Struggling Firms Get a Second Chance

Posted on Monday, June 25, 2018

For many business owners and executives, filing for Chapter 11 bankruptcy proceedings seems like admitting defeat, but it shouldn't be that way.

Current Bankruptcy Law

A wide-ranging law that makes major changes to the country's bankruptcy laws was signed by President W. Bush on April 20, 2005 and went into effect on October 17, 2005.

Under the Bankruptcy Abuse Prevention and Consumer Protection Act, it is more difficult for individuals to file for Chapter 7 bankruptcy, which wipes out most unsecured debts — including credit card debt. Lawmakers say the changes, which prohibit some individuals from filing for bankruptcy altogether, are necessary because at the time this law was passed, filings had reached historic highs.

In addition to the major changes in consumer bankruptcy, the Bankruptcy Act also contains numerous changes for business bankruptcy cases, including rules for reorganizing under Chapter 11. It also created a new chapter of the Bankruptcy Code, Chapter 15, which addresses cross-border insolvency.

The bankruptcy code exists to provide second chances. Chapter 11, which covers business reorganizations, allows struggling companies to right themselves so that they may once again be profitable engines of the nation's economy.

No provision in the Bankruptcy Code is more important to achieving this goal than the automatic stay provision of Section 362.

Time-Out

The automatic stay provides a time-out — a window of opportunity to fix problems. In some cases, time is all that's needed.

Whenever a company — or an individual — files for bankruptcy, the automatic stay kicks in. Like a temporary injunction, the automatic stay prohibits any action by a creditor against the debtor or its property.

Actions prohibited to a creditor under an automatic stay include repossession, foreclosure and lawsuits. The automatic stay even affects the IRS. While the stay is in place, the IRS is prohibited from issuing tax liens or seizing property.

There is one major difference between the automatic stay in bankruptcy and a typical temporary injunction: No hearing is needed for the automatic stay to take effect. It occurs as soon as a petition to file for bankruptcy proceedings is stamped at the court.

Power to Punish

A company can then move forward without fear. The bankruptcy court has the power to punish creditors that knowingly violate a stay by filing a contempt charge against them. Harassing letters and phone calls should stop. If they don't, notifying the court of a creditor's transgression generally ends the problem.

While the automatic stay is in place, the debtor company is prohibited from paying most of its pre-petition debts. This provides a chance for the company to rebuild itself as a going concern.

However, recent changes in the bankruptcy law impose limits on the duration of the stay for certain repeat filers (see box). These debtors must seek a stay from the court in order to have the protection of the automatic stay.

You might think that filing for bankruptcy to get an automatic stay sounds all well and good, but filing will surely dry up the pool of available credit for things such as operating expenses. Won't bankruptcy tie the company's hands and kill any hope of future success? This is generally not the case. Sometimes, a struggling company has an easier time obtaining credit once bankruptcy has been filed and the automatic stay is in place.

Credit availability tends to increase because of the prohibition against paying pre-existing debts. All debts incurred after bankruptcy has been filed (post-petition debts) must be paid first, before any pre-petition debts. As long as the company shows that it can operate profitably if it doesn't have to immediately pay its pre-petition debts, credit is likely to be available.

Fruitful Negotiations Count

Consult with your accountant about the best way to proceed. And keep in mind that corporations that successfully come out of bankruptcy almost always do so because of fruitful negotiations with creditors. The automatic stay is not a cure-all. For some businesses, no amount of time can fix things. But for a company that is fundamentally strong, with credit in hand, the automatic stay provides an important opportunity to talk to creditors and get back on track.

Posted in Tax And Accounting Topics For Business

Disclaimer: The information contained in Dulin, Ward & DeWald’s blog is provided for general educational purposes only and should not be construed as financial or legal advice on any subject matter. Before taking any action based on this information, we strongly encourage you to consult competent legal, accounting or other professional advice about your specific situation. Questions on blog posts may be submitted to your DWD representative.