September 2005

After nearly ten years, Congress has acted, passing “The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005.” While it references consumers in its title, this law affects both large and small businesses alike, and has ramifications whether you are the debtor or the creditor. In the most part, the law will take effect on October 17, 2005, although some provisions of the law went into effect on April 20, 2005. Some analysts have referred to the new law as advantageous to creditors who are looking to collect accounts for goods delivered and amounts owed. Others have spoken about the increased difficulty a business will now face as it assesses its position and attempts to reorganize under the constraints of the new law. Some critics say it will result in more liquidations that potentially may hurt the economy as companies disappear rather than reorganize and restructure their financial affairs.

Impact on Small and Middle Market Businesses

One of the provisions of the new law was intended to give a break to small businesses attempting to reorganize and restructure debts. A small business is defined as a business with less than $2 million in debt. The intent of the law is to speed up and simplify the reorganization process, and presumably reduce time and costs. However, the tightened time to confirm a Reorganization Plan and the onerous disclosure and reporting requirements may actually work against the small business and make achieving a successful reorganization and debt restructuring very difficult.

There are many middle-market businesses with debt significantly exceeding $2 million which are nonetheless considered small businesses. These businesses will not fall under the small business provision, but they too will be significantly impacted by the new law.

Like every coin, the new law has two sides depending on whether you are the debtor trying to reorganize the business and restructure the debts in a bankruptcy proceeding; or a creditor to the debtor business. Each party, whether debtor or creditor, must assess its position. The new law has changed the rights, priorities and even the amounts to be paid. It has generally shortened the periods that a reorganizing debtor has to assess its operations and make binding decisions about the future business plan. Further, the reorganizing debtor now has a new, stricter set of rules to follow to ensure retention of key employees critical to the reorganization. Retention payments and bonuses for these critical executives and managers will be severely curtailed and limited.

Impact on Private, Closely Held Businesses

However, it is the owner of the private, closely held company that could have the most to lose. The value of the business enterprise may still represent the most important and valuable asset to the owner. The loss is not only the enterprise value but also the loss of continued employment and earnings if the business is ultimately closed and liquidated. However, the owner’s loss may not stop there.

Consider the owner who has personally guaranteed any of the debts of the business entity. In a worst-case scenario where the owner’s assets were insufficient to cover the guaranteed business indebtedness, that owner would have the option to proceed with a personal bankruptcy filing. In the past, that option alone often brought about realistic settlements between the guarantor and the creditor.

Now consider what will change. No longer will future earnings of the guarantor solely benefit that guarantor, providing a truly fresh financial start. Instead, a creditor who has a guarantee may be able to look for recoveries from future earnings of the guarantor. One thing is certain: this slight nuance arising from the new law may cause entrepreneurs to think more carefully before signing guarantees of debt to fund an idea or a start-up. Likewise, the owner of an established enterprise with substantial guaranteed debt may chose to evaluate options while options yet remain.

Cost of a Bankruptcy Restructuring

We know that the cost of a bankruptcy reorganization proceeding is not inexpensive. It is a burdensome, time-consuming legal process involving filings, disclosures and negotiation between the debtor and any number of constituents who have an interest in the outcome of the case and the financial settlements. In the past, one very large benefit the debtor had was the ability to defer some payments to soften the cash requirements in the early months of a case. While the debtor always had to pay costs and expenses incurred in operating the business after the bankruptcy filing, it was usually limited to those costs alone. The only added cash requirements to the debtor in the early months were ongoing legal and professional fees related to the bankruptcy process and reorganization. The reorganizing debtor was able to maximize cash resources for future benefits and results.

Under the new law, more parties will potentially make claims against those cash resources and make those claims sooner rather than later. Take, for example, the supplier who sold and delivered goods to the debtor within 20 days of the bankruptcy filing. That supplier will now have an administrative claim payable during the reorganization process. Further, the new law offers much greater assurance of payment to a utility company, for example, by providing assurance such as a cash deposit, letter of credit, prepayment of its bills or a bond. Items such as these will only increase the amount of up-front cash necessary and make it more difficult and costly to finance the early days of a bankruptcy case.

When you consider the tighter timeframes for the debtor to complete its analysis, make the critical decisions that will have long-term affects on future operations and profitability and the payments that may be required to confirm a reorganization plan, the real cost of a successful reorganization in a bankruptcy proceeding will be high. Consequently, it is no wonder that some critics of the new law predict even more failed attempts to reorganize and a greater number of liquidations.

What will the impact of the new bankruptcy law be on business? Largely, your perspective on the law’s impact will depend on whether you are a creditor or a debtor. Only time will tell the full impact of the law. The subtleties and consequences of The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 will be revealed as time passes and the new law is applied.

- Dave Hamernik

317-684-1550

djhamernik@hamernik.com