Planning for Disaster: If a Chapter 11 filing may be needed to save your business 12 months down the road, consider calling a bankruptcy attorney today.

Columbus C.E.O. Magazine

Bankruptcy is something no business owner wants to think about, much less plan for. But with the economy in recession, lenders increasingly tightfisted and consumers cutting back spending, some businesses inevitably will find themselves in dire financial straits.

"Money has been relatively easy to find and relatively cheap for companies. Now we're seeing lenders are not so quick to lend, and that's impacting the number of distressed companies," says Yvette Cox, a member of Bailey Cavalieri and chairwoman of the Columbus Bar Association's bankruptcy judicial liaison committee.

"When sales are trending down, squeezing cash flow, the company often turns to its credit- loans and lines of credit- to meet expenses, rather than the income it's generating," says Reggie Jackson, a partner at Vorys, Sater, Seymour and Pease and 2007- 08 president of the American Bankruptcy Institute. "In times of difficulty, they use the credit up and eventually run out of money."

ln some cases, filing for bankruptcy either a Chapter 11 reorganization or a Chapter 7 liquidation- may be the only realistic option. "Bankruptcy is not a panacea," cautions Jackson. "It's expensive and time-consuming. If there's a way to overcome the problems and avoid it legitimately, that's a best-case scenario."

Even as a business struggles to stay afloat, it's important to understand and anticipate what will happen if the best-case scenario falls apart and bankruptcy becomes unavoidable. Actively preparing for the worst and hoping for the best is a good approach to prebankruptcy planning.

Most business owners would prefer a Chapter 11 filing, which keeps the business operating until it can restructure its finances, to a Chapter 7, which almost always requires assets to be chopped up and sold off. But the 2005 Bankruptcy Abuse Prevention and Consumer Protection Act has made filing for Chapter 11 reorganization more extensive and cumbersome. Here's a quick checklist of things to consider before you 're at a point of no return.

Don't Wait
Business owners, understandably, can be reluctant to admit they're having a tough time. "My colleague A.C. Strip refers to us as a legal emergency room," says Myron Terlecky of Strip, Hoppers, Leithart, McGrath & Terlecky Company, which specializes in bankruptcies and receiverships. "The hardest part is walking through our front door."

"The typical time a debtor comes to see me is when the payroll is due tomorrow and they don't have the cash in the bank to cover it," says attorney Fred Luper of Luper Neidenthal & Logan.

"I like to say you don't start looking for the gas station when you're in the middle of the desert," says attorney Tim Robinson of Squire, Sanders & Dempsey. "You make sure the tank is full when you start out. It's the same in bankruptcy. You have to look at the business situation objectively, and then think ahead for it to have the best possible outcome."

Ideally, a client will have the foresight to seek legal advice six to 12 months in advance of the moment when a budget crunch becomes an irreversible tailspin. "You want to give your advisor something to work with before the situation is a crisis," says attorney Larry McClatchey, chair of the creditors' rights and bankruptcy practice group at Kegler, Brown, Hill & Ritter.

Business owners who take drastic actions without first consulting a lawyer may regret those actions later. "I see entrepreneurs who will do whatever it takes to save their business," says Cox. "They liquidate their 401 (k) or they cash out their life insurance. I need to talk to them before they do any of that. We need to assess the potential of the business or the potential for the demise of the business. Can we reorganize to ride out the storm or reinvent it so it can survive?"

As the firm struggles to find its way financially, keeping up-to-date corporate records is a must. "Proper record keeping helps retain the protection of the corporate veil, which helps protect personal assets and avoid personal liability if bankruptcy is filed," McClatchey says. "You can lose those protections if the company is set up as a corporation but isn't really run like one."

Why do owners often wait too long before beginning to plan for a bankruptcy? An abundance of optimism often clouds the cold, hard facts. "More often than not, the company's officers wear rose-colored glasses. They think it will turn around next quarter, or the next quarter," Robinson says.

"Terminal euphoria" is what Jackson dubs the phenomenon. "Business owners begin not to view things objectively," he says. "They only see the positive, even when it's not supported by the facts. If a large receivable is already eight months late, what makes you think it will come in next month?"

Rarely does a single catastrophic circumstance precipitate a financial collapse. More often than not, a company fails because of incremental slippage of its financial performance that's been ignored or glossed over.

"My job is to say we need a little bit of disaster planning," says Cox. "You may come to hate me, but I'm here to keep you grounded in the reality of the financial situation. I want to be wrong, but ifI'm not, we need a Plan B regardless of the remedy you choose."

Tax and Benefit Obligations
When cash flow is tight, business owners may be tempted to "borrow" the sales tax dollars that have been collected at the point-of-sale, or the income, unemployment compensation, Social Security and Medicare taxes that have been withheld from employees' paychecks.

"It's one of the first things to happen when a company is short on cash," Jackson says. "The owners stop paying taxes and dip into what's already been collected to pay the day-to-day expenses."

"Never borrow from Uncle Sam. He doesn't like it, and sometimes he even suggests that it's stealing," Terlecky advises. "As a bankruptcy attorney, I can make a lot of things go away. I cannot make the IRS go away."

Caught with his hand in the cookie jar, a business owner will likely have some personal liability. "If the employer withholds the taxes, the IRS must give the employee credit. So in the eyes of the lRS, the proprietor has actually stolen from the U.S. Treasury. That's a big problem," McClatchey says.

Problems also arise when a desperate owner dips into employee benefit programs. "Anything that's withheld from employees' paychecks needs to be paid in full: insurance premiums, employee 401(k) contributions, garnishments for child support payments," McClatchey says. "If you default in any employee benefit plan, especially when you've withheld from their wages, it's a serious problem."

Cash is King
If a business owner thinks accumulating enough money to pay the bills is tough, bankruptcy can be even more expensive. "It costs a lot of money to go broke," Luper says. " Frankly, with Chapter 11 you need to hoard a lot of cash to afford it. I'll say to a decent-size company, bring me a $50,000 retainer. For a company of between $ 10 million and $50 million in sales, a Chapter 11 reorganization is probably going to cost $100,000 to $300,000. Some of that comes out of ongoing operating funds, but a big chunk of it is paid upfront."

"Cash is king in bankruptcy," Robinson says. "To have a soft landing or a chance at reorganization, you have to know your capital needs and set a baseline for expenses. Your working capital needs will increase substantially during bankruptcy."

Cash-eating culprits include fees for attorneys, accountants and the bankruptcy court. Suppliers eat up the cash, too. "Usually vendors place [a bankrupt business] on COD [cash on delivery], require cash payment in advance or a sizable security deposit. A lot of cash is needed to pay for those things that keep the business functioning," Robinson says.

Doing a little advance homework about suppliers may come in handy if a vendor refuses to do business with your distressed company. "I never would've believed it, but I did a bankruptcy where the creditor wouldn't sell to the client on a cash-in-advance basis," Terlecky says. "I understand not wanting to extend credit, but cash in advance should've been a no-brainer. The creditor was so angry, my client just had to find someone else to do business with."

Reassuring customers that you're not going to shut down overnight can be an important part of advance planning for a Chapter 11 filing. "For some businesses it doesn't matter," Terlecky says. "The corner candy store will still be open for business. But I'd imagine customers planning a large gala would think twice about spending money with a catering business that they've heard is in trouble."

Seeking legal counsel well in advance can help a business owner avoid the serious consequences of poorly timed financial transactions. "Usually the owner wants to do the morally right thing and take care of the employees or long-time vendors," Robinson says. "From an insolvency planning standpoint, they just can't do that. Everyone needs to know that any such payment like that will be ' clawed back' into the case to ensure equal treatment of the creditors."

There's a 90-day prefiling window during which any unusual payments will be subject to strict scrutiny. And there's a one-year "look back" period for payments to family members who loaned money to keep the business going or other financial activity involving insiders.

"Things like employee retention policies and officer incentive programs must be implemented at least a year prior to pulling the bankruptcy trigger," Robinson says.

As a company creeps closer to Chapter 11, it needs a communications strategy. "You want employees, creditors and vendors to get word of the filing from you, not the newspapers or the rumor mill. Get ahead of it and get the message out about your reorganization strategy," McClatchey says.

"Honesty matters. Keep the lines of communication open," Jackson advises. "Make sure your lender is aware of the situation. They're going to know anyway once they see a drop in your available credit or ongoing late payments. You'll have a better chance of getting some relief if you're honest and talk to them early."

Don't make promises that can't be kept. "Companies often will begin to stretch their payments, but at the same time still tell the creditor what they want to hear," Jackson says. "The owner promises payment on the first when he knows it'll be the 15th. It's best to be upfront and don't lie. You'll use up your credibility. The extent they'll continue to do business with you is often based on how you treated them before you filed bankruptcy. Don't burn your bridges."

Before committing to a Chapter 11 filing, company officers need to take a hard look at the business plan. "All of the legal gymnastics won't matter if the business isn't viable and the cash isn't there," Terlecky says. "You have to figure out how to increase your revenue, decrease your expenses, or both."

"What got you [in trouble] and is it likely to persist? That's the question," Luper says. "A bankruptcy lawyer can buy you some time and use certain reorganization strategies and techniques to help you come out of it in as good a shape as possible. But there's nothing a bankruptcy attorney or the courts can do to make a failing business viable."

"If you have a sound business, but no one is buying your product because they're trying to save their house, that's not the company's fault," Luper adds. "On the other hand, if you're in the buggy whip business, you have a product no one wants to buy. You 're already dead, but don't have the decency to lay down yet."

Jackson suggests looking at the company both as a whole and in parts: "If it has multiple markets and product lines, examine each of them individually. Do you need to get out of one to do better in another? It might be better to liquidate and get rid of some debt to strengthen another, better-performing product line."

Small and mid-size businesses should not underestimate the value of a good accountant. "If you 're not getting timely financial statements or you don't understand them, you really don't have your finger on the pulse of the company," Terlecky says. "What I see increasingly is that entrepreneurs don't understand their financials inside and out. They rely on management by intuition instead," Cox says.

"Chapter 11 doesn't make money grow on trees," McClatchey says. "The company must still [have] cash flow. The nature of Chapter 11 reorganization is that management stays in place unless the court orders a change, and that's rare. The business owners have to understand what went wrong. Something must change when Chapter 11 is filed."