Q: If my business has filed for bankruptcy and I am required to remain with the business until it’s complete, can I establish a new business as well?

– Tri-Cities Area Journal of Business reader “Jason”

A: The partial answer to this question is that the type of bankruptcy sought determines the rights and obligations of the debtor (here, “Jason”) during the pendency of bankruptcy protection.

Understanding bankruptcy 

During tough times when businesses find that their financial situation has become unmanageable and other debt relief strategies have failed, the business might consider bankruptcy as an option.

Bankruptcy is a legal strategy authorized under federal law, starting at 11 U.S.C. § 101 (The Bankruptcy Code). That section of law contains various chapters and the specific kind of bankruptcy protection sought is administered under the corresponding chapter within the Bankruptcy Code (e.g., Chapter 11 bankruptcy or Chapter 7, etc.).

The rights and obligations of the debtor are further determined by the bankruptcy court judge who presides over the case. A judge then appoints a trustee. The trustee’s role is to oversee the debtor’s repayment plan and to ensure payments are made to creditors while monitoring the debtor’s actions to ensure compliance. The bankruptcy trustee reports to the judge on the debtor’s compliance with the repayment plan.

In short, there are a lot of moving pieces to a bankruptcy proceeding that might affect the answer to the question.

If a business has the potential to survive the bankruptcy and pay off the debts, then the bankruptcy would likely fall under Chapter 13 or Chapter 11. Chapter 11 often pertains to businesses while Chapter 13 applies to individuals and sole proprietors with lower debt limits and regular income.

Starting a new business

Let’s look at an example. Assume Jason has a company that sells artisanal lip balm under the brand name “Kiss Bliss” and his company has filed for bankruptcy because it is unable to pay its debts in the normal course of business.

Then, the question Jason wants answered is whether he can take his same formula under a new business and rebrand it as “Smooch Smoothie” and directly compete with the Kiss Bliss brand. Ostensibly, the Smooch Smoothie business isn’t subject to the same restrictions and oversight as the Kiss Bliss brand.

It’s a compelling idea for Jason. Why run a business under the strict oversight of a court-appointed trustee and bankruptcy judge if the owner can move operations to a new business?

Under Chapter 11 or 13, there is an expectation that the debtor can pay off all debts without the need to liquidate the business and cease operations.

To accomplish this, there is further expectation from the court that the debtor stay engaged in the business which is the subject of the bankruptcy.

Accordingly, the debtor would likely need to obtain approval from the bankruptcy court before starting any new business. This involves demonstrating that the new business will not negatively impact the debtor’s ability to adhere to the prescribed repayment plan and would not further erode any rights of any creditor.

But there are other issues to consider aside from bankruptcy oversight. For example, one issue is how the debtor might get financing for the second business venture while going through a bankruptcy proceeding.

Many potential lenders (both institutional lenders and personal lending sources) will be discouraged from lending given the bankruptcy proceedings. Keep in mind, the debtor will have an obligation to make a full and fair disclosure of the material facts surrounding the bankruptcy to any potential lenders.

The debtor also should consider obligations to others that might be affected by a new business. For example, this might be any person with whom the debtor has some kind of legal obligation and where a new business could violate the rights of the partner or third party, like a partner, co-owner, supplier, or customer. This could come in the form of a violation of a non-compete, non-solicitation, supply contract, or others.  

Seek guidance

As with most legal issues, the answer depends heavily on the material facts in the particular case. The reader is encouraged to seek out competent legal advice to address his circumstances.

Beau Ruff, a licensed attorney and certified financial planner, is the director of planning at Cornerstone Wealth Strategies, a full-service independent investment management and financial planning firm in Kennewick.