Reasons Not To Choose Business Bankruptcy

Bankruptcy preference avoiding powers constitute a serious reason not to choose a corporate bankruptcy to close a failing business.

Yet, preferences and the trustee’s ability to recover them have to be one of the hardest concepts to convey to business clients.

Clients gag at the thought that paying a genuine debt before a bankruptcy filing can expose the innocent recipient to suit.

I was reminded of a further preference wrinkle in a corporate insolvency situation this week when exploring bankruptcy possibilities for a long established business that had shut down.

Management wanted to know if bankruptcy for the corporation offered any advantages over managing the wind up outside of court.

Insiders exposed

As in most corporate business situations, the sole shareholder had guaranteed the bank line of credit.  Further, the shareholder borrowed money against his house and contributed it to the corporation, with the business paying the lender the monthly debt service.

All of this invoked the part of §547(b) that makes recoverable transfers “to or for the benefit of a creditor”.  Each of those payments by the corporation benefited the shareholder by reducing the shareholder’s liability to the lender.

Transfers that benefit insiders are exposed to recapture if they occur within 12 months of the bankruptcy filing.

Bankruptcy counsel can’t rely on the payee designation on the business checks to evaluate insider exposure.  You have to know both who the check went to AND who besides the business was liable on the debt. [ Check out Walldesign from the 9th Circuit for a further twist.]

So, if the corporation files a Chapter 7 in order to hand off the wind up to others,  the shareholder-guarantor is exposed to suit to recover the amount paid by the corporation on guaranteed debts.

Worse, only the insider is exposed for transfers within a year of the filing but more than 90 days from filing by reason of 547(i):

(i) If the trustee avoids under subsection (b) a transfer made between 90 days and 1 year before the date of the filing of the petition, by the debtor to an entity that is not an insider for the benefit of a creditor that is an insider, such transfer shall be considered to be avoided under this section only with respect to the creditor that is an insider.

This subsection was added to the Code in 1994 following the 7th Circuit’s decision known as Deprizio.  In that case, recovery of a transfer made within a year of the filing was allowed against the non insider bank to whom the payments were made, since it was an initial transferee within the meaning of §550 of a payment benefiting an insider.

Subsection (i) was designed to overturn Deprizio and limit recovery of those transfers made outside of the 90 days to the insider alone.

So, in my case, the shareholder choosing bankruptcy for the business steps squarely into the trustee’s cross hairs for recovery.

Additional avoidance exposure

Less obvious, consider the corporate credit cards and the premises lease.

It is my experience that there is no credit card in existence for which a real, flesh-and-blood individual is not also liable along, perhaps, with the corporate entity.  (I suspect that is an overstatement but not by much, in the world of clients I serve.)

My shareholder could conceivably be liable to a bankruptcy trustee for the payments made within the last 12 months on a credit card used by the business but for which the shareholder is liable.

Then there’s the lease.  In my case, it turned out that only the shareholder was liable on the lease.  No corporate rights or liabilities at all.   Query whether the ordinary course of business defense would protect the monthly rent payments.  But who wants to find out by means of a trial.

Counting the cost of business bankruptcy

The liability of the shareholder in the event of a corporate Chapter 7 , of course, may be of no concern if the shareholder faces filing bankruptcy as well.

But if the human being who sits across from you may survive the business collapse without filing bankruptcy himself, they need to be advised about the reach of the trustee’s avoiding powers,  before they shuffle the corporation off to bankruptcy.

More

Introduction to business bankruptcies

Examining debts shared by business and business owner

The business lease when business fails

Image courtesy of Flickr and Ell Brown.