A new legal landscape
Changes in bankruptcy law create some pitfalls for businesses

by Joan Hennessy
for Virginia Business
February 2006

Just five years ago, Switch drinks seemed poised to explode onto the beverage scene as a healthy alternative to soda. Billed as 100 percent fruit juice with carbonation “to make it fun,” marketers boasted that The Switch had “no added sugar, no corn syrup, no preservatives and no mystery ingredients.” Its Web site challenged soda drinkers to “Get Off the Hype.” By 2004, the newly converted could choose from a dizzying array of fruit flavors.

Despite its exuberant launch, Switch Beverage Co. finds itself where no self-respecting business wants to be: in bankruptcy court. The board of directors for the Richmond-based company decided in November to file a voluntary petition of bankruptcy under Chapter 11, the portion of the law that allows businesses to reorganize with court supervision. As this story went to press, efforts were under way to sell the company. But in filing the petition, Switch Beverage plunged headfirst into the murky waters of a newly reformed system.

The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 took effect in October. Passed last spring, the comprehensive reform of the country’s bankruptcy law has been described as both complex and technical. Lawyers started predicting it would need clarification even before it won passage amid broad bi-partisan support.

One of the law’s key sponsors, Sen. Chuck Grassley, R-Iowa, says in a press release that he has been working for years “to make common-sense reforms to the current bankruptcy system so that people who are responsible and pay their bills on time don’t have to subsidize the irresponsible actions of a few.”

One goal of the overhaul is to stop consumers from running up debts, then waltzing away without paying. Indeed, statistics show an ever-increasing number of bankruptcies filed by consumers eyeball deep in red ink.

In 2000, 36,191 bankruptcies were filed in Virginia and 1.25 million nationwide. By 2004, that number escalated to 51,986 in Virginia, 1.6 million nationwide. Business bankruptcy filings, according to the government, represent only 2 percent to 3 percent of the total number, although that figure is being challenged by recent research.

Following an economic slump in the early 1980s, the percentage of business bankruptcies peaked in 1985 at 18.3 percent of all filings, according to research by Robert Lawless, a law professor at the University of Nevada, Las Vegas, and Elizabeth Warren, a professor at Harvard Law School. Since then, the percentage has dropped, but how far is the subject of debate. According to the professors, new computer software and an effort to simplify the bankruptcy reporting process in the 1980s contributed to the misclassification of entrepreneurs filing for bankruptcy as consumers. Their research shows that a larger portion of bankruptcies than previously thought is connected to some form of business or entrepreneurial activity. In fact, based on telephone interviews with a sample of debtors, the authors extrapolated that instead of 37,000 business filings reported for 2003, the number was probably more like 260,000 to 315,000.

To be sure, most entrepreneurs don’t plan on bankruptcy. “I think when people go into business, they need to prepare for the what-if scenario,” says Jody Keenan, state director of the Virginia Small Business Development Center Network. ‘People are not saying, ‘I want to start a business and if it doesn’t work, I’m going to claim bankruptcy.’” When businesses plan an exit strategy, she adds, they think along more positive lines. “We’re going to sell this business to a larger firm. That’s going to be our transition out of the business. Not bankruptcy.”

While most publicity about the new law has focused on its impact for consumers, many provisions will affect businesses — large and small. “Any change of this magnitude is going to be a problem to deal with, and different people have disparate views about whether it is a good change or a bad change,” says John Penn, president of the American Bankruptcy Institute and an attorney with Haynes and Boone in Fort Worth, Texas.

Key changes
One change focuses on curbing excess in key employee retention plans. These incentives help companies in financial trouble retain “key” employees, even as some of these corporate Tit-anics begin to sink. Enron presented a case in point. According to published reports, retention bonuses aimed at securing executives’ services totaled approximately $55 million. The new law’s wording forbids such perks absent a finding by the court that the person “has a bona fide job offer from another business… ” Also, the services provided by the person must be “essential to the survival of the business. …”

Ideally employee retention plans save companies money. “If you are in bankruptcy, and you have to fill an executive position, you are going to pay more than you have been paying, or the functions [of that job] will be done by a consultant that will cost you more,” explains Penn.

Another provision governing commercial leases could hurt some businesses. “There is a concept in bankruptcy law that allows a debtor in possession [the business filing bankruptcy] ... to use business judgment to decide which commercial leases should be continued and which should be rejected,” says Alexander Laughlin, an attorney with Wiley, Rein & Fielding in McLean and counsel for Switch Beverage Co. The initial deadline used to be 60 days, he says. “Now ...we don’t have to confront the landlord issues until 120 days.”

That works fine for Switch Beverage, because unlike a department store contending with bankruptcy, there aren’t multiple leases. But for other companies, it could be problematic. “If we had 25 leases all over the country, we would have to make the decision with 120 days,” Laughlin says. “If we couldn’t, we could ask for [an additional] 90 days. After that, we’d be beholden to the landlord.”

Small businesses, big impact
Ironically, the new law’s biggest impact could be shouldered by small businesses. “The most dramatic changes affect sole proprietorships,” says Penn of the American Bankruptcy Institute. “Those individuals are subject to all of the requirements that were imposed on individual consumer debtors, including credit counseling and the means test.”

Under the new law, consumers can’t declare bankruptcy unless they have received credit counseling within 180 days before filing their petition. The means test assesses a person’s ability to repay debts by taking into account whether the filer earns more than the state median income and can repay at least $100 a month of unsecured debt over five years. Expenses such as food, shelter, health care and transportation are taken into account.

Another impact could make a difference for entrepreneurs who sometimes go through several business models before finding one that’s successful. They won’t have as much breathing room under the new law. “People who have a failed business will find themselves stuck with the business debt and not able to start a new business,” explains Lawless.

Overall, some lawyers think it’s too early to know how businesses will fare. “On the consumer side, there’s been an enormous impact. On the business side, that’s not yet apparent,” says Peter Zemanian, bankruptcy attorney in Norfolk and vice chair of the Bankruptcy Law Section of the Virginia State Bar. Yet, he can see a correlation between consumer behavior and business. With the new law, consumers will no longer be able to “clear off debts and spend money like any consumer would,” says Zemanian. “Looking through an economic crystal ball…that could have a secondary impact.”

To amend or not to amend
Proponents view the law as taking dead aim at an issue that directly impacts the economy: Losses from bankruptcy lead to higher prices on goods and services for everyone. When lawyers discuss the law, they often remark on the need for amendments to clarify ambiguities. Lawless describes the law as “special-interest legislation, plain and simple.” Credit card companies, he says, have “spent millions lobbying to get this bill passed. ... They are vigorously going to fight any attempt to reopen the bill.”

On the other hand, credit card companies know well the cost of bankruptcy. McLean-based Capital One Financial Corp. reported earnings of $491.1 million in the third quarter of 2005, compared with $531.1 million for the second quarter. The third quarter results included a $75 million dollar impact from a spike in bankruptcy filings just prior to the new law taking effect last October.