Bankruptcy Alternatives for Troubled Businesses
By Rhea Bucy
RBucy@gsrm.com

Luxury Goods USA Company* learned firsthand how quickly businesses can end up on the verge of bankruptcy through no fault of their own.

Luxury Goods had developed a profitable niche supplying components for internationally known makers of luxury electronic products, but its fate changed in 2006 when the U.S. Government and several allies implemented restrictions on the sale of many luxury goods to North Korea.

Two major customers expected these restrictions to reduce their sales by approximately 15%. Both customers were cutting production and would no longer need any of Luxury Goods’ components. Both wanted to cancel their contracts.

To make matters worse, the company’s banker was concerned about how the restrictions would affect Luxury Goods. He said the bank would not renew the company’s line of credit when it matured two months later.

As the example above illustrates, businesses can unexpectedly find themselves in a situation where they don’t have enough liquid assets to pay debts as they become due. 

The pressures of debt led to unwise decisions in the case of Luxury Goods. The leadership falsely assumed that filing bankruptcy was the best solution.

The U.S. Congress created federal bankruptcy law to provide unique remedies for financially troubled individuals and businesses, but bankruptcy should be the last resort.

Troubled businesses have several alternatives available to them that may be more favorable than bankruptcy:

• Composition with creditors agreement. All creditors agree to accept partial payment of the total amount of their claims, which is divided pro rata among them. The partial payment could be in one lump sum or deferred installments over an extended period. This involves bringing all of your creditors together and letting them know that your business is worth less than what is owed and that, if they sue you, they get even less than that. You ask them to let you sell or refinance your assets and arrange an amount that all creditors will receive (e.g. all creditors get $.50 on $1).

• Extension agreement. If your assets are worth more than your debts, you might be able to get your creditor to extend or push forward the due date on a loan. This usually involves letting the creditor know that you can’t pay today and that you are planning to sell assets, refinance, or get additional capital that will allow you to pay the loan by a certain date. An extension agreement sometimes involves giving some kind of security for the debt. The agreement may be a long-term engagement.

• Wind up. Under Tennessee law, a corporation may terminate its legal existence by dissolving and winding up its affairs. A corporation that is experiencing debt problems can often use this process effectively to deal with its creditors. Winding up can be voluntary or involuntary, meaning the corporation itself or one or more of its creditors can initiate the process. The process can occur out of court or be performed under the supervision of a judge (judicial dissolution). If the corporation is proceeding by means of judicial dissolution, the court can appoint a custodian to sell the assets and distribute the proceeds to creditors.

• Assignment for the benefit of creditors. This agreement generally involves assigning business assets to a trusted third party who will be responsible for liquidating the assets and remitting the net proceeds to the creditors. This arrangement usually occurs when creditors have lost confidence in the company’s management.

You have a fighting chance for avoiding bankruptcy if you consult an insolvency expert as soon as you realize financial problems exist. A lawyer can help you understand other bankruptcy alternatives that apply to your situation.

Who Gets Paid First
Businesses that decide to pursue any of these options should be aware that certain creditors, such as the United States and the State of Tennessee, have priority by law over other unsecured creditors. For example, a company that owes back taxes will have to pay the government in full before other creditors get anything. The officers and directors of the business are personally liable for the shortfall if the priority in favor of the government is not observed.

Dealing with a Business in the Zone of Insolvency

• Buyers. Oftentimes a business in the zone of insolvency will try to sell itself. The buyer of a distressed company can be liable for the debts of the seller if it does not comply with the relevant laws for going out of business. The buyer should seek legal advice to minimize exposure to the seller’s liabilities.

• Customers. You may be tempted to give a troubled company some room to meet its past due obligations, but this may make things worse down the road. If you allow deferral and the company later files for bankruptcy, you may have to give back the deferred payment because they occurred outside the scope of normal business. For this reason, customers of a troubled company also need expert consultation.

*A fictitious company.