From Boom to Bust and Back: Recovering From Bankruptcy

Via LearnVest By Libby Kane ~

chapter 11 bankruptcyIn 2009 a Chicago-area transportation company called The BusBank filed for bankruptcy.

The company had been depending on investor funds, which dried up—along with the economy. ”It started getting rough in 2006, and by 2009 we were struggling for cash,” explains Brandon Dudley, BusBank’s director of marketing and operations. “At that time we had over $10 million of liabilities to local bus companies.”

The company filed for Chapter 11 bankruptcy protection at their lawyers’ advice—and then set about rebuilding. BusBank changed its focus from getting new customers to being more efficient with spending, which included restructuring the company’s senior management. Each quarter they make a payment (decided in bankruptcy) to the vendors that they still owe.

“Every day was long and stressful,” Dudley recounts. “We didn’t know if we would make it through.”

But today BusBank is still alive and kicking. The company has paid off most of its smaller debts, and it’s even profitable—in fact, BusBank’s 2012 profits surpassed company goals and increased over 1,000%. In 2013 they’re already operating ahead of revenue projections.

Filing for bankruptcy can feel like a hard stop—a failure. Yet the reality is that bankruptcy can actually serve as a clean state to start building a better business model. But what’s the difference between a company that successfully rebuilds, and one that shutters its doors forever?

Bankruptcy Doesn’t Have to Be a Death Knell

One inspiring—not to mention high-profile—case of post-bankruptcy reinvention is Betsey Johnson, a dynamic clothing brand named after its equally dynamic founder. When the 34-year-old company found itself $4 million in debt, it announced, in April 2012, that it would file for Chapter 11 bankruptcy, closing 63 stores and letting go of 350 employees.

Designer Steve Madden, who stepped in to take over a $48 million loan on which Betsy Johnson LLC had defaulted in 2010, now owns the Betsey Johnson license in conjunction with Castanea Partners, a Boston-based private equity firm. Madden explained what ultimately landed the company in so much financial trouble to The New York Times: ”They borrowed a lot of money, they had too many stores and their rents were too high.”

But far from retreating into the shadows, Johnson pursued a new business model post-bankruptcy—one that continues to offer her designs in such high-end department stores as Nordstrom—as well as lower-end shops, like Macy’s Herald Square. This spring the 70-year-old fashion icon premiered her new, more moderately priced line of dresses and activewear at New York Fashion Week to largely positive reviews. And she’ll be releasing her third fragrance this year, as well as starring in a reality show on the Style Network. By scaling down her brick-and-mortar holdings, and expanding her brand into more affordable clothing, Johnson has restructured to be more sustainable in the long run.

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Another example of bankruptcy rebirth is American Airlines, whose parent company AMR Holdings filed for Chapter 11 bankruptcy in 2011—hot on the heels of the same move made by Delta, Northwest, United and U.S. Airways. Thomas Horton, the chairman, CEO and president of the company, gave the following reason for filing: “Our very substantial cost disadvantage, compared to our larger competitors, all of which restructured their costs and debt through Chapter 11, has become increasingly untenable given the accelerating impact of global economic uncertainty and resulting revenue instability, volatile and rising fuel prices, and intensifying competitive challenges.” 

It seems to have been the right move for the struggling carrier: Just last month the bankruptcy court approved a merger between American Airlines and U.S. Airways, which would make the combined airline the biggest in the world. The merger is still subject to approval from Department of Justice antitrust regulators and U.S. Airways shareholders, but it’s expected to be finalized in the fall.

If you look at the bold fashion designer, the Chicago transportation company and the massive airline, it may not seem as if these three decidedly different companies have anything in common. But, in fact, their one commonality is what made the difference between pulling the plug on their bankrupt companies and taking another stab at success: They all filed for Chapter 11.

Chapter 11 vs. Chapter 7

When we hear about a company filing for bankruptcy, we may not make the crucial distinction between Chapters 7 and 11, the two types of bankruptcy that a company can file. (Chapter 13, on the other hand, is limited to individuals and sole proprietorships.)

“The key to a successful Chapter 11 case isn’t just filing—it’s the ability to confirm a successful plan of reorganization.”

The chapters, which refer to sections of the United States bankruptcy code, mean very different things. Chapter 7 is essentially a self-destruct button: The company is liquidated, and the money is used to pay off its outstanding debt. According to the U.S. Courts, over 27,000 businesses filed for Chapter 7 in 2012.

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Chapter 11, however, exists to provide some breathing room for a struggling company. Under the supervision of a trustee—a third party certified by the United States Trustee’s Office, who’s appointed to hold the company’s assets—business continues to function while the company tries to reorganize its debt. For instance, a company that has filed for Chapter 11 might contact its creditors to work out a payment plan or get more manageable terms on a loan. For this reason, it’s also called “rehabilitation bankruptcy.” Over 415,000 businesses have filed for Chapter 11 since the bankruptcy code took its current form in 1979. By taking this course, all three of the companies mentioned above were able to strategize and figure out how to stay afloat.

Why Chapter 11 Isn’t Always the Answer

Barry Roy, a New Jersey bankruptcy attorney, points out that bankruptcy doesn’t come out of the blue. Warning signs, like an inability to pay debts—remember how Betsey Johnson LLC surrendered a $48 million debt to Steve Madden two years before filing?—may indicate that a company is headed down that path. Once a company has filed, it’s time to start digging out of the hole.

In fact, a company that files for Chapter 11 must have a solid business model in place, as well as enough revenue to keep up operations during the restructuring process. And that process can be an expensive one—both in terms of money and time. “A small business could spend several hundred thousand, mostly for professional help from people like attorneys and accountants,” Roy explains, adding that “people who file have a full-time job running their company and another full-time job dealing with the Chapter 11 case.”

For many businesses, this double burden is just too much. “The key to a successful Chapter 11 case isn’t just filing,” cautions Roy. “It’s the ability to confirm a successful Chapter 11 plan of reorganization. So coming out of bankruptcy is the key.” To do this, a company needs its creditors to agree to the new plan. And, sometimes, that’s just not possible.

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For this reason, It’s common for businesses to convert their cases from Chapter 11 to Chapter 7, when they can’t cover the costs associated with the restructuring, their business model doesn’t prove to be viable or an economic event (like a recession or new government regulations) changes the environment to a degree that the business can no longer function. In fact, more cases ultimately convert to Chapter 7 than follow through on the Chapter 11 process—only about 10% of Chapter 11 cases successfully restructure their businesses.

One thing to keep in mind is that some businesses don’t want to keep functioning. While we tend to see filing Chapter 7 as a last resort, it can also be a strategic move because, as Roy explains, it’s the neatest and cleanest way to end a company. In addition to situations of unmanageable debt or lawsuits, companies may elect to declare Chapter 7 because the owners want to retire and dissolve their business or take advantage of lower interest rates, among other reasons.

Is There a Trick to Avoiding Bankruptcy?

“This is one of the reasons why it’s so important to have a well-constructed business plan,” explains LearnVest Planning Services CFP® Samantha Vient. “Like any other project, you’ll want to do your research and prepare for rough spots ahead of time.” So Vient suggests speaking with established business owners to find out which red flags they’ve encountered—and how they’ve extricated themselves from financial problems in the past.

One pitfall that you’ll want to avoid in particular? “You don’t want to base your company’s expansion solely on the brand’s popularity at the moment,” Vient cautions. “So try to foresee where the market is headed, and who your new competition will be five to ten years down the road.”

Vient also notes that it’s important to have your board of directors (if you have one) and your legal team on the same page—these are the people who will advise for or against declaring bankruptcy, if it comes to that.

Of course, there’s no foolproof way to avoid serious financial problems when you’re launching a business—but if you do your research, and cover your bases before there’s an issue, you’ll be better prepared to address problems as they arise.