and referring them to appropriate counsel - is a good practice. Taking action early, whether through a bankruptcy case or out of court solution, can be the difference between your client continuing to live well or your client’s financial despair.
Arthur W. Rummler is an attorney in the law firm of Springer, Brown, Covey, Gaertner and Davis, LLC, in Wheaton, Illinois. He concentrates his practice in bankruptcy. He is a 1991 graduate of the Chicago-Kent College of Law and a 1987 Graduate of the University of Michigan Ross School of Business. He lives in Downers Grove with his wife Claire and two children, Jackson and Christian.