Operational Issues

The Life Raft is Sinking! – The Rise and Fall of the Subchapter V Bankruptcy Debt Limit

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Bankruptcy is a widely misunderstood legal proceeding, especially in the business context. Perhaps the reader, who is understandably totally unfamiliar with bankruptcy law (as was this author until recently), thinks of bankruptcy like it appears in the board game Monopoly: it means you’ve lost. However, bankruptcy is actually a powerful tool for a business owner, which may enable a business to survive when the business is drowning in debt.

Historically, as Dickinson Law’s Insider Entrepreneurship Law Blog previously reported, bankruptcy really was a death declaration for small businesses. The two traditional small business bankruptcy options, filing under Chapter 7 or Chapter 11 of the bankruptcy code, did not offer positive outcomes for small business owners. Under a Chapter 7 proceeding, the business dies. Its assets are sold off to pay some liabilities, and the entity ceases to exist. Under Chapter 11, the business survives bankruptcy, but enters into a payment plan with existing creditors. The Chapter 11 procedure is often called a “restructure” since the business survives. However, Chapter 11 bankruptcy had a miserably low success rate.

This changed with the enactment of Subchapter V of Chapter 11. Congress enacted the new Subchapter in late 2019, and it took effect in 2020. As Dickinson Law’s Insider Entrepreneurship Law Blog previously reported, the new Subchapter is the life raft struggling small businesses desperately needed. Subchapter V filings are cheaper and faster. Creditor approval of a payment plan is usually not required under the Subchapter, improving the efficiency of the process. And, of course, the small business owner retains their ownership of the company during and after a Subchapter V proceeding. Subchapter V enables businesses to escape drowning in debt.

There is a significant catch. If a business has debts exceeding $7.5 million, it cannot utilize Subchapter V, and must take its chances in a regular Chapter 11 proceeding, or close through a Chapter 7 proceeding. The trouble is, this debt maximum is set to automatically fall to just over $3 million in Summer 2024. It was raised during the first weeks of the Covid-19 pandemic, in a congressional act which contained an automatic “sunset” provision. If congress doesn’t act to keep the debt limit up, the door to Subchapter V is automatically shrinking.

Bankruptcy filings are on the rise. When Spring 2024 filings are compared to those of Spring 2023, business bankruptcy filings are especially higher. This trend is expected to continue throughout the year.

If your small business is facing pressure from debt, or if you just want Subchapter V to remain more accessible for the future, action is necessary to keep the debt limit where it currently stands.

Who Benefits from a Sinking Debt Limit and Who Loses?

Creditors are understandably distrustful of Subchapter V since it reduces their ability to approve bankruptcy payment plans. As reported in the ABI report discussed below, Subchapter V debtors often fail to meet their payment plans. However, given that the alternative is likely a Chapter 7 filing where creditors may get little or nothing, perhaps they don’t benefit from a lower Subchapter V debt limit after all.

The American Bankruptcy Institute, a national organization of bankruptcy professionals which advocates for bankruptcy policy changes to congress, published a preliminary report which argues the debt limit should stay at $7.5 million. In refuting the arguments of creditors who support a fallen debt limit, the ABI argues that Subchapter V’s successful implementation is only proven under the high debt limit, since the limit was raised to $7.5 million soon after the Subchapter took effect. The ABI notes that most bankruptcy professionals support the higher limit and that $7.5 million in debt is not unrealistic for small businesses.

The obvious beneficiary of Subchapter V is the small business owner. No longer expected to follow the same procedures as major corporations undergoing a restructure, small businesses can access a cheaper and expedited proceeding. Access to Subchapter V enables more successful Chapter 11 proceedings and a higher debt limit allows more businesses to access Subchapter V.

So, What Should you Do?

As an entrepreneur who wants to keep Subchapter V accessible, you should make this issue a priority for your legislative representatives in congress. Cliché as it may sound, you need to write or call your congressman, and ask them to support legislation to keep the Subchapter V debt limit at $7.5 million. They need a reminder that the Subchapter V debt limit is set to fall, and they need to know this issue is important to their constituents. While we hope not, your business may need access to this Subchapter to stay alive down the road.

 

Sources:

ABI Report – https://abi-org.s3.amazonaws.com/SubV/media/SubV_Report_Final1.pdf

Bankruptcy Rates on the Rise – https://www.epiqglobal.com/en-us/resource-center/news/bankruptcy-filings-increase-across-all-chapters-in-first-quarter-2024

Previous Blog Post on Chapter 7 and 11 before Subchapter V – https://sites.psu.edu/entrepreneurshiplaw/2018/09/24/difficult-decisions-whether-to-file-chapter-7-or-chapter-11-bankruptcy-and-what-it-will-mean-for-you-and-your-business/

Previous Blog Post on Subchapter V – https://sites.psu.edu/entrepreneurshiplaw/2022/05/23/subchapter-v-a-bankruptcy-solution-for-small-businesses/

Capitol picture taken by author. All other pictures from Microsoft Word stock photos

Operational Issues

“Who Do You Work For?!” – What To Expect from Your Company’s Legal Counsel

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You hired a business attorney to represent your startup. Nice work! Legal counsel can ensure your business doesn’t run into any trouble during takeoff. But what kind of advice can your attorney give? Can he/she help you with personal matters too? What obligations does your attorney have to you?

On the other hand, maybe you’ve stumbled upon this article because you’re considering securing an attorney for your business, but you don’t know what to expect. How can you pay this attorney? You understandably would prefer to keep your cash on hand for business expenses, not legal fees. Can you pay your attorney with an ownership interest in the company?

This article will answer questions such as these. I will explore the relevant ethical rules which control the actions of attorneys. In describing the ethical rules which affect business representation, I refer to the American Bar Association Model Rules of Professional Responsibility, a set of rules drafted by the national association of attorneys which have been adopted (perhaps with some modifications) by the various state governments of the United States.

For Whom Does the Attorney You Hired Work?

Perhaps this question seems silly. After all, you hired the lawyer, so they must work for you, right? Actually, this likely isn’t the case. When you hire an attorney to assist your business, they probably represent the company itself, not its owner. While this may seem like a distinction without a difference, it actually matters a great deal. An attorney owes certain duties to its client, known as “fiduciary duties”. These duties require attorneys to loyally serve their client’s best interests.

Under ABA Model Rule 1.13, an attorney who represents a business owes fiduciary duties to the business itself, not its manager-owners. This means that, should a manager engage in activities which would harm the best interests of the company, the attorney is not only permitted, but required to take action to prevent such activity. This typically involves revealing the proposed harmful action to the higher-ups of an organization.

This rule is especially relevant if your startup is a corporation. The attorney of a corporation has an ethical duty to report activities of the managers which could hurt the company to the board of directors. This power even enables the attorney to reveal confidential information to third parties, should it be necessary to protect the company.

Hopefully, this rule is a total non-issue for you and your company. You obviously want your company to succeed, so your interests are aligned with its best interests. However, the fact that your attorney represents the company itself may restrict the kind of assistance they can provide you, as an individual.

Can The Company Attorney Offer You Personal Legal Advice?

You picked an attorney because you feel you can trust them. Reasonably, you may also seek their advice for your personal legal questions. Can they provide this information if they represent the company? To give the annoying lawyer answer; it depends.

Your company’s attorney can also represent you, provided there is no conflict of interests. This rule sounds simple: if you ask questions unrelated to the running of the business, the company lawyer can answer, and thus also represent you, right? Not so fast. Conflict of interests rules are a minefield. You may think that a question is sufficiently unrelated to the business for a lawyer to answer but be disappointed to hear them refuse to answer. The existence of a conflict of interests is a highly fact specific issue – it depends on the situation.

However, just because there is a conflict doesn’t mean you’ll never get an answer out of your attorney. In many cases, an attorney can still represent two clients which have conflicting legal interests, provided the attorney believes he or she can still effectively represent both parties, and receives the informed consent of both clients, confirmed in writing.

Can The Attorney You Hired Serve as a Director on Your Company’s Board?

In short, yes. The company’s attorney is obliged to serve the best interests of the company, and he or she may also serve on the company’s board and offer business advice. However, this can pose some issues. If there is a conflict between the attorney’s ethical duties and their fiduciary duties as a board member (yes, board members have such duties too), this creates a major conflict of interests issue.

Can The Company Attorney be Paid with an Ownership Interest?

Yes. The company attorney can accept an ownership interest in the company, provided the exchange is objectively fair and the client (so the business, as represented by its managers/owners) gave their informed consent, in writing. The attorney must also advise the company to seek separate legal counsel for negotiating this deal and give the company an opportunity to do so.

Other Ethical Issues

It is unreasonable, for the purposes of this blog post, to give an exhaustive list of the ethical rules which arise when an attorney represents a business. I will simply note that, when your lawyer interacts with federal agencies such as the IRS and the SEC on behalf of the company, the lawyer is subject to special ethical rules, imposed by those agencies, which may alter their behavior.

 

The Takeaway

Hopefully, this article provided you, a small business owner and/or manager, with some idea of what to expect from your company’s legal counsel. However, if you understandably have questions about what your attorney can do for you company, even after reading this introduction to legal ethics in business representation, you should discuss your concerns with your attorney. They will be able to describe the boundaries of your particular relationship and enable you to make the most effective use of your new counselor.

Sources:

https://psu.pb.unizin.org/entlawoperationalissues/chapter/chapter-2-introduction-and-preview/

https://www.americanbar.org/groups/professional_responsibility/publications/model_rules_of_professional_conduct/model_rules_of_professional_conduct_table_of_contents/

Image Sources:

ABA Logo – www.americanbar.org

SEC Logo – https://en.wikipedia.org/wiki/U.S._Securities_and_Exchange_Commission#/media/File:Seal_of_the_United_States_Securities_and_Exchange_Commission.svg

IRS Logo – https://en.wikipedia.org/wiki/Internal_Revenue_Service#/media/File:Logo_of_the_Internal_Revenue_Service.svg

Other Images from Microsoft Word Stock Images

Company Creation

The ROBS Plan: Will it Get Your Business Rolling or Just Rob You of Your Future?

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So, you have an idea for a business venture. The next step is to secure some startup capital so you can begin forming your business. But, as any entrepreneur knows, cash can be hard to find. If you’re transitioning from employee to entrepreneur, you may be interested in your options for liquidating your 401k/IRA for use as startup capital. After all, you may have a lot of money in those plans. And it’s yours, right? So, you should just be able to take it out and start spending it? Unfortunately, this is not the case.

If you wish to liquidate funds from your retirement plan, you have three options. The first option is to take out a loan against those funds. This can be wise, since the interest you pay on the loan goes into your retirement funds, so you essentially pay interest to yourself. However, the ability to take out a loan against your retirement funds is dependent on the rules of your retirement fund plan. You can only do it if your employer/plan administrator lets you. Alternatively, you could just withdraw your funds early (assuming you are younger than 59.5). Unfortunately, this option is just plain bad, since you will pay a hefty 10% fee for early withdrawal. In addition, from the IRS’s perspective, you also receive all that money as taxable income in the year you withdraw early, meaning that you take on a LOT of tax liability.

So, what about that third option? Enter the Rollovers as Business Startups (ROBS) plan. A ROBS plan can allow you to utilize your retirement funds as startup capital. You can avoid a loan and any penalties for early withdrawal. Let’s first explore the process for creating a ROBS plan, then we can investigate the pros and cons of this option.

The Method:

A ROBS plan is conceptually uncomplicated. You first form your new business as a C-Corporation: the standard American corporate model. Next, you form a 401k plan for that corporation, name yourself as an employee of the company and beneficiary of the plan, and rollover your fund from previous retirement plans into this new plan, as you could anytime you started a new job. Then, that new 401k ROBS plan buys stock in your corporation. The proceeds from the stock sale can then be used by the new corporation as startup capital.

The Pros:

            The process of forming a ROBS plan, if done right, enables the liquidation of retirement assets without early withdrawal penalty, loan payments, or tax liability. Securing startup capital is a mountainous challenge for most entrepreneurs. Venture capitalists and other investors are unlikely to invest in your project if you can’t first demonstrate an investment of your own money – a vote of personal confidence in your idea. If you don’t have a nest egg laying around for this purpose, that startup capital mountain just became an impenetrable castle wall. You may need to liquidate your assets, and your retirement plan funds are a significant asset. This makes the  ROBS plan an extremely attractive option.

The Cons:

            Unfortunately, there are quite a few downsides to using a ROBS plan. The first one is obvious: you are risking your retirement on your business idea. If the company fails, you will probably lose significant portions of your retirement savings. On this basis alone, the utilization of retirement funds for startup capital should probably be a last resort.

            However, there are other problems with the ROBS plan. In order to institute a ROBS plan, you have to form your business as a C-Corporation. You can’t use an LLC or any other business entity form. C-Corporations require formal management systems: you will need company bylaws, a board of directors, to prepare annual filings, etcetera. These formalities make C-Corporations unattractive to entrepreneurs who want to manage their business on their own and in their own way. In addition, C-Corporations are subject to the corporate double tax. The new company will be expected to file its own tax returns and pay income taxes (as well as other corporate taxes). If the company issues dividends, the company pays taxes on the income from which those dividends are derived, AND the shareholders pay income taxes on the dividends they receive – double taxed.

Another downside of the plan is the annual filing requirements. ROBS plans are new 401k plans. The plan administrator will have to file the annually required forms on behalf of the plan, including the Form 5500, which summarizes the annual status of the 401k plan. These filing requirements can be a serious hassle, especially for small businesses which are trying to focus on daily operations.

            As a final note, ROBS plans face significant IRS scrutiny. The ROBS plan enables the taxpayer to dodge tax liability while liquidating retirement assets, and the IRS will ensure that the plan is formed and administered properly. If it appears that the ROBS plan is operating like a bank account instead of as a proper retirement plan, the IRS may become suspicious, and the resulting investigation will be a major disruption for your business. Be careful to follow the rules in forming and administering your ROBS plan.

The Takeaway:

            So, is a ROBS plan the way to go in securing some startup capital? The answer is going to depend on the situation of you, the entrepreneur. As discussed above, the plan is an option for liquidating retirement funds without incurring early withdrawal penalties, tax liability, or loan payments. However, there are tradeoffs to this plan. Prospective entrepreneurs should seriously consider whether the risk of forming a ROBS plan are worth it for the cashflow. Other options, such as bank loans or crowdfunding, may be more desirable.

 

Image Credits:

401k Graphic (Adobe Stock Photo) – https://www.theastuteadvisor.com/401k-plans/

ROBS Plan Graphic – https://psu.pb.unizin.org/expsk909/chapter/using-401k-retirement-money-for-seed-funding/

 

Sources:

https://psu.pb.unizin.org/expsk909/chapter/using-401k-retirement-money-for-seed-funding/

https://www.irs.gov/retirement-plans/rollovers-as-business-start-ups-compliance-project

https://www.irs.gov/pub/irs-tege/robs_guidelines.pdf

https://www.lendingtree.com/business/robs/

https://www.nerdwallet.com/article/small-business/rollovers-as-business-startups-robs

https://www.guidantfinancial.com/401k-business-financing-robs-guide/

Company Creation

Showing Your Hand: Can Any Business Succeed Without IP?

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Coke or Pepsi? D.C. or Marvel? It’s safe to say you probably prefer one of each category, or simply dislike both options. But why? After all, Coke and Pepsi are both Colas. D.C. and Marvel both make comic books. The answer is obvious. You prefer Coke or Pepsi because of the flavor, because of the recipe. You prefer D.C. or Marvel because of the characters and stories of one option.

In the Cola example, each company’s recipe is not public information. In the D.C. vs. Marvel example, each company holds intellectual property rights over its characters and settings. These companies’ business models necessitate protection of their intellectual property from use by other companies. This business model is the norm in most industries: if you create/invent something, copyright, patent, or trademark it so you can control the sales. But what if your company totally ignored this standard? What if your company deliberately eschewed intellectual property rights and put the recipe about its products out on the internet, for everyone to see?

       

In the 2010s, a technology manufacturer headquartered in Loveland, Colorado tested this idea. Aleph Objects produced a 3D printer line called the “Lulzbot.” What made this product interesting was the “open ethos” behind its production. Not only was the product developed using open-source technology – technology produced and published without securing intellectual property rights – but the device itself was “open.” The recipe of hardware components used to build the physical printer was available online through Aleph’s website. The software used by the printer was fully open-source as well. Nothing in the device’s makeup was proprietary. Individuals were free to build their own Lulzbot with Aleph’s help and without paying the company anything.

So, can this model be effective? If the company doesn’t protect its product from being replicated by other manufacturers, can it still make a profit? Let’s explore the pros and cons of this model.

Pros:

Cheaper startup expenses on the legal side: If you’re starting a company to sell a product you designed/invented, any decent lawyer will encourage you to get a patent on your design. You produced something unique, which is why it can be competitive in the marketplace. However, the expenses necessary to secure a patent can be intimidating when starting a company. Costs vary depending on the industry but securing a patent will likely cost a business thousands of dollars. This price tag includes fees assessed by the USPTO and expenses on attorneys who will help secure the patent. You may spend even more money if your first application is rejected and you need to try again. If you choose not to patent your product, you obviously save this money, allowing it to be allocated elsewhere.

Harness your customers to improve your product: Employing an open model can reduce R&D expenses. If you produce open-source software and hardware, your customer base can contribute to the development of your company. As customers tweak the product with minor improvements and revisions, you can implement these changes in your production model. Under this scheme, you aren’t dependent on your R&D engineers (which, as a startup, may just be yourself) to come up with all the good ideas. A limitless team of people can make suggestions, all for free.

No need to defend your IP: Even if you secure intellectual property rights to your product, you still need to defend these rights from would-be duplicators. Failing to do so will hurt your business as your market share is eaten up and also may result in the loss of your patent altogether. If you never secured the patent in the first place, this problem doesn’t exist. You don’t need to spend money on lawyers protecting your IP.

Cons:

Idea Theft: Obviously, if you aren’t securing Intellectual Property rights over your product, your competitors are free to replicate it. If you place your cards on the table, your opponents will know exactly what they’re up against. Any good ideas you have will be implemented in their product, and their improvements won’t be so visible to you. It’s easy to see how your business can fall behind the competition in this situation.

Industry Dependent: Let’s face it, in most industries, this model just can’t work. You won’t beat Coke by simply making your own Cola and publishing the recipe online. If you’re trying to beat D.C. and Marvel, letting them use your characters in their stories isn’t going to help. This business model may be effective in the technology industry, but perhaps nowhere else. Open-source software is already an industry standard, and open hardware has been done before, as seen with the Aleph Objects example.

How do you make money? If you publish the schematics for your product online, allowing anyone to build their own, how can you expect to sell any units? Why buy from your company when they can make their own? In order for this business model to work, you need to take advantage of economies of scale. Your production costs need to be low so you can still price compete with individuals who would buy the parts and build your product themselves. But these margins are going to be tight. You can’t markup your product’s price when building one is easy and cheap. This model may require higher startup costs in order to make production efficient enough for prices to stay low.

The Takeaway

It’s impossible to recommend an “open ethos” model to all business owners. The model is too industry and circumstance specific. Lawyers usually recommend that business owners secure IP for a reason. However, for some entrepreneurs (particularly those with very progressive views regarding the philosophy of ownership) the model may just work. Playing while showing your hand is a bold strategy in any card game, but you can still win if those cards are good enough.

 

 

Image Credits:

Coke vs. Pepsi – CNN Money https://www.cnn.com/videos/cnnmoney/2018/04/26/coke-vs-pepsi-cola-war-back-orig.cnnmoney

DC vs. Marvel – Games Radar (DC / Marvel Comics) https://www.gamesradar.com/whats-the-difference-between-marvel-and-dc/

Aleph Objects Logo – Wikipedia (Aleph Objects) https://en.wikipedia.org/wiki/Aleph_Objects

Lulzbot Printer – Lulzbot https://lulzbot.com/store/taz-6

Cards – Wellness Training Institute http://www.wellnesstraininginstitute.com/blog/2018/03/08/cards-on-the-table-heres-what-were-all-about-at-the-wellness-training-institute

 

Sources:

https://www.elsevier.com/connect/6-things-you-should-know-about-open-source-hardware#:~:text=Using%20open%2Dsource%20hardware%20can,researcher%20for%20the%20same%20scope

https://opensource.com/business/15/11/open-ethos-powers-lulzbots-success

https://www.schroederpatlaw.com/intellectual-property-faq-archives/can-i-lose-the-right-to-patent-my-invention/

https://www.uspto.gov/trademarks/basics/trademark-patent-copyright

https://uslawpros.com/how-much-does-a-patent-cost/

https://www.ycombinator.com/library/56-why-the-best-companies-and-developers-give-away-almost-everything-they-do

About Me

About Me

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Hi! My name is Joe Crowley, and I am recent graduate of Penn State Dickinson Law in Carlisle, Pennsylvania. I’m originally from Fort Collins, Colorado. I received my undergraduate degree from Colorado State University. I can contacted by email at jmc8880@psu.edu.