After reluctantly shuttering her family owned Widgets-R-Us last month due to insufficient profits to pay even the secured debt, Susie Sears is now dealing with disbelieving unsecured creditors. What should she do?
Personal Liability Avoided
Acting on her attorney’s advice last month, Susie took care to avoid potential personal liability for employment taxes, franchise taxes and income taxes, and she confirmed that she has no personal contract liabilities.
Susie should notify all known creditors and, to the extent of available funds, pay all known creditors before distributing any assets or profits. Any money she pays to owners when there are still creditors puts Susie at risk to pay them. Susie may elect to dissolve the business once operations have ceased and creditors are paid or otherwise resolved. She should wait until the statute of limitations expires before paying any questionable claims and before dissolving. Most importantly, she should follow the Widgets-R-Us governing documents and/or Texas statutes regarding dissolution voting rights and the order of dissolution.
Initiate Final Dissolution
If all employment taxes, franchise taxes and income taxes have been paid, if there are no assets other than that paid to the secured creditors and if, therefore, the purpose of the Company has legitimately come to an end then Susie may elect to either: (a) keep the Company open until, for example, the statute of limitations runs out, or (b) shut down the Company so long as it was in existence and in good standing during the time in which the business had operations.
Tilting the Scales in Your Favor
Don’t Forget. As an officer / director Susie still owes a fiduciary duty of due care and loyalty. The duty of due care requires directors and officers to make fully-informed, good faith decisions in the best interests of the company. The duty of loyalty imposes on directors and officers the obligation not to engage in self-dealing and instead to put the interests of the company ahead of their own. Even if the company is insolvent, directors and officers still owe fiduciary duties of due care and loyalty to the company, meaning they must maximize enterprise value first for the creditors and then the owners.
Legal Options to Wind Down
Options to wind down range from an informal approach all the way to a public bankruptcy filing, a brief overview of which are:
- Walk Away. Assuming there is no value or assets that are not subject to a secured creditor, Susie eventually lays off her employees, and shuts down her operations without a formal termination and dissolution. Be advised that an informal wind down can leave legal loose ends with unintended consequences.
- Dissolve It. Formally winds up the corporate affairs, liquidates assets, and ends the company’s legal existence. This option may be elected when bankruptcy protection is not needed or preferred, but a formal, legal wind down of the corporate entity is wanted.
- Bankruptcy – Chapter 7: Upon filing with the United States Bankruptcy Court, an appointed bankruptcy trustee takes control of company’s assets, including the company’s attorney-client privilege. The directors and officers no longer have any decision-making authority over the company or its assets. The filing triggers the bankruptcy automatic stay preventing secured creditors from foreclosing on company assets and prevents creditors from pursuing or continuing lawsuits. The Trustee assumes all litigation authority and may pursue preferential transfers and possible breach of fiduciary duty claims against directors or officers.
- Bankruptcy – Chapter 11. Filed with the U.S. Bankruptcy Court and also triggers the bankruptcy automatic stay. Unlike a Chapter 7 bankruptcy, in the Chapter 11 reorganization bankruptcy the board and management remain in control of the company’s assets (at least initially) as a “debtor in possession” or DIP. Business operations many continue with funding at the higher cost of the Chapter 11 process requiring DIP financing and/or use of a lender’s cash collateral. This process permits a venture-backed company to sell assets “free and clear” of liens, claims and interests through a Bankruptcy Court-approved sale process under Section 363 of the Bankruptcy Code.