Posted 4 years ago in Guest Blog by Ira Bodenstein and David R. Doyle of Cozen O'Connor
13 MIN READ – The financial distress caused by the COVID-19 pandemic has left many companies reeling. Unable to wait for business to improve, these companies are forced to consider their options for reorganizing their debts, winding down or liquidating. In this guest blog, we at Cozen O'Connor will explore some of the options that are available under Illinois and federal law for companies facing financial distress, including the newly enacted Small Business Reorganization Act.
General Considerations
Before discussing options for a distressed company, it is critical to understand why the business is struggling. For example, is it experiencing only a temporary decline in cash flow, and reasonably expects to return to profitability in the near future? Are there specific obligations that are not sustainable and could be renegotiated? Or is the business beyond salvaging? The answers to these threshold questions will determine whether the company can avoid taking a drastic step, like filing a bankruptcy case, and work with its creditors to regain solid financial footing.
Other relevant factors include: the amount of debt; whether any of the company’s property is subject to liens; the overall value of the company as compared to its obligations; and whether the company’s assets could be sold as a going concern. These considerations will likely determine the options available to the company.
Finally, any decision should be made with the interests of all stakeholders in mind. In particular, if the company is insolvent, it has a duty to act in the best interest of its creditors.
State Dissolution Procedures
The first option to consider is a simple dissolution under Illinois law. The Illinois dissolution statutes allow business entities of all types – corporations, limited liability companies (LLCs) and partnerships – to dissolve, wind-up business operations, and liquidate their assets. See 805 ILCS 206/801 (dissolution of Illinois partnership); 805 ILCS 5/12.05 (dissolution of Illinois corporations); 805 ILCS 180/35-1 (dissolution of Illinois LLCs). Generally speaking, the voluntary dissolution of a company is straightforward. The company’s stakeholders vote to dissolve the company and file appropriate dissolution papers with the Illinois Secretary of State. Upon dissolution, the company’s operations are limited to winding up its business, e.g., selling assets, making distributions to creditors and shareholders, and taking other actions to close the business.
For corporations, Section 12.75 of the Illinois corporation statute creates a procedure for resolving claims. Within 60 days of the dissolution date, the dissolved corporation may send a notice to all creditors of the company requiring all claims to be submitted to the corporation within 120 days of the dissolution date. If a claim is not submitted by the deadline, the creditor will be barred from enforcing the claim against the dissolved corporation and its officers, directors, and shareholders. (This process does not bar contingent or unknown claims against the company.)
No similar process is available for Illinois LLCs or partnerships. However, dissolved businesses are required to satisfy the claims of the company’s creditors before making distributions to equity holders.
The state dissolution statutes are ideal for solvent companies – that is, companies that can otherwise satisfy their obligations upon liquidation. It may also be the best option for insolvent companies with few or no assets available to satisfy creditors.
But for a company that is insolvent, but has material assets available to partially satisfy creditors, it usually does not make sense to rely solely on the state dissolution statutes. That is because creditors require assurance that the company is selling its assets to equitably satisfy claims. Additionally, a court supervised proceeding is often required to resolve disputes with creditors and approve distributions. Finally, third-parties may be reluctant to purchase the company’s assets over concerns that they could incur successor liability for the company’s debts, absent a court order.
In sum, the dissolution statutes do not provide the oversight of an independent fiduciary or the finality and transparency of a bankruptcy case.
Assignment for the Benefit of Creditors
Another option for winding down a business is an assignment for the benefit of creditors (ABC). An ABC is a voluntary assignment of all of the company’s assets to a third-party (the assignee) pursuant to a written trust agreement. Although many states have statutes establishing the process and requirements for ABCs, Illinois does not. Instead, ABCs in Illinois are a common law liquidation procedure.
A valid ABC must include an assignment of all of the company’s assets, and the trust agreement must provide that the ABC is for the benefit of all of the company’s creditors. The assignee receives the assets subject to all liens, claims and encumbrances of the company’s creditors.
Upon the creation of an ABC, the role of the assignee is to liquidate the company and distribute the proceeds to creditors. An assignee will inventory the company’s assets and, if a market exists, run a sale process designed to maximize the return to creditors. If the company can be sold as a going concern, the assignee may operate the business pending the consummation of a sale.
After the assets are sold, the assignee will pay lienholders from the proceeds of their collateral. The assignee and his professionals (typically attorneys and accountants) next receive payment of the fees and expenses incurred as an administrative priority. Finally, the assignee will run a claims process and use the remaining proceeds to pay valid claims of the company’s unsecured creditors, including taxing authorities.
The benefit of an ABC is that an independent, third-party fiduciary of the company’s choosing is installed to wind-down and liquidate the company. ABCs also tend to be quicker and less expensive than administering the company pursuant to a chapter 7 bankruptcy case. Further, a company’s management is not subject to direct examination by creditors as they would be in a bankruptcy case.
In addition, an ABC can be an effective mechanism to administer the assets of a cannabis company. Currently, federal law prohibits a company in the business of growing or distributing cannabis to file a Chapter 7 or Chapter 11 bankruptcy case. In an ABC, a cannabis company can liquidate or sell its assets and operations as a going concern.
One of the downsides of an ABC is there is no automatic stay of creditor litigation. Litigious creditors may choose to file an involuntary bankruptcy case against the company upon the creation of an ABC, which if successful will terminate the ABC and force the company to liquidate under the provisions of the Bankruptcy Code. Further, an assignee is not vested with the avoidance powers of a bankruptcy trustee to “clawback” certain transfers and maximize value for unsecured creditors of the company.
Chapter 7 Bankruptcy Case
A Chapter 7 bankruptcy case is a liquidation of a company under the supervision of a federal bankruptcy court. Chapter 7 bankruptcy cases are commenced by the filing of a bankruptcy petition. Upon the filing of the petition: (i) an independent, third-party trustee is appointed to oversee the liquidation of the company’s assets and, if assets exist, make distributions to creditors; (ii) a bankruptcy “estate” is immediately created comprising all of the company’s assets, including causes of action; and (iii) an automatic stay takes effect barring any creditor litigation against the company.
In addition, the company will cease operating, although the trustee may operate the company on a limited basis as necessary to wind-down the business and preserve the value of its assets.
The role of a Chapter 7 trustee is to maximize the value of the bankruptcy estate for the benefit of creditors. To that end, a trustee’s tasks will include: (i) investigating the financial affairs of the company and any liens asserted against the company’s assets; (ii) filing lawsuits against third-parties to recover preferential or fraudulent transfers made by the company; (iii) analyzing and, if necessary, objecting to claims filed by creditors; (iv) selling any non-liquid assets of the company; and finally (v) distributing property of the bankruptcy estate to creditors and, if sufficient assets exist, to shareholders.
All creditors of the company will receive notice of the bankruptcy case and, if assets exist, have the opportunity to file claims. Generally, a bankruptcy case will not impact valid liens of secured creditors. Liens are said to “ride through” a bankruptcy case unaffected, and secured creditors will receive either their collateral or the proceeds of their collateral before any other creditors are paid. To the extent any money remains above the claims of secured creditors, it will be used first to pay the costs of the administration, including the fees and expenses of the trustee and his professionals, and second to pay unsecured creditors on a pro rata basis according to the priority scheme established by the Bankruptcy Code.
The benefits of a Chapter 7 bankruptcy case, as opposed to an ABC, include finality and predictability. The automatic stay forces all creditors to immediately cease any litigation against the company or face contempt of court. The Bankruptcy Code ensures a prompt and expeditious liquidation of assets according to an established priority scheme. The bankruptcy court provides a ready venue for quick and efficient resolution of disputes. In addition, the bankruptcy court may authorize the trustee to sell the company’s assets “free and clear” of all liens, ensuring purchasers that they will not be tagged with successor liability. Finally, the Bankruptcy Code provides creditors with transparency over the company’s financial affairs, permitting both the trustee and creditors to interview the company’s management and examine its books and records.
Chapter 11 Bankruptcy Case
Chapter 11 of the Bankruptcy Code is used by operating companies to reorganize their balance sheets pursuant to a chapter 11 plan of reorganization. Alternatively, the company may utilize Chapter 11 to sell its business as a going concern and then liquidate. The benefit of a Chapter 11 bankruptcy case is that it provides the company some “breathing room” while it negotiates with creditors and other stakeholder over the terms of a plan.
Like a Chapter 7 case, a Chapter 11 case is administered under the supervision of a federal bankruptcy court and is commenced by the filing of a chapter 11 bankruptcy petition. Upon the filing of the bankruptcy petition, the automatic stay takes effect and a bankruptcy estate is created. Creditors are notified of the bankruptcy case and may participate in the case and file claims. Unlike a Chapter 7, however, a company in Chapter 11 may continue to operate and its pre-bankruptcy management continues to control the business. In addition, depending on the size of the company’s creditor body, a committee of unsecured creditors may be appointed to represent the interests of all unsecured creditors in the case.
A company in Chapter 11 may emerge from bankruptcy by confirming a Chapter 11 plan of reorganization. The plan is essentially a contract addressing how the company will satisfy its obligations to creditors. The plan must classify creditors and specify distribution and payment terms for each class. Companies have fairly wide latitude in determining how to implement the plan and fund payments to creditors. To give some examples, the plan may permit the company to obtain new financing, sell some or substantially all of its assets, or merge or consolidate entities.
Most successful reorganizations involve the company negotiating with stakeholders to arrive at a consensual plan of reorganization. Once the plan is formulated (with or without agreements from key constituents), the debtor will seek approval of a disclosure statement and distribute the plan and disclosure statement to its creditors. Creditors who are impacted by the plan will then vote on whether the plan should be confirmed.
If the company is unable to confirm a plan, the bankruptcy court will either dismiss the bankruptcy case or convert the case to one under Chapter 7. Or as noted above, the company may undertake to sell its assets, whether or not as a going concern.
During a Chapter 11 bankruptcy case, the company must continue paying its post-bankruptcy obligations in the ordinary course. Failure to do so can result in the case being dismissed or converted to Chapter 7. Moreover, if the company has a secured lender, the lender is entitled to “adequate protection” of its interest in the collateral, which can include providing the lender with additional collateral or making periodic payments to the lender.
The benefits offered to businesses that file Chapter 11 bankruptcies include the company’s ability to right-size its balance sheet, reduce liabilities, reject or restructure burdensome leases and executory contracts, renegotiate funded debt, and sell its assets. One of the primary drawbacks to a Chapter 11 bankruptcy case is its expense. The cost will be significantly higher in a Chapter 11 than a Chapter 7 or an ABC.
Small Business Reorganization Act (Small Business Chapter 11)
In August 2019, Congress passed the Small Business Reorganization Act (SBRA), which became effective on February 19, 2020. The primary objective of the SBRA was to enable small businesses to successfully emerge from bankruptcy with a plan of reorganization, without having to incur the costs associated with larger Chapter 11 filings. To implement those objectives, the SBRA created sub-chapter V of the Bankruptcy Code, which provided small businesses (companies, including sole proprietorships, with non-contingent, liquidated debts in an amount not greater than $2,725,625) with an opportunity to restructure their liabilities through a streamlined and cost effective Chapter 11 bankruptcy process.
In light of the economic impact of COVID-19 virus on U.S. businesses (both large and small), Congress passed the CARES Act on March 27, 2020, which amends the SBRA to increase the debt limit for companies filing under sub-chapter V from $2,725,625 to $7.5 million. The debt limit will revert back to $2,725,625 after one year unless further extended by Congress.
If a company seeking to reorganize meets the $7.5 million debt limit, an SBRA case is a particularly attractive option. An SBRA bankruptcy case is similar to a regular Chapter 11 case, but includes the following additional benefits:
- Unlike most chapter 11 cases, owners of the company are permitted to retain their equity in the reorganized company.
- A streamlined process to file and confirm a plan.
- No official committee of unsecured creditors will be appointed (unless the bankruptcy court for cause orders otherwise), reducing the administrative burden on the company of having to pay fees and expenses incurred by committee professionals.
- The company can seek to modify a mortgage against a principal residence, provided that the mortgage loan was not used primarily to acquire the residence. The SBRA thus makes it harder for creditors to take away a business owner’s residence pledged as collateral to support the business.
Another difference is that a “standing trustee” will be appointed and will remain throughout the payment period set forth in a confirmed Chapter 11 plan. The duties of the standing trustee include accounting for all of the property received by the company, examining and objecting to the allowance of claims, reviewing the debtor’s financial condition and business operations, reporting fraud or misconduct, appearing at hearings, preparing a final report and account, helping facilitate a plan of reorganization, distributing property in accordance with a confirmed plan, and ensuring the company’s compliance with the confirmed plan.
Conclusion
This is just a brief summary of the options available to deal with the financial distress of a business. Regardless of the situation, it is important to be proactive. Doing nothing is not an option. Waiting often leads to your creditors dictating how you wind down your business, limiting your options and often reducing the value of the assets of the business.
For questions about winding down or reorganizing your business, you may contact Ira Bodenstein or David Doyle at Cozen O'Connor.
DISCLAIMER
The information provided in this article does not, and is not intended to, constitute legal advice; instead, all information, content and materials available in this article are for general informational purposes only. Nothing in this article is intended to or does in fact create an attorney-client relationship. Information in this article may not constitute the most up to date information. Readers of this article should contact an attorney to obtain advice with respect to any particular legal matter
