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      Insolvency News and Analysis - Week Ending September 12, 2014
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    “Small Business” Chapter 11’s – Are They Really Worth It?

    A recent post by University of Illinois’ Professor Bob Lawless over at the always-stimulating “Credit Slips” blog focuses on an often-ignored, but important, corner of the Chapter 11 world: “Small Business” Chapter 11’s.  Perhaps more accurately, the post focuses on Chapter 11’s that could be – but aren’t – formally designated as “Small Business” Chapter 11’s.

    Prof. Lawless – whose research interests include empirical methodologies in legal studies – recently reviewed bankruptcy data from 2007, observing that of 2,299 chapter 11s filed in 2007 where the debtor (i) was not an individual; (ii) claimed predominately business debts; and (iii) scheduled total liabilities between $50,000 and $1,000,000, only 36.8% were designated “small business” bankruptcies.  Anecdotally, Prof. Lawless refers to one of the cases he surveyed:  a manufacturer that scheduled about $800,000 in debt and yet did not self-designate as a small-business debtor.

    So why don’t more “small businesses” that commence Chapter 11 proceedings (many don’t, but this is a different issue) claim “small business” status?

    The answers from practitioners – some of whom responded on the post, and others who voiced their views on a national list-serve also maintained by Prof. Lawless. – appear to coalesce around the following:

    – Congress’ 2005 amendments impose additional filing requirements.  Section 1116 requires the provision of “the most recent” balance sheet, profit-and-loss statement, and statement of cash flows, as well as the most recent Federal income tax return.  One busy LA practitioner noted that he avoids the “Small Business” designation for this reason.

    – The “small business” deadlines are too compressed.  For example, the Code’s exclusivity provisions generally “caps” the time period in which a “Small Business” debtor may file a Chapter 11 Plan and Disclosure Statement at 300 days.  This period can, of course, be extended within the original 300-day period if the debtor can demonstrate that plan confirmation within a “reasonable period” is “more likely than not.”  But as a practical matter, the debtor has about 10 months to get a Chapter 11 Plan and Disclosure Statement filed.

    – The combination of increased reporting and compressed deadlines puts any “small business” case on a hair-trigger under the expanded dismissal provisions of Section 1112.

    – Some practitioners simply overlook the designation – which appears as a “check-the-box” on the face page of the petition’s official form.

    – The concept of separate “small business” treatment emerges out of “local practices” implemented by bankruptcy judges for the purpose of streamlining their own dockets, but which were never really a good idea from a practical perspective.

    With the possible exception of attorney oversight, these all appear emininently practical reasons for staying away from “Small Business” Chapter 11’s.

    But are they always?

    It may be that “small business” cases are perceived as problematic because, in fact, they cut against the grain of the traditional law firm business model.  For example:

    Additional filing requirements.  There may be circumstances where the client’s non-compliance with income tax filing requirements preclude any “small business” self-designation.  But most businesses – even troubled ones – can generate a very rudimentary set of financial statements.  Even for clients who generally operate without them, it should be possible to generate such statements (albeit very cursory ones) at the initial client interview or very shortly thereafter.  It’s worth noting that in California’s Central District, the additional “up-front” filing requirements are offset, at least to some degree, by the dramatically reduced monthly reporting requirements with the US Trustee’s Office.  In one “small business” Chapter 11 case handled last year by South Bay Law Firm, the extremely relaxed monthly operating reporting requirements were one – though certainly not the only – reason a “small business” filing was recommended for the client.

    Compressed deadlines.  Part of South Bay Law Firm’s pre-petition planning involves a review of the client’s “exit strategy.”  The fundamental question is: What is the client’s perceived business objective for the contemplated Chapter 11?  If there isn’t one, the client has more fundamental issues to consider – and the conversation typically turns to a discussion of whether or not Chapter 11 makes business sense.  If there is a business purpose for the contemplated Chapter 11, the business purpose and the “exit strategy” are typically reduced to an informal “Plan Term Sheet” which will, itself, become the nucleus of a combined Chapter 11 Plan-Disclosure Statement.  At South Bay Law Firm, our experience is that the combined document is generally a bit easier and less time-consuming to draft than 2 separate documents.  And with the “end game” relatively well-defined at or near the outset of the case, getting to a successful exit just got a lot easier.  This is a factor critical to the speed that is so important to an economically successful Chapter 11.

    More reasons for dismissal.  It is certainly true that Section 1112 imposes draconian consequences for failure to make required filings.  But more often, the real challenge isn’t Section 1112 – or the US Trustee’s Office.  Instead, it’s helping the “small business” Chapter 11 debtor focus on the administrative requirements of a Chapter 11 – and in California’s Central District, there are many.  To that end, the extra discipline required up-front for a “small business” Chapter 11 is, in fact, an important test of the debtor’s ability and willingness to get through the process with success.  If the debtor can’t even comply with a few additional filing requirements, it’s preferable to know right away that this debtor will have difficulty dealing with the myriad other contingencies that are certain to emerge in even a small Chapter 11 case.

    It’s all an impractical (though perhaps well-intended) judicial idea.  For the reasons described above, the additional filing requirements and compressed deadlines of a “Small Business” Chapter 11 may, in fact, bt very practical – at least in the larger scope of Chapter 11 economics.  But even if the practicalities are questionable (practicality is, after all, in the eye of the practitioner), their result – docket efficiency and speed of administration – are both great sources of judicial pleasure.  The judicial clerkship experience resident at South Bay Law Firm attests that there really is no better way to make friends with everyone behind the bench than making their job easier – even if the job is just a tad bit harder on counsel’s end.  We’ll gladly invest a little extra effort if it will mean the benefit of the doubt on a “jump ball” in front of the person wearing the black robe.

    All of this may be very interesting, but how does it implicate the law firm business model?

    Only this way: In an industry predominated by an “hourly fee” pricing model and on bringing as much business in the door as possible, the pressure on increased speed and discipline in a “small business” Chapter 11, requires more focus (and time) up-front, drives down administrative costs, demands an internal adherence to business process, and “weeds out” many candidates unsuitable for Chapter 11 – “small business” or otherwise.  This, in turn, has the effect of making “small business” Chapter 11’s generally quicker and cheaper – and therefore potentially less profitable, at least from an “hourly fees” point of view.  It also tends, at least initially, to restrict or limit overall client “volume.”

    However, it also has the effect of creating a relatively well-defined “product” which is potentially salable to a larger segment of troubled small businesses.  And a larger overall market segment means a larger absolute number of “small business” debtors who are possessed of the discipline and determination to reorganize their businesses successfully.

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