Kindergarteners have one answer to the question in our title. Bankruptcy attorneys have another. An ABC is an “Assignment for the Benefit of Creditors,” and it provides an alternative to Chapter 7 liquidation for a small business that is shutting down. Let’s compare the two approaches to resolving business debts.
I. Business Bankruptcy
The Bankruptcy Code is a federal statute enacted pursuant to the authority of Congress to “. . . establish . . . uniform laws on the subject of bankruptcies throughout the United States.” U.S. Const. art. 1, § 8. Businesses that file for bankruptcy protection do so under one of two chapters of the Bankruptcy Code: Chapter 7 or Chapter 11.
A. Chapter 11 Reorganization
Chapter 11 bankruptcy is known as reorganization: the business wants to continue and needs a way to address its debt problems. As part of the process the debtor (or if the exclusivity period has passed, a creditor – see 11 U.S.C. § 1121 for details) files a plan of reorganization. The plan may erase some debts entirely, convert some debts to stock, and pay some debts in full. To accomplish this some assets may be liquidated. In the typical scenario the holders of stock in the business – the equity holders – find that their interest is wiped out. The big picture goal in a Chapter 11 is to return the business to a profitable state.
B. Chapter 7 Liquidation
Chapter 7 bankruptcy is known as liquidation: the business’s assets are liquidated and the proceeds are distributed to the creditors on a pro rata basis according to certain priority rules found in 11 U.S.C. §§ 507 and 726. At the end of the process the business ceases to exist. Therefore, a business cannot receive a discharge under Chapter 7 because once the bankruptcy is completed the business is over.
In a liquidation bankruptcy the Court appoints a Chapter 7 Trustee to administer the assets. This usually means that the owners of the business no longer have anything to do with the business.
ABCs are a state law, rather than a federal law, concept. They have been used in California for almost a hundred years.
In an ABC the business hires someone to liquidate the assets and distribute the proceeds to the creditors. The business assigns the assets to that person for that purpose. The assignee then serves as a sort of private “Chapter 7” Trustee, and has a fiduciary obligation to maximize the liquidation proceeds.
One fundamental difference between Chapter 7 liquidation and an ABC is that an ABC usually does not involve any court – state or federal. The result is that an ABC is a more streamlined process that takes less time to complete than a Chapter 7 bankruptcy. Thus, while the net effect is frequently the same in both processes: the business is liquidated and ceases to exist, the time involved can be significantly less in an ABC.
Another difference is that in a Chapter 7 the creditors have very little, if any, input in the process, whereas in an ABC the creditors have to agree to the results beforehand for the process to succeed.
However, ABCs can backfire on the business owners if used in the wrong context.
III. Four Common Settings Where ABCs Are Inappropriate
A. The Unincorporated Business
The concept of incorporation was developed to limit the liability of businesses owners. When a business owner forms a corporation, he or she creates a new person. While the person created is not a biological person, it is a legal person with its own assets, liabilities, income, expenses, and legal life. As long as the separate personhood of the corporation is preserved, the business owner frequently does not share the business’s liabilities.
With an unincorporated business the owner is usually personally liable for the business’s debts, in part, because the owner and the business are essentially one and the same person – i.e., “alter-egos of each other.” As a consequence, upon completion of an ABC the business owner may still be personally liable for the unpaid portion of the business’s debts. Therefore, ABCs are generally not recommended for unincorporated businesses.
B. Piercing The Corporate Veil
Even if a business is incorporated, a creditor may still be able to go after the owner if it can show that the owner eroded the separate personhood of the corporation. Once the creditor has established that the owner and the corporation are alter-egos of each other, it can hold the owner personally liable for the business’s debts.
Typical ways to establish an alter-ego relationship include showing: (1) undercapitalization at the time of incorporation, (2) failure to maintain corporate niceties such as regular meetings of the board of directors and the keeping of minutes of those meetings, and (3) comingling of funds.
For the small business owner, the problem of fund commingling is quite common. For example, the owner may need funds for personal expenses and takes money from the till to cover them. Even if the money is repaid, the use of corporate funds for personal use demonstrates an alter-ego relationship. Another common example involves the owner putting personal funds into the business to keep it afloat. Once again, even if the money is repaid the use of personal funds for corporate use demonstrates an alter-ego relationship.
One way around this problem is to have formalized loans. However, many small business owners fail to formalize the loans – especially if the dollar amounts are relatively small – perhaps because the need is usually immediate and the exigencies do not permit time for formalization of the transaction.
Therefore, if a creditor can pierce the corporate veil, the owner may still be liable for the business’s debts after the completion of the ABC.
C. Personal Guarantees
When a business needs financing the owner may attempt to get a loan from a bank. The bank may be reluctant to give such a loan to a small business unless the owner provides a personal guarantee.
As a result, the owner signs the loan documents in two capacities: one as the authorized representative of the business, and the other as a separate human being. As the authorized representative of the business the owner’s signature obligates the business to repay the loan under the contract terms. As a separate human being the business owner’s signature obligates the owner personally to repay the debt.
Consequently, the owner is now personally liable for the entirety of the debt! In the United States co-debtors are jointly and severally liable for the debt. Each co-debtor is 100% liable for the debt (though the creditor cannot collect more than the total contractual liability).
Therefore, if the owner has signed a personal guarantee, the owner will still be liable for the unpaid portion of the debt at the conclusion of the ABC.
D. Undersecured Debts
In the taxonomy of debt there are many ways to break things down. One way is to distinguish between secured and unsecured debts. A secured debt is one in which the debtor has put up some form of collateral to secure the debt. Common examples include a home mortgage and a car loan. In those two cases the house and the car serve as security for their respective debts. In the event of default the creditor is permitted to repossess the collateral and resell it.
Suppose a business takes out a loan that is secured by a business asset. Suppose further that at the point when the business needs debt relief – either through a Chapter 7 bankruptcy, or through an ABC – the asset has dropped in value to the point that it is worth considerably less than the current balance on the loan; i.e., the debt is undersecured (in the popular vernacular: “under water”). Then an ABC may not be possible.
In an ABC a secured creditor is entitled to payment in full upon the liquidation of the asset securing the debt. Therefore, if a secured creditor’s debt is undersecured, it must consent to the ABC before the ABC can proceed.