Reorganization of a Business

Bankruptcy Article #16

A. Authority under Chapter 13

• Only sole proprietorships can conduct a business in Chapter 13. 11 U.S.C. Section 1304(a) provides a description of a person who is considered in business under Chapter 13:

  (a) A debtor that is self-employed and incurs trade credit in the production of income from such employment is engaged in business.

  Section 1304(b) permits a debtor in business to operate the business in Chapter 13 subject to the limitations on a trustee under Section 363(c) (requiring a debtor to obtain permission from the Court before the sale of property unless in the ordinary course of business) and Section 364 (requiring a debtor to obtain permission from the Court to borrow money unless in the ordinary course of business).

  The code requires a debtor engaged in business in Chapter 13 to provide periodic reports on the status of the business, including a statement of income and disbursements, in the same manner as a trustee under Section 704(8). This requirement has been carefully monitored by the Court and Chapter 13 Trustee.

  11 U.S.C. Section 1302(6) notes that the Chapter 13 Trustee shall perform the duties specified in Sections 1106(a) (3) and 1106(a) (4) of the Code. Section 1106(a)(3) obligates a trustee to investigate the acts, conduct, assets, liabilities, and financial condition of the debtor, the operation of the debtor's business and the desirability of the continuance of such business, and any other matter relevant to the case or to the formulation of a plan. Section 1106(a)(4) requires the trustee to file a statement of investigation regarding his or her findings under Section 1106(a)(3) noted above, including facts pertaining to fraud, dishonesty, incompetence, misconduct, mismanagement, or irregularity in the management in the affairs of the debtor. The Chapter 13 Trustee has created a final confirmation report which accomplishes this purpose for post petition business activities. This report can result in some Chapter 13 businesses ending their experience in Chapter 13 rather quickly if a Court concludes the debtor has no ability to honestly and competently operate the business.

B. Screening a Business for Chapter 13

1. Business Survivability

   One of the first considerations is whether the business can continue to operate in a Chapter 13. Self employed debtors provide a variety of reasons why they are experiencing financial problems, and almost always the problems have nothing to do with the business. It is critical to evaluate the debtor's reasons for the financial dilemma, and determine whether the business has the characteristics of a healthy business enterprise before embarking upon a Chapter 13.

   The principal issue is whether the business, free from the shackles of prior debt, can operate profitably. If so, the enterprise may be able to navigate its way through Chapter 13. One must understand the nature of the business, its customer base, its historical gross income, its historical operating expenses, and the ways in which the business could be operated differently in order to compete with similar businesses.

2. 2. Business Skills of the Debtor(s)

   Critical in the operation of any business is whether the debtor(s) possesses the skills necessary to operate the business. Although this requirement may seem self evident, it is surprising how many people operating businesses are creative, bright, and hard working, but do not understand basic business principles. Keeping track of the balance in a checkbook, charging and retaining appropriate sales tax, setting aside funds for unemployment and social security taxes, basic employment law, basic municipal law (zoning and planning), and properly pricing products to be sure that the debtor(s) charges more for a product than it costs to produce the product, are all examples of skills that one expects to find in a business person.

3. Past Business Records

   The business records for the past 6-12 months should detail the cash flow for the business, balance sheet, the bank statements, and evidence of tax return filing compliance. Assuming that the debtor has such records in a form that permits cost effective review much can be learned about whether the business was the reason the debtor experienced financial problems. The cash flow reports should reflect the business's ability to generate income and how the debtor has spent the income. Whether or not the debtor is simply taking too much income from the business instead of paying the businesses bills will be apparent.

   Of particular importance are the tax filing records. Small business owners are notorious for failing to timely file and pay their income, sales, and withholding tax obligations when their businesses are experiencing problems. The business owners are instead focused on paying suppliers and employees without which the business would shut down quickly. Unfortunately, failure to address the tax obligations results in a much more serious long term problem for these debtors.

4. Business/Household Budgets

   A small business person in Chapter 13 must provide the Court with a schedule I for the business showing the gross income from the business. The business debtor must then provide a schedule J for the business (showing all business expenses such as trade debt, rent, employees, taxes, etc.) as well as a schedule J for the debtor's personal expenses (detailing all the usual monthly personal living obligations as well as income taxes set aside for those infamous self-employed quarterly reports).

   The true test for a skilled business person is whether thoughtful schedules J can be prepared by the debtor without extensive assistance from counsel or an accountant or bookkeeper. Many self employed debtors are unable to project future income (except in very broad terms) and even less able to predict future expenses on a monthly basis (since they have never kept track of such expenses before). Any business debtor to be certain that the budget presented to the Court on schedules I and J bear close resemblance to what the debtor expects will occur in the foreseeable future.

C. Operation of the Business in Chapter 13

1. Monthly Business Reports

   While a debtor operates a business in Chapter 13, the debtor is obligated to report his or her monthly cash flow from that business to the Chapter 13 Trustee. The Trustee requires the reports be made on preprinted forms unless, of course, the debtor is sophisticated enough to have a computer program that provides the same information on a slightly differently format. In fact, a debtor using a computer program to keep track of income and expenses demonstrates a level of business sophistication that usually results in deference by the Chapter 13 Trustee regarding the business operations. The Trustee is noted for reading each and every report generated by the debtor and questioning debtor's counsel about inconsistencies.

2. Current Tax Reports

   The Chapter 13 Trustee is particularly attentive to a debtor's failure to file tax returns pre-petition. He will ask the Court to issue an order providing the debtor with a limited time period to file any pre-petition tax returns (expecting that any tax debt associated with the returns to be included in the Chapter 13 plan).

   Similarly, the Trustee insists upon all post-filing tax returns to be promptly filed when due and paid in the ordinary course of the business. Both the Internal Revenue Service and the Maine Revenue Service keep close track of post-petition taxes. If a debtor fails to file returns or fails to pay post-petition taxes, the IRS and MRS will file a notification with the Court of the debtor's failure (almost certainly generating a Trustee's motion to dismiss the case), and the tax authorities will also request payment of an administrative claim for these taxes. Unless a debtor can promptly convince the Trustee and the tax entities that the taxes can be addressed, the case can be short circuited and the debtor find himself or herself facing a Chapter 7 conversion or dismissal of the Chapter 13 case.

3. Employment of Professionals

   In cases where the debtor does not possess the requisite skills to operate the business by him or herself, it is necessary to employ professionals to assist the debtor. The statutory authority for the employment of professionals is 11 U.S.C. Section 327.

   Whenever it appears necessary employ a professional, it is important to include in the affidavit of the professional that there are no conflicts of interest. Undisclosed conflicts which are later discovered can result in the professional being discharged from his or her duties and being denied compensation for services performed for the debtor. A recent example of the seeming harshness of this rule was the Filenes Chapter 11 case in Massachusetts in which the debtor's counsel, Hale & Dorr, was prohibited from representing the debtor once certain conflicts of interest were discovered by the Court.

   Just as important as the professional's affidavit is the motion to employ which should state the terms upon which the professional will be compensated for its services (upon later approval by the Court after reviewing the reasonableness of the relation to the services rendered and the effect upon unsecured creditors). If the Court is not convinced that the services can be paid by the debtor or that the services are necessary for the success of the case, the Court will not permit the employment of the professional.