Bankruptcy Laws Need to Adequately Protect Entrepreneurs from Downside Risks

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Individuals (photo by Grant Swanson)

By Donald L. Swanson

Individuals can, and often do, file for Chapter 11 bankruptcy.  Three professors recently published an article in the ABI Law Review on a ground breaking study of Chapter 11 bankruptcy cases for individual debtors.

–The three professors are Richard M. Hynes (University of Virginia; Charlottesville, Va.), Anne Lawton (Lansing, Mich.), and Margaret Howard (Washington & Lee Law School; Lexington, Va.), and their article is, “National Study of Individual Chapter 11 Bankruptcies,” ABI Law Review at 68 (Winter 2017).

The report profiles a typical individual who seeks protection and relief under Chapter 11 of the U.S. Bankruptcy Code. The profile looks like this:

Entrepreneurship: A “very large proportion” of them “operated businesses as their primary occupation.”

High Wealth: They “are wealthier than the average American,” and they “are more likely to own real property.”

High Income: Their incomes “are much higher than that of the typical American household.” For example, (1) “Half” in the 2013 sample “reported combined monthly income of $8,624 or more, which annualizes to a figure in excess of $100,000,” (2) “Approximately 36%” are “in the top 20% of household incomes nationally,” and (3) “14% had annual incomes in excess of . . . $225,333 in 2013, which placed them among the top 5% of American households nationally.”

High Expenses: They “had expenses comparable in size to their incomes. . . . in both 2010 and 2013, more than three in ten debtors in the random sample reported monthly expenses of $10,000 or more.”

High Debt-to-Income Ratios: They “also had enormous debt-to-income ratios relative to the ratios reported by prior scholars studying bankrupt individuals in other chapters.”

My Translation: Individual Chapter 11 debtors are, typically, business owners/operators who, in earlier days, had a thriving business (i.e., they experienced entrepreneurial success). However, the business is now in difficult times, and in all likelihood they already plowed nearly everything they owned back into the business to weather the financial storm. Unfortunately, the storm is winning, and Chapter 11 bankruptcy is a last-attempt at business survival.  These are solid-citizen people. They’ve taken entrepreneurial risks, created valuable assets, employed others, paid lots of taxes and contributed to local communities in many ways.  And there are many, many of these people throughout the U.S.

But every entrepreneur over the course of a lifetime will encounter times of crisis — times when the business structure he/she created is in peril. Some businesses will not survive such perils, including businesses built on the soundest of foundations and operated with the most prudent of practices. For example, take businesses serving the residential construction industry from 2009-13: such businesses, regardless of the quality of their leadership and business practices, were in mortal peril back then due to the Great Recession. This happens. It is unavoidable and the nature of entrepreneurial risk.

Some of these individual business owners end up in bankruptcy court as Chapter 11 debtors. They want to keep the house they’ve been living in for the past 20 years, which is mostly paid-for, except for that new mortgage they obtained last year to get cash to put additional money back into the business. Most of all, they want to salvage the business, if possible.

Desperate people do desperate things: they deplete their retirement assets that would otherwise be exempt from creditors, they mortgage their house to get extra cash for their business and thereby impair their homestead exemption, and/or they fail to pay withholding taxes and use the money to keep the business from sinking, thereby incurring personal liability that cannot be discharged in bankruptcy.  In many such circumstances, they are also less than truthful with their creditors (and take other actions for which they are less than proud) as difficult times intensify, which can also have nondischargeability implications in bankruptcy.

They are still earning a good income from the faltering business, and they have developed a lifestyle that is relatively modest but still higher than most. Yet they are swimming in a sea of debt; the business obligation amounts they have personally guaranteed are vast, compared to their personal income and assets, and are far beyond anything they could ever hope to repay.

These people are living the entrepreneurial American Dream, but they are living the downside of that dream. The nature of business includes success, but it also includes failure — an unavoidable component of business life.

So, the question becomes this: How should we treat such people in bankruptcy? And the answer is this: With more respect and dignity than what the bankruptcy laws currently provide.  Consider these no-win bankruptcy options:

1. Chapter 11 is unworkable. Chapter 11 has the “absolute priority rule,” which requires, essentially, this: to get a plan of reorganization confirmed, the individual debtor must either pay all unsecured creditors in full, or get unsecured creditors to agree to something less. In many individual cases, this rule is an insurmountable obstacle.

2. Chapter 13 is not available. Chapter 13 would be great for owners of failed or failing businesses. However, such individuals are rarely eligible for Chapter 13 relief because of the low debt-limits established for Chapter 13 eligibility.

3. Chapter 7 might not be available. Under 11 U.S.C. § 706(b), an individual is not eligible for Chapter 7 relief, if that individual and spouse have sufficient income to make significant payments to creditors over time.

There you have it. Failed business individuals, in many instances, can’t get a Chapter 11 plan confirmed, are not eligible for Chapter 13, and cannot be in Chapter 7. There is no viable bankruptcy option available to them, so what are they supposed to do now?

Chapter 11 is Unworkable – The Absolute Priority Rule

The absolute priority rule is a long-standing requirement for confirming a Chapter 11 plan (see 11 U.S.C. § 1129(b)(2)(B)). It provides that unsecured creditors have an absolute priority of distribution over the ownership class, which means that in an individual Chapter 11 case, the individual debtor cannot “receive or retain” any pre-petition property, unless the unsecured creditors are paid in full or agree to something less.

Under this rule, payment of 100% to unsecured creditors (or agreements on lesser amounts) is required for plan confirmation. An individual debtor must satisfy this rule before he/she may keep such basic assets as their home, household furnishings, clothing, a vehicle, an IRA, or 401(k) assets.

We have some hard experiences with the absolute priority rule for individual debtors from the 1980s farm crisis. In those days, many farmers filed for Chapter 11, and most were individual cases. Plans in these cases are rarely confirmed because of the absolute priority rule: The farmers could not pay 100 percent (that is why they were in bankruptcy), and their creditors refused to agree to anything less. Bankruptcy and appellate courts struggled to find ways around the rule. However, the U.S. Supreme Court finally put the kibosh on those efforts in Northwest Bank v. Ahlers, 485 U.S. 197 (1988), wherein it expresses sympathy for the plight of farmers but declared its inability to help because the absolute priority rule is, well, absolute.  The result: Congress enacted Chapter 12 for farmers, which eliminated the absolute priority rule and provided a Chapter 13-like relief for farmers.

In an effort to provide similar (but more limited) relief to individual debtors in Chapter 11, Congress adopted in 2005 an “individual” exception to the absolute priority rule (see 11 U.S.C. § 1129(b)(2)(B)(ii)).  The first-ever ruling on this new exception (In re Tegeder,  369 B.R. 477 (Bankr. D. Neb. 2007)) declared that the absolute priority rule no longer applies in individual Chapter 11 cases. Other courts follow this approach.

However, a divergence developed: Tegeder provides a “debtor-friendly interpretation” (as the professors described it), while a “less debtor-friendly interpretation” stated that the absolute priority rule continues to apply in individual cases.

The “less friendly” interpretation gained preeminence starting in 2013, and Tegeder is now over-ruled by the Eighth Circuit Bankruptcy Appellate Panel in In re Woodward, Case No. 15-6001 (8th Cir. BAP 2015).  When asked to reverse himself in the Woodward case, the Tegeder Bankruptcy Judge declined to do so because the Tegeder rule “has worked well in this jurisdiction the last seven years” in that “many individual Chapter 11 plans have been confirmed” (In re Woodward, Case No. 11-40936, Doc. 287 (Bankr. D. Neb., April 4, 2014).

Given the 100 percent payment or agreement-of-creditors requirements of the absolute priority rule, it’s not surprising that the professors made the following finding:

“Chapter 11 cases filed in jurisdictions with debtor-friendly interpretations of the [individual] exception to the absolute priority rule were more likely to succeed than cases in jurisdictions with less debtor-friendly absolute priority rule decisions.”

It would be interesting to now follow up with a study on the impact of the less-friendly rule prevailing in courts that previously applied the friendlier rule. My prediction is that the follow-up would find both a drop-off in individual Chapter 11 filings and a lower percentage of plan confirmations (i.e., the experience of these newer cases will be about the same as that of individual Chapter 11 cases back in the farm crisis days).

Chapter 13 Is Not Available

Chapter 13 eligibility is limited to debtors with modest levels of debt. The current total-debt limitations for Chapter 13 eligibility are $1,184,200 for secured debts and $394,725 for unsecured debts (see 11 U.S.C. § 109(e)). Many individual who guaranteed the debts of their failed or failing business are, in all probability, not even close to meeting the $394,725 unsecured debt limit for Chapter 13 eligibility. Accordingly, Chapter 13 is simply unavailable to many individual debtors who end up in Chapter 11.

Chapter 7 Might Not Be Available

Bankruptcy Courts have struggled over what to do with high-income debtors, and this struggle continues in individual Chapter 11 cases, given the levels of wealth and income found.

My first recollections on this struggle are from the early 1980s, when a young adult filed Chapter 7 with lots of spend-thrift debt and lots of assets in a spend-thrift trust. She got her discharge and kept her trust fund. As I recall, everyone involved (except for the debtor and her attorney) expressed concern — and a little disgust — over this result. But that was the law of that day.  However, things have changed.

Today, a consumer debtor with even a modest income must make payments for several years under a Chapter 13 plan instead of obtaining an immediate discharge under Chapter 7. Individual debtors with primarily business debts are exempt from this rule (see 11 U.S.C. § 707(b)).  However, where § 707(b) comes-up short for individuals with business debts, some courts say that § 706(b) steps in.  It provides:

“(b) On request of a party in interest and after notice and a hearing, the court may convert a case under this chapter to a case under chapter 11 of this title at any time.”

Some courts say this § 706(b) language authorizes a bankruptcy court to convert — involuntarily — an individual debtor from Chapter 7 to Chapter 11 when the debtor has substantial income (see, e.g., In re Decker, 535 B.R. 828 (Bankr. D. Alaska 2015), and In re Parvin, 538 B.R. 96 (Bankr. W.D. Wash. 2015).

A contrary view, expressed by a Texas Bankruptcy Judge in 2016 (see In re Smith, 544 B.R. 126, 131-35 (Bkrtcy.W.D.Tex. 2016)), is much more persuasive:

“[T]here are no statutory standards for conversion under section 706.”

“[T]o determine whether conversion is appropriate in this case, the Court will consider the benefit of chapter 11 to all parties, including the debtors.”

“All the Court would accomplish by converting this case [from 7 to 11] is the zero-sum transfer of some portion of the Debtors’ future income to creditors, at the cost of the chapter 11 process.”

“[A]bsent some benefit to the Debtors, however small or intangible, it is difficult to see how the Debtors will be incented to work as productively as they are now for five years, when all their disposable income is being directed to creditors against their will.”

This analysis is particularly compelling for wealthy/high-income debtors described by the three professors when confirmation of a Chapter 11 plan is governed by the less-friendly version of the absolute priority rule. Where is the benefit of conversion to an individual debtor who won’t be able to get a Chapter 11 plan confirmed? Conversion in such circumstances is, in all likelihood, an exercise in futility.

Conclusion

Small business entrepreneurs in these United States deserve better from our bankruptcy system; they deserve at least one viable bankruptcy option! These are the people who take the business risks that make this nation work.

So when they find themselves on the downside of those risks, they should still have the opportunity for a fresh start and a discharge of debts they will never be able to repay, as well as a viable prospect for dealing with the tax liabilities that often follow the failure of a small business.  Currently, the U.S. bankruptcy laws fail to adequately provide even one direct avenue of opportunity for such entrepreneurs.

This needs to change.

**  If you find this article of value, please feel free to share.  If you’d like to discuss, let me know.

Footnote:  This article was originally published by the American Bankruptcy Institute on June 28, 2017, in its Business Reorganization Committee Newsletter.

 

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