What can you/should you do when it becomes obvious that your start up business should wind down?
For the entrepreneur, shutting down an insolvent business presents a tough challenge: you must honor the legal rights of creditors while minimizing the damage to the founders and employees.
First, some basic principles:
- The board of directors of an insolvent corporation owes its duty of loyalty to the creditors, not the owners.
- Creditor claims get paid before the claims of equity holders of the business.
- Management can legally pay some creditors and not others.
Bankruptcy or not
There is no clear or universal answer to whether a failed business should file a Chapter 7, which is a liquidation proceeding. It depends on the value and nature of the assets; the attitudes of creditors; and the availability of management to oversee the process.
A corporation does not get a discharge in a Chapter 7 case; only a Chapter 11 reorganization erases the debts of a corporation. So the only purpose a business bankruptcy serves is to liquidate the business assets and satisfy creditors as far as possible.
Companies can go out of business without filing bankruptcy: they liquidate their assets and cease operations. Creditors have a right to recover their claims from the assets of the corporation.
If there are no assets, the corporation cannot be further harmed by lawsuits that try to collect from the corporation.
The danger to management in this approach is the tendency of some creditors to assume that the business’s failure to pay means that there is some sort of skullduggery afoot, and sue the officers as well as the corporation to collect the debt.
While the claim against the individuals may be invalid, the individual has to appear and defend in the lawsuit, or a judgment will be entered against him. Sometimes, the individuals are liable.
Personally managing the wind up has advantages, if you are willing to devote the time and energy to the process. On the other hand, filing bankruptcy may protect assets from creditor action, preserving value for the payment of taxes and employees.
Doing it yourself has advantages
- Management can usually get better price for assets since they know the market, know the asset and are motivated to get highest recovery
- Outside of bankruptcy, you control who gets paid with the available funds
- You can act swiftly to limit exposure of management or investors by paying first debts guaranteed by insiders, subletting leased space, returning leased equipment, etc.
- Creditors are protected from having to give back preferential payments to the bankruptcy trustee
- Assets can be sold to insiders so long as the price is fair
But…
Handling the shut down yourself has some down side:
- May prevent management from accepting new employment
- May require cooperation from creditors and lessors
- May increase likelihood that disgruntled creditor will sue individuals too
Bankruptcy is simple
- Bankruptcytrustee becomes responsible for liquidating assets, returning equipment, and dealing with creditors, freeing management to turn to other endeavors
- Trustee has powers under Bankruptcy Code to sell leases despite anti assignment provisions and to avoid levies and writs of attachment, recovering value for creditors that isn’t possible outside of bankruptcy
- Filing bankruptcy seems to reduce the instance of creditors suing individual managers for corporate debt
- The automatic stay prevents aggressive creditors from diverting cash that could be used to pay taxes, employees, and guaranteed debts or recovering property needed for wind up
But….
If the bankruptcy trustee winds up the business:
- Trustee unlikely to get top dollar for saleable assets
- Insiders may be prohibited from buying technology, intellectual property or projects in development
- Trustee’s fees and expenses are paid off the top
- Trustee can recover preferences to trade creditors and to insiders and challenge pre petition transfers of assets if legally fraudulent
- Bankruptcy process frequently slow and inexact
- Claims are paid according to priorities in the Bankruptcy Code
This choice is not necessarily an either/or decision. Management can liquidate assets as far as feasible, and file bankruptcy thereafter to let the trustee mop up.
Read more
Business bankruptcy FAQ
Business issues in bankruptcy
Closing a business without bankruptcy
Finding a bankruptcy lawyer
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