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December 12, 2005

The bankruptcy blues | New federal bankruptcy laws aimed at individuals might also mean bad news for small businesses

By Taylor Smith
On Nov. 9, American Falcon Corp., an Auburn-based manufacturer of office products, quietly made news. The firm became the first corporation in the state to file bankruptcy under a new set of federal laws that went into effect in mid-October. American Falcon's Chapter 7 filing, obtained by Mainebiz from the Maine District of the U.S. Bankruptcy Court, estimates that there will be no money left over after the bankruptcy to pay back the money owed to the firm's 197 creditors. The company's filing estimates that its assets are less than $50,000, while its estimated debts run as high as $1 million. It's a simple equation: No money plus big debts equals bad news.

What exactly will become of American Falcon is unclear. Under Chapter 7 bankruptcy, a company will shut its doors, liquidate its assets and use those proceeds to pay its creditors. After that's done, the owners essentially walk away from the company's remaining debt, often leaving creditors hanging in the breeze. Whether the court will accept the company's Chapter 7 filing is unknown; American Falcon's additional bankruptcy filings weren't due to the court until Dec. 7, after this issue of Mainebiz went to press.

But the larger issue that concerns American Falcon and hundreds ˆ— if not thousands ˆ— of other small businesses in Maine is how the process of bankruptcy will be changed as a result of the new law, which went into effect Oct. 17. Much of the ink spilled on the law change focused on how the new regulations will affect individuals declaring bankruptcy. For example, the new law includes a set of stringent regulations that make it more difficult for individuals to file for Chapter 7 bankruptcy protection. As a result, those individuals will be forced to file under Chapter 13, which requires repayment of debts to creditors ˆ— whether equipment suppliers, service providers or credit card companies.

The bill, called the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, sailed through the U.S. Senate and House of Representatives in April with strong bipartisan support, and was then signed into law by President Bush. Politicians cheered that the new laws would make it much more difficult for individuals to game the system. "The genesis of the revised bankruptcy code was that [the previous laws] were being abused by people who didn't need a bankruptcy discharge, who if given time could pay their debts or at least a percentage of them," says Stephen G. Morrell, an attorney with Eaton Peabody in Brunswick who focuses on bankruptcy law.

But many experts say that some small businesses may be incidental casualties in this war against scofflaw consumers. That's because many small-business owners' personal finances are inextricably tied to their company's operations ˆ— especially in Maine, where the state's economy is largely small-business driven. As a result, the challenges facing individual filers are likely to also be faced by entrepreneurs who can't separate their business and personal finances. "There's no question that the new laws are not a friend of small business," says Bob Keach, a bankruptcy lawyer with Bernstein Shur in Portland. "And I think there's a disproportionate effect on states like Maine."

Caught in a bind
Among Maine bankruptcy declarations, it's difficult to tell how many are corporate filings versus individual filings. Nationally, some experts estimate that as many as one-fifth of all individual bankruptcies are filed on behalf of a business. So when Celia Strickler, the clerk at the Maine Bankruptcy Court in Portland, saw a veritable flood of bankruptcy filings in the weeks ahead of the Oct. 17 law change, it's likely that corporate bankruptcies were well represented. According to Strickler, roughly 3,000 bankruptcy cases were filed with the court between Sept. 1 and Oct. 17 ˆ— a huge volume, considering that an average year at the court sees roughly 4,500 cases total.

The story was the same elsewhere, as newspapers across the nation reported lines wrapping around city blocks filled with people trying to get their filings in under the deadline. In the nearly two months since the law change, that pace has slowed considerably: Since then, only 20 or so new bankruptcy filings show up on a search of Maine Bankruptcy Court's online database.

But while experts like Stephen Morrell believe that the number of individuals filing for bankruptcy will decrease significantly as a result of the new laws, that change won't necessarily correlate to the business community. Steve Bird, president of Presque Isle accounting firm Chester M. Kearney, says some business owners just can't catch a break when it comes to business success. "Some people just chronically lose money, so it makes it tough," he says.

Meanwhile, the simple realities of running a small business put owners of such firms at a disadvantage. According to Keach, many small-business owners are faced with a difficult decision when it comes to startup funding. That's because many end up putting their personal property ˆ— their house, for example ˆ— or finances up as collateral for a business loan.

The owner of a startup mom-and-pop restaurant, for example, will likely have difficulty securing a $200,000 loan for new kitchen equipment. The solution? To put his house up as a guaranty of that loan. The problem with that arrangement is that if the restaurant goes belly up for whatever reason, the business' failure might seep deeply into the owner's personal net worth, potentially forcing him to not only declare a business bankruptcy, but also a personal bankruptcy. "There are ways you can try to limit the amount of the guaranty," says Keach, "but for the small-business person, avoiding it is very difficult."

Meanwhile, the new laws also make it more difficult for small businesses to enter Chapter 11 bankruptcy, which allows them to reorganize the company while slowly repaying creditors. Additional paperwork and oversight from bankruptcy courts might mean that a bankruptcy trustee will declare a company unlikely to successfully emerge from that filing. As a result, the trustee will recommend Chapter 7 bankruptcy and repaying creditors by liquidating the company's assets.

What's more, the old bankruptcy laws allowed corporate bankruptcy filers the ability to extend their filing deadlines indefinitely, says Morrell, giving them time to work out a well-formed reorganization strategy. But now companies are faced with a 45-day deadline to have the bankruptcy plan approved by the court, and are allowed only one 45-day extension. "That's going to impose a great deal of discipline on the business that's going into bankruptcy and the officials that are assisting in turning it around," he says.

But while many experts say the new laws will be hard on small businesses facing bankruptcy, they add that small-business owners will find some bright spots. Among the most important new developments, they say, is a change in the way creditors collect money owed to them by debtors. Under the old law, small-business creditors often were stuck at the end of the line when it came time for the bankruptcy filer to repay its debts. A company that supplied fresh vegetables and meat to that mom-and-pop restaurant, for example, would be less likely to recoup its money than a bank that extended a secured loan to the borrower. "One person's lack of money is another person's lack of money," says David Clough, Maine state director of the National Federation of Independent Business. "But how that gets resolved has an effect on both people. It used to favor the debtor."

These days, however, the new laws seem to favor creditors ˆ— no matter how small they may be. That's because the recent changes widen the net for debts that can't be discharged through the filing process, as well as forcing many individual bankruptcy filers into Chapter 13 bankruptcy, which requires repaying creditors over a five-year period.

What's more, businesses that provide goods or services to a creditor within 20 days of that creditor's bankruptcy are much more likely to get paid back in full. "The new laws should basically be a plus for small businesses if they have collection issues," says Bird.



Taking care of business

According to Steve Bird, president of Presque Isle accounting firm Chester M. Kearney, there's only one thing to do if you win the lottery or go bankrupt: See a lawyer. It's sage advice, at least on the bankruptcy side, since the entire bankruptcy process is a labyrinth of paperwork and court filings, estimations and projections. Better to get some help on the way than go it alone. The following are a few tips for small-business owners on how to avoid making that trip to the lawyer's office. Unless, of course, that Powerball ticket turned up a gem.

Don't ignore the IRS. Many small businesses make the mistake of procrastinating making payments to the Internal Revenue Service, says Bird. That's because the IRS doesn't immediately start banging down a company's door ˆ— as some of its other suppliers might do ˆ— if it isn't receiving payments. But that doesn't mean the IRS isn't paying attention: "Those guys don't go away," says Bird. "The IRS has all kinds of methods of recovering their money. Even if you file bankruptcy, you still have to pay those taxes."

Keep an eye on the ball. Bird says he sees a lot of small-business owners who aren't keeping close enough tabs on their company's financial performance, and who aren't making smart fiscal decisions. His advice to business owners is to make sure they're regularly checking up on their company's financial status. "The ones that are successful are the ones that are always watching their costs and monitoring their sales and making sure that things don't get out of hand," says Bird. "Those are things that need to be looked at on a daily basis."

Take control. Some costs are impossible for a small-business owner to control. For example, grocery stores can't control the price of Cheerios, so they've got to find other places to keep costs in line. Bird says the trick is to find areas to cut back that won't interrupt operations. One place to look, he says, is the company's workforce: "You can't have five people working in that grocery store if you can only afford to have three," he says. "You've got to work with what you can control."

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