Can You Just Walk Away from a Debt-Riddled Business and Start Fresh?

In the wake of the coronavirus shutdown, many business owners are under immense financial stress caused by the economic impact of a nearly worldwide standstill. Some may be in or at risk of breach or default. Creditors may be jockeying for payment and applying pressure through demands and threats of legal action.

Meanwhile, for many professionals, such as doctors, dentists, technical specialists and professional advisers, the value of their business is often tied much more to their personal services and goodwill than to hard physical assets. For these owners, walking away from the business may mean walking away from leased or heavily leveraged equipment with a chance to take their licensed skills and talents into a new business.

I am often asked by indebted business owners whether they can simply close an existing heavily indebted practice and open a new one. The answer, in some cases, is yes — but it should only be considered by the right people (those whose debts won’t follow them) and be done in the right way.

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Do NOT Do This

An example of what not to do is found in an old Florida case, Munim, M.D., P.A. v. Azar, M.D. The defendant’s medical practice was sued for breach of contract and lost. Twelve days after a substantial money judgment was awarded, the physician-owner incorporated a new practice, stopped seeing patients and rendering medical services under the old practice, and immediately commenced seeing patients in the new practice. The new practice was in the same office building, used the same furniture and equipment, employed the same office manager and staff, and saw the same patients. The new practice was simply a reincarnation of the old wearing a new hat.

The judgment creditor pursued the new practice based on a fraudulent transfer of assets, de facto merger and mere continuation of business and won. Consequently, the creditor was entitled to enforce the original judgment (entered against the old practice) against the physician’s new practice.

With a more strategic approach, the outcome may have been different.

Instead, Start with a Thorough Analysis

Although it may be tempting to walk away from a business plagued by debt and start over fresh, such drastic action should not be taken without a careful assessment of the personal risks and long-term implications. Bankruptcy, either business or personal, may be an answer for some, but many professionals may want to avoid personal bankruptcy for fear of the effect on their license, credit, reputation and other long-term implications.

Instead, strategic resolutions are often plausible. In my experience, most reasonable creditors would rather work with historically sound borrowers, lessees and tenants to achieve long-term success. Following are some steps that business owners — particularly those in health care or other professional service practices — should take when considering their options.

Perform a Business Exposure Analysis

First, assess the financial obligations of the business. What are the ramifications if those obligations are not promptly satisfied? Can the practice continue to operate on a short-term or long-term basis? What workout options — such as extended terms, forbearance, renegotiation or other, more creative, alternatives — may exist? For example, will landlords move to evict, or will equipment be subject to seizure or repossession or will creditors be amenable to other options, which may involve modifying existing agreements?

Business owners should already have created separation between business and personal interests and assets. Proper use of legal entity structures, such as corporations, limited liability companies and professional associations, generally insulates business owners from personal obligation for business liabilities (except in cases of professional malfeasance or malpractice).

Assuming the business operates as a separate entity, then a business wind-down with a fresh start may be considered. This further depends on the extent to which the individual owners are liable for the business debts.

Check for Personal Exposure for Business Debts

Shareholders and LLC members are generally shielded from personal liability for debts incurred by a corporate entity. Exceptions include obligations for which the business owner has personally signed, either as a primary obligor or guarantor. In more limited cases, an individual owner may face personal liability depending upon the nature of the business obligation.

Some states’ laws, like Florida’s, provide that individuals acting in a management capacity may be personally liable for malfeasance or injury caused by their own breach, recklessness, bad faith or malice. Such bad acts might not be personally avoidable by winding down the business. Many professionals also remain personally liable for their own professional negligence.

Individual practice owners may be liable for business debts if factors are present to “pierce the corporate veil.” Elements vary by state, but generally, the “veil” of entity protection may be pierced when the company fails to follow corporate formalities required to exist separate from the owners. Comingling business and personal funds, and failure to maintain proper accounting and documentation, are common factors. Some states consider fraud or improper purpose as one of many factors, but a few states, like Florida and Delaware, require a showing of fraud or improper business purpose, as a prerequisite to pierce. States following this rule are generally more protective of owners of business entities operating legitimately and in good faith.

Have Personal Asset Exposure? Examine Your Options

Many business owners will no doubt find that they have personally signed as principal obligors or guarantors of many of the business leases and credit facilities. When this is the case, a thorough analysis of the individual's personal asset exposure is essential. The individual obligor must understand what personal assets are at risk and which may be insulated from creditor attachment. Just as importantly, the creditor must be informed of its ability to collect for unsatisfied business obligations from the individual. From a creditor’s perspective, there is little value in a personal claim that cannot be collected.

Assets should be reviewed for titling, method of ownership (e.g., direct ownership or via trust or entity), and the extent to which those assets may be exempt or otherwise unavailable to creditors (whether by law, public policy or as a result of prior strategic planning). A word of caution is due here: Whatever is done is done. Asset protection strategies must generally be implemented before claims arise. After claims arise, it is generally too late to implement asset protection strategies. So-called “late-stage” transfers — transfers made to avoid a creditor — raise fraudulent transfer concerns. Fraudulent transfers — those asset transfers made with intent to avoid creditors — can have independent legal consequences for the transferor and anyone else involved in the transfer.

Many states offer statutory protections that should be closely analyzed. For example, Florida generally protects qualifying homesteads, retirement accounts, education savings accounts, annuities, life insurance and head-of-household wages from creditor attachment. Most states have similar statutory exemptions. Asset analysis and preservation strategies in times of stress generally involve — at a high level — identifying and parsing exposed assets and protected assets and acting appropriately to maximize the preservation of those protected.

Next, Use Your Leverage to Negotiate Your Debts

For most professional practices and many small businesses, a thorough understanding of personal exposure is essential when negotiating resolution options for debt obligations and credit facilities. The analysis also informs the skilled negotiator as to leverage when dealing with creditors. Knowing the creditors’ options — and limitations — is a valuable tool in renegotiating agreements and obligations currently in distress.

Professional advisers and health care professionals have a unique advantage, because significant business value is usually based upon personal services and personal relationships (with patients/referral sources). The real value of a medical professional's business is the individual performing services. That personal talent/qualification/ability cannot be encumbered, impaired or lost to creditors. The professional business owner, whose business value lies primarily in the goodwill of the owner’s services, will likely find much leverage when dealing with creditors, vendors, lessors, obligors, etc., if the business debts cannot be enforced as personal obligations. (This is one reason why I try to resist having my clients sign personal guaranties when establishing any business.)

Not Enough? Consider Options for Workouts

If personal assets are not heavily at risk, either because personal liability does not attach to the owners or because the owner’s assets are not exposed, then the owners may weigh the costs of any available workouts with the costs associated with winding down the heavily indebted post-COVID-19 practice and starting fresh. The value of assets in the practice, level of debt, and extent of potential personal liability are all factors to be considered. Lenders and creditors know that many business assets have little value in second-hand liquidation sales. The value lies in the skilled use of those assets by the well-trained professional and the personal goodwill that has accrued over time.

Creditors may also look at the relationship history and consider the costs and risks of terminating a known relationship. If prior to the COVID-19 crisis, the business enjoyed a positive performance history, then post-COVID-19 workouts should be possible with all but the most unreasonable of creditors.

If workouts are not possible or feasible, and if the owner bears little personal risk, then closing a business and starting anew will be a consideration. This can be done through bankruptcy, but as noted above, that can have long-term ramifications.

Finally, Consider a Potential Fresh Start, but Be Careful

You’ve assessed your debts and determined they will not follow you. You’ve looked at the possibilities to work out your debts with creditors, and they don’t look promising. So, now it’s looking like starting fresh is your best option. This is where concerns of successor liability and fraudulent transfer implications must be carefully navigated.

Under many states’ laws, a successor entity generally does not acquire the obligations of a predecessor entity, but there can be exceptions. In Florida, for instance, liabilities may be imposed on a successor when the successor expressly or impliedly assumes the obligations, or where there is a deemed “de facto” or “mere continuation” of the predecessor; or where fraud or fraudulent transfers exist. The imposition of liability upon a successor entity is based on the notion that no entity should be permitted to avoid liability for its obligations through corporate transformation in form only.

Creditors therefore have at their disposal several legal arguments to support enforcing a debt against a successor entity when the successor appears to be a simple recreation of the old business wearing a new hat, as we’ve seen with the Florida case mentioned above.

What the Florida Doctor Did Wrong

The primary mistake the doctor in that case made was trying to shed the old business obligations while retaining the business assets. Had the doctor instead considered ways to create separation between the old and new business, he may have avoided the successor liability issue. Examples might be relocating the practice, partnering with other professionals (or separating from partners), liquidating, surrendering, or purchasing physical assets, and paying fair value to the old practice for patient records. Any sums paid would be held in trust for the benefit of the old business creditors.

Corporate and limited liability company laws (as well as most sophisticated corporate governing documents) also generally provide for a formal wind-down process that should be followed to shield the individual owners from further liability for business debts. Owners who choose this route are generally advised to do so with a team of competent advisers.

The key point is that owners of financially stressed professional practices and health care practices often have several resolution options at their disposal, including perhaps, starting a new practice. If this latter option is chosen, due caution must be exercised to avoid carrying forward unintended business obligations from the old business.

Conclusion

COVID-19 is not just a health crisis but an economic one. Financial recovery will require careful planning and strategy. Each person's circumstances are different. Business owners providing health care services and professional advice stand in a unique situation; one which may offer more leverage for strategic resolutions with creditors. Those owners should make a careful assessment of business and personal obligations and assets, consider all options for strategic resolutions, and proceed with informed caution.