Professionals and Bankruptcy: a high-level overview
by Dean Langdon
Those who practice a profession tend to be well-respected and well-compensated by society for their services and contributions. But, mastering a profession does not automatically translate to business success. As a lawyer, I left law school with limited insight into how to start, grow and operate a business – even my own. And although many professionals are employed by mid- to large-sized companies, a substantial number of professionals work in solo or small group practices. Consider your doctor, dentist, veterinarian, insurance agent, accountant, lawyer or realtor. Occasionally, economic conditions, competition or just poor business practices lead to financial trouble for professional practices. If bankruptcy is an option, there are issues, risks and opportunities which professionals should consider before acting.
To evaluate options, you must learn the reasons why a professional practice is struggling, but more important is knowing the client’s ultimate goal. Will the practice close and the professionals find other employment, or can it continue if debts are restructured through a reorganization process? This initial decision drives which form of bankruptcy will be considered. A chapter 7 bankruptcy is a liquidation process, and business operations end at or before a case is filed, with rare exceptions. A chapter 11 allows a business to continue operating under court protection and restructure its debts under a court-approved plan. A chapter 13 also allows a restructuring of debts, but is only available to individuals and is subject to limits on the amount of debt which can be addressed. Unless a professional operates as a true sole proprietor, chapter 13 will not be an option.
Once the goal is identified, the analysis begins. Most professional practices are operated as a professional limited liability company, partnership or professional service corporation. Especially in multi-party practices, examining company governance documents is essential to determine the rights and obligations between the owners and the entity, and amongst each other. Different approaches to how a practice is run, or simple personality clashes have been the demise of more than one professional practice group. If an entity files bankruptcy, the equity holders are the last one to be paid, if they recover anything at all. If an individual files, a bankruptcy trustee acquires most rights the individual has an equity holder. This could include anything from a right to receive distributions, to a right to liquidate the assets of the entity, depending on what the governance documents say. On occasion, it may be prudent to change governance of the entity to address such issues before a bankruptcy is filed.
Ownership of assets and liability for debts is not usually limited to the entity. Individuals may own anything from their own office furnishings to important equipment to intellectual property which is used by a professional practice. And it is common for individuals to be liable for a practice’s debts ranging from bank loans to equipment and premises leases. Our firm often sees professionals who have used individual credit cards to help keep a practice afloat, too. Determining who owns what, and who is liable on which debts factors into the decision of whether the individual or the entity needs bankruptcy relief, and which type of relief. For example, if an entity owns the assets of a practice and the assets are all pledged as collateral for a bank loan, it may be better to simply close the business rather than file chapter 7 bankruptcy. Or, an individual may need the relief offered by chapter 7 as part of moving from a sole practitioner to being an employee or partner of a larger group. Without a clear picture of the debt/asset structure of a practice, risks and opportunities could be overlooked.
Professionals may not fully realize all the assets associated with a professional practice. Traditional assets such as furniture, fixtures and equipment may be supplemented with accounts receivable, patents or trademarks, website url’s and content, and client data. While most professional licenses are not transferable, sometimes value can be obtained from a name or logo, or even from things like patient healthcare records (although these could also be a liability). Other items, such as architectural or engineering plans, may actually belong to the client instead of the practice. Professionals may have lien rights against property to secure payment for their services. Healthcare practices have transferable provider agreements which come with both benefits and obligations. Lawyers and law firms can present unique challenges here, as a defunct firm often makes a claim to future revenue from work which follows partners who join other firms. And professionals are often interested in keeping or acquiring some assets to use in their next venture. In order to gauge the potential benefits and risks of a bankruptcy filing, having a firm grasp of the nature and extent of the assets of a professional practice is crucial.
On the other side of the equation are the debts of the practice. Secured creditors may need to be contacted in advance of a bankruptcy if their collateral (such as accounts receivable) are critical to the continued operation of a business. Although it may be possible to modify the terms of a secured debt through reorganization, liens normally survive the bankruptcy. As a result, analyzing what assets are truly necessary, as well as a lender’s alternatives if assets are surrendered, comes into play during negotiations. Debts such as wages, employee benefits and taxes owed must be addressed. Employees rarely continue working if they are not paid (although we’ve seen it happen), and a failure to pay withholdings or contributions for taxes, insurance or retirement benefits can lead to individual liability for such debts. If tax collection efforts are threatening the practice or an individual, a bankruptcy reorganization may offer an opportunity to reduce the amount which must be repaid, and extend the payment period for up to five years.
Other aspects of operating a business create rights which could be considered a debt or an asset, depending on the circumstances. A lease is just one example. While a lease is certainly an obligation, a long-term lease at below market rates is an asset which might be assigned (or sold) to a third party. On the other hand, a practice that grew too fast may need to reject (or cancel) a lease for a satellite location or space that is no longer needed. Contracts between an entity and professional employees, or service contracts with specialized vendors for professionals may offer the same type of opportunities. Of course, reviewing the specific contract terms is required, but the bankruptcy process can expand options for a professional practice in order to help it restructure and survive instead of closing its doors.
Each area mentioned above deserves analysis in order to identify and evaluate potential risks and benefits of a bankruptcy filing when a professional practice needs help. Bankruptcy may be “just what the doctor ordered” to permit a professional to resolve burdensome financial issues and focus on using their professional skills instead.