Small Businesses and Entrepreneurs in Financial Stress Need a Chapter 12 Solution

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A small business and its entrepreneur

By Donald L. Swanson

It’s been 40 years since enactment of the Bankruptcy Code [Fn. 1].  And the Code has been highly effective in many contexts.

But the Bankruptcy Code is, and always has been, inadequate for the needs of small businesses and entrepreneurs in financial stress.  Congress needs to address this deficiency.

What Works & What Doesn’t

Over the intervening decades since the Bankruptcy Code’s enactment in 1978, three conclusions about the Bankruptcy Code’s effectiveness are inescapable:

1. The Code works for reorganizing large businesses (e.g., General Motors under Chapter 11) and cities (e.g., Detroit under Chapter 9);

2. The Code works for providing a fresh start to consumers (under Chapters 7 and 13); but

3. The Code is an abject failure for small businesses and entrepreneurs.

An Illustration—The 1980s Farm Crisis

Farms are small businesses. And farmers have their own bankruptcy chapter: Chapter 12.

Here’s the reason Chapter 12 exists for farmers:

–because Chapter 11 did not work for farmers in the 1980s Farm Crisis.

Here’s what happened, back in the 1980s, in the vast majority of Chapter 11 farm cases:

Farmer and Secured Bank are in a disagreement—collateral values had been sufficient to support Farmer’s loans, but those values came crashing down;

Bank wants Farmer to liquidate, and Farmer wants, more than anything else, to keep farming;

So, Farmer files Chapter 11 to “reorganize”—by that, the farmer’s idea is to liquidate some non-essential assets, discharge a bunch of debt, re-amortize the remainder, and keep on operating;

But Farmer can’t get a plan confirmed because of the absolute priority rule (a requirement that unsecured creditors receive 100% or agree to something less, before owners can retain anything);

Time passes—maybe a few months or maybe a year or two or three—and Farmer runs out of cash, can’t continue operating, and converts to Chapter 7;

Bank gets relief from stay and starts foreclosure; and

Farmer’s assets are sold at rock bottom prices—everyone loses, and the new tax burdens from liquidation are beyond Farmer’s capacity to pay.

That’s what happened—time and time and time, again.

The same problems have existed, since enactment of the Bankruptcy Code, for small businesses and entrepreneurs in every type of industry—over the entire four decades.

Misinformation

Many small businesses and entrepreneurs have a false impression about Chapter 11 and what its limitations might be. Here’s an example of misinformation:

Back in the early 80s, a Father/Son farming team came to see me—I’m a young attorney, back then, and am thrilled and flattered as all-get-out that they came to see me.

In the early chit-chat, it seems that Father built the operation and Son is presiding over its demise.

So, I say, “How can I help you?” To which Son responds (with an air of sophistication), “We want one of them-there Chapter 11s!”

I’m thinking, “Oh, crap! They’ve got no clue. How am I supposed to manage this?!”

So . . . I start informing them about Chapter 11—what it can and can’t do and some of its problems, like insider preferences, fraudulent transfers, absolute priority, compensation of creditor committee professionals, non-dischargeability, etc.

As I’m doing that, Son’s complexion is turning red, he’s visibly distraught, and finally, he’s done—they get up, walk out, and go find someone else to provide one of “them-there Chapter 11s.”

General Motors Model

This Father/Son team, I suggest, were misinformed about Chapter 11.

What they believed possible is what I now call the “General Motors model.” General Motors, in bankruptcy, discharged gobs of debt, reorganized remaining debts, and kept on making cars.

–“We want that deal!” is what the Father/Son team was saying.

But what they didn’t realize is this: the pre-bankruptcy owners in a case like General Motors are gone. Those owners retained nothing through the bankruptcy—that’s what absolute priority is all about.

And that’s NOT what the Father/Son team wanted—they wanted, more than anything else, for their ownership interests to remain in place!

Chapter 12 Solution for Farmers

Congress created Chapter 12 in response to problems for farmers in Chapter 11. The new Chapter eliminated the absolute priority rule and allowed many farmers to reorganize in the late 1980s and early 1990s.

This creation of a reorganization possibility proved to be good for financially-stressed farmers, of course. But it also proved to be good for their local communities and its businesses in the long run.

Such an approach makes sense:

It’s one thing for the absolute priority rule to apply in large business cases, like General Motors with its absentee owners who have only a passive investment at risk; but

It’s an entirely different thing for the absolute priority rule to apply in small business cases, where entrepreneurs have invested their time, treasure and entire lives in the business—in many instances, they are the business.

A Chapter 12-Type Solution for Other Small Businesses and Entrepreneurs

Small businesses and entrepreneurs of every type and nature, these days, have the same Chapter 11 problems that plagued farmers back in the 1980s.

These small businesses and entrepreneurs need a Chapter 12-type solution, just like the farmers received a couple decades ago.

Congress needs to act now to provide such a solution!

Footnote 1:  The formal title of the Bankruptcy Code is, the Bankruptcy Reform Act of 1978.

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

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