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The Threat of the ‘B’ Word

This article was originally published in Valley Lawyer, April 2009.

There is virtually no business in today’s economic climate that is not affected by the worldwide economic downturn.   Yes, even bankruptcy lawyers have to watch their receivables.  Commercial litigation also is directly affected, as threats of a defendant’s bankruptcy – which perhaps used to be taken lightly by plaintiffs – now need to be considered much more thoroughly.   The purpose of this article is to give some general examples of how a bankruptcy might affect the rights of litigants in commercial litigation, and its consideration in resolution, analysis and strategy.

Generally speaking, a potential loss in commercial litigation is not a sufficient reason to file a bankruptcy.  A business considering the filing of a bankruptcy usually will have several other issues or creditors. In fact, if there is only a “two-party” dispute, that is, the entity really has only one creditor whose debt it wants to avoid through a Chapter 11 bankruptcy, such a maneuver probably won’t allow for a successful reorganization.

There are two types of bankruptcy that a business could file: Chapter 7 (liquidation) or Chapter 11 (reorganization).   Although a corporation or LLC can file a Chapter 7 proceeding, such an entity, unlike an individual, does not receive a discharge.[1][2]

Conversely, individuals can file three different kinds of bankruptcy: Chapter 7, Chapter 11, or Chapter 13, which provides a mechanism for a three or five year payout of some or all of the individual’s debts. The 2005 changes to the bankruptcy law made it harder for individuals to file Chapter 7.    Depending upon an individual’s assets, debts and income, an individual may be required to file a Chapter 13.[3]

Now, let’s discuss the possible way in which a bankruptcy, or the threat of a bankruptcy, could help resolve a pending commercial business dispute.   Here is the situation.

Two entities are involved in a business dispute.   Let’s presume that they are in an arbitration and the arbitrator has made a preliminary ruling in favor of the plaintiff entity.  The arbitrator has reserved the determination of issues on the amount of attorney’s fees[4] and whether the two shareholders of the defendant entity will have personal liability for the entity’s liability in the matter.   For the sake of this discussion, let’s also assume that the arbitrator’s preliminary findings also have some hint of fraudulent conduct.

Plaintiff’s counsel may feel pretty confident knowing that his client, the clear prevailing party, is likely to get a substantial attorney’s fees and cost award, in addition to the preliminary award.  Moreover, Plaintiff’s counsel may feel that the ruling is a likely harbinger for a finding of personal liability against the shareholders/members of  the business entity.

Conversely, Defense counsel could feel a little downtrodden.   His or her client may even question the result (it wouldn’t be the first time a client blamed his or her counsel for a loss).   How can the defense attempt to reach a deal that minimizes the hit the client takes, allows the business to maintain operations, and avoids a finding of personal liability for the entity’s shareholders/members?

If defense counsel simply throws out the “B” word, most plaintiff lawyers won’t take it seriously.   The best way to get the attention of Plaintiff’s counsel is to bring in a bankruptcy professional to either help, or possibly take over, the negotiations of a settlement. [5] Certainly, Plaintiff’s counsel, if presented with the “B” option, may want to do the same thing.

Now, what distinguishes the “B” option as a real threat, as opposed to nothing more than a negotiating ploy?  Assuming that the defendant, or soon to be debtor, is considering a Chapter 7 bankruptcy (or in other words, make a deal or we will just go out of business), the plaintiff needs to conduct a liquidation analysis.  First off, any defendant that truly threatens a bankruptcy must be willing to show its cards (i.e., tax returns, financial statements, appraisals, etc.).   If a defendant asks a plaintiff to “take my word for it,” the plaintiff should hang up the phone and tell the defendant to call back when he or she is serious.

Having said that, assuming a defendant is willing to show its true financial picture to the plaintiff, the plaintiff must then determine whether it will do better or worse, if the defendant is forced to file.   In other words, the plaintiff needs to analyze how much it would get as a creditor through the bankruptcy process and what is a real economic of a personal award.

For example, what would the defendant’s assets sell for through a bankruptcy liquidation?  A Chapter 7 Trustee would be appointed to liquidate the assets.  That Trustee may be required to hire counsel to help with the liquidation.  As a result, there could be at least two levels of administrative expenses that would have priority (be paid first) prior to the plaintiff seeing a dime.

Moreover, the plaintiff’s recovery as a general unsecured creditor will be at the same level of all other general unsecured creditors.  Thus, the plaintiff will get, if any monies are left after administrative expenses, a pro-rata share of all of the monies left over to pay general unsecureds.   A legitimate threat of a formal proceeding elevates all other general unsecured creditors to the status of this litigation creditor.

Another question to ask is whether the defendant has any secured debt.  For example, does the defendant have an outstanding bank loan for which the bank has a security interest in the defendant’s assets?   In such an instance, the bank would have the right to foreclose on its assets and pay off its debt, or receive (subject to certain practical issues) the value of liquidation activity by a trustee or a debtor in possession.  If there are excess monies after the bank loan is paid in full, such assets would then be administered by the Chapter 7 Trustee.

Now, the Chapter 7 Trustee’s job may not be limited to simply liquidating the assets.  There may be avoidance/preference actions that need to be filed.  A preference action is a legal proceeding filed within the Chapter 7 case (as well as in a Chapter 11) to recover monies paid by the debtor to a third party within 90 days of the filing, or to an insider within 12 months of the filing of the bankruptcy.    Whether these preference actions will bear fruit could be a process taking years.[6] During this time, the Chapter 7 Trustee and its counsel are spending time and money going after the assets.

When all preference actions are either settled or resolved (and all other liquidation activity has been completed), the Chapter 7 Trustee will then file a report and its counsel will file an application seeking its fees.   This could take years to finish and, as noted above, the Trustee and its counsel’s administrative claims take priority over the payment of creditors.  Finally, presuming that the debtor had multiple creditors, not just the plaintiff, and that monies are available, the plaintiff should be paid its pro-rata share.

The liquidation analysis can help the plaintiff/creditor determine if it will be better off with the settlement amount or at the conclusion of the Chapter 7 process. The plaintiff also needs to consider the time value of money, which comes into play as the Chapter 7 process can take years, as well as a value in a certainty to a result.

On the flip side, the defendant must decide if it is willing to end its business just to avoid paying the plaintiff.  How much is a little pain (e.g., a settlement of either a lump sum or payments over time) compared to walking away from its business? Moreover, if the defendant files for a Chapter 7 proceeding, what is the likelihood of the plaintiff seeking to impose personal liability on the individuals?  These questions warrant a separate analysis; the answers to which may present a double-edged sword.

If the corporation or LLC files for a Chapter 7 proceeding, and the claim against the individuals is based upon a contention that the individuals are the alter ego of the defendant corporation or LLC, a judicial finding that the individuals are the alter egos of a debtor probably gives the existing Chapter 7 Trustee rights against the individuals’ assets.  Now, this could increase the pool of assets available to all creditors; but could further delay the process and/or could require the plaintiff to wait for the liquidation process to be completed.  This scenario is an apt description of the phrase – “be careful what you wish for.”

The threat of a Chapter 11 poses similar problems for the plaintiff and potentially large economic issues for the defendant.  First, the filing of a Chapter 11 proceeding will probably require an initial retainer of $25,000 – $100,000, depending upon the type and size of the business.[7] In addition to the upfront costs, a debtor in possession within a Chapter 11 bankruptcy has reporting requirements, major administrative burdens, and must put together a plan of reorganization.  The costs for even a smaller bankruptcy can exceed $100,000.   The defendant/debtor has to decide whether the costs of such a process, without any guarantee that a successful plan of reorganization might be approved, and exposing the equity of the entity to the marketplace, is better than paying a plaintiff a little more money in a settlement.   There also may be stigma issues attached to the defendant’s filings that would make a bankruptcy more detrimental to a particular defendant.  For example, will its suppliers be willing to continue to supply the debtor throughout the bankruptcy?  Will changes in terms (i.e., COD as opposed to monthly payments) make the filing of a bankruptcy just too difficult on operations?  Are their warranty/reliability issues impacting on the customer base?

As with a Chapter 7, a Chapter 11 filing may not stop a creditor from pursuing alter ego liability against the individual shareholders/members.  However, as with a Chapter 7, a successful alter ego finding may not necessarily bring the plaintiff a quicker recovery.   Certainly, though, the individual defendant may want to pay money to avoid the even greater costs of fighting alter ego and/or finding himself or herself in a bankruptcy proceeding.

So, as it generally is with commercial business litigation matters, each case has its own issues and own unique circumstances.  The issues noted above are merely descriptive of the type of roller coaster ride the threat of a bankruptcy proceeding – or an actual proceeding – can provide.

Throwing out the “B” option can be a lot like playing poker.  You have to always evaluate your opponent’s strengths and weaknesses.  How have they played their cards in the past?  Is it better to play it safe and fold or go for it all and risk, perhaps, everything.  Every negotiation, like every hand, is a little different.  However, like in most business contexts, it is better to have experienced professionals on your side.

[1] Although a corporation or LLC does not receive a discharge, there can be business reasons for the filing.  For example, it may be important to officially “notify” creditors of the filing so as to stop enforcement activity.   Creditors often want to see a bankruptcy filing even if a corporation or LLC can show that it has ceased business operations.

[2] There are also bankruptcies that can be filed under Chapter 9 (municipalities) and Chapter 12 (fishing and farming interests).   These types of bankruptcies will not be addressed in this article.

[3] The purpose of this article is not to detail all of the precise rules and/or limits applicable to the filing of a Chapter 7, as opposed to a Chapter 13.

[4] For the sake of this example, the business dispute would permit the recovery of attorney’s fees and costs to the prevailing party.

[5] This is not a veiled advertisement to hire one of the many fine bankruptcy lawyers of the San Fernando Valley.  Rather, it is simply the observation of a practicing lawyer who has seen how the perceived likelihood of a bankruptcy, demonstrated by a bankruptcy practitioner, changes the way a plaintiff views its relative strengths and weaknesses.

[6] There are a myriad of available defenses to a preference action.   The fact that a creditor received a payment within 90 days of the filing of the debtor’s bankruptcy does not mandate the return of any monies.

[7] I am not including within this estimate what it would cost to file Circuit City’s bankruptcy or similar major global kinds of cases. This estimate is based upon a reasonably sized business.  Unlike the free hat that you get at a local store give-away, one size of a proposed bankruptcy retainer does not fit all.  For Chapter 7 cases, usual fees range from about $2,000 to $7,500.  Again, this will not be true for all Chapter 7 cases but for most.