Struggling Firms Get a Second Chance

For many business owners and executives, filing Chapter 11 bankruptcy seems like admitting defeat. It shouldn't be that way.

The bankruptcy code exists to provide second chances. Chapter 11, which covers business reorganizations, allows struggling companies to right themselves so that they may once again be profitable engines of the nation's economy.

No provision in the bankruptcy code is more important to achieving this goal than the automatic stay provision of Section 362.

The automatic stay provides a time-out -- a window of opportunity to fix problems. In some cases, time is all that's needed.

Whenever a company -- or an individual -- files for bankruptcy, the automatic stay kicks in. All debt collection actions against the company must temporarily cease. Like a temporary injunction, the automatic stay prohibits any action by a creditor against the debtor or its property.

Actions prohibited to a creditor under an automatic stay include repossession, foreclosure and the filing of lawsuits. The automatic stay even affects the IRS. While the stay is in place, the IRS is prohibited from issuing tax liens or seizing property.

There is one major difference between the automatic stay in bankruptcy and a normal temporary injunction: No hearing is needed for the automatic stay to take effect. It occurs as soon as a petition to file for bankruptcy is stamped at the court.

A company can then move forward without fear. The bankruptcy court has the power to punish creditors that knowingly violate a stay by filing a contempt charge against them. Harassing letters and phone calls should stop. If they don't, notifying the court of a creditor's transgression generally ends the problem.

While the automatic stay is in place, the debtor company is prohibited from paying most of its pre-petition debts. This provides a chance for the company to rebuild itself as a going concern.

However, recent changes in the bankruptcy law impose limits on the duration of the stay for certain repeat filers (see box). These debtors must seek a stay from the court in order to have the protection of the automatic stay.

You might think that filing for bankruptcy to get an automatic stay sounds all well and good, but filing will surely dry up the pool of available credit for things such as operating expenses. Won't bankruptcy tie the company's hands and kill any hope of future success? This is generally not the case. Sometimes, a struggling company has an easier time obtaining credit once bankruptcy has been filed and the automatic stay is in place.

Credit availability tends to increase because of the prohibition against paying pre-existing debts. All debts incurred after bankruptcy has been filed (post-petition debts) must be paid first, before any pre-petition debts. As long as the company shows that it can operate profitably if it doesn't have to immediately pay its pre-petition debts, credit is likely to be available.

Consult with your accountant about the best way to proceed. And keep in mind that corporations that successfully come out of bankruptcy almost always do so because of fruitful negotiations with creditors. The automatic stay is not a cure-all. For some businesses, no amount of time can fix things. But for a company that is fundamentally strong, with credit in hand, the automatic stay provides an important opportunity to talk to creditors and get back on track.