If a lawsuit against your small business is draining your time and money, Chapter 13 can encourage the favorable settlement of that lawsuit.

A lawsuit against your sole proprietorship business can jeopardize its survival. The last blog post was about litigation that drives a business owner into closing the business, and how to protect the owner afterwards. But bankruptcy can often save a business by getting rid of the lawsuit more quickly and usually under much better terms. How does filing bankruptcy accomplish this?

The Example

We’ll show how bankruptcy can help with the following scenario.

Ken has been operating Convenient Car Care, a vehicle maintenance and repair shop, as a sole proprietorship for the past 5 years. He had bought the business from Gary, its founder, after working for him at the shop for 10 years.  The purchase contract required Ken to pay Gary $1,000 per month plus 5% of the shop’s gross receipts, for 7 years. Ken also agreed to provide accurate monthly sales records to justify the 5% he was paying Gary. And to prevent Ken from not paying that 5%, he agreed to do this kind of work only through this business during these 7 years.

The business’ gross receipts took a big hit when another repair shop opened around the corner. Ken fell behind on his payments to Gary, who eventually got very angry, fearing that he could lose the stream of income he’d counted on getting from the sale of his business. He started believing that Ken was not being straight with him, and so accused him of producing falsified gross receipts data in order to reduce the monthly payment amounts. Ken adamantly denied the accusation. Over the course of the following year they tried unsuccessfully, first by themselves and then through attorneys, to resolve their differences.

Then Gary sued Ken. Ken had precious little money to pay his attorney to fight this lawsuit, but he desperately wanted to hang onto the business. In spite of being behind, he had paid more than half of the purchase price to Gary. Plus he had sunk 5 years of his life into this business—and the 10 years before as an employee—so it’s all that he knows.

But now Ken is supposed to show up next week for his deposition—his oral questioning under oath by Gary’s attorney—at a time when he has no money to pay his own attorney, with the trial in state court scheduled to begin two months later.

Bankruptcy Stops Litigation

Ken goes to a free consultation meeting with a competent bankruptcy attorney, and decides to file a Chapter 13 “adjustment of debts.”

The first thing that bankruptcy filing accomplishes is that it immediately stops Gary’s lawsuit. Ken does not need to attend next week’s deposition.

This at least temporary stopping of the litigation can change everything, and can result in Gary’s lawsuit getting resolved on favorable grounds, for the following reasons.

The Threat of Discharge of the Debt

Even though Ken makes clear in his Chapter 13 plan that he wants to keep the business and pay off the contract, Gary is advised by his attorney that at any point Ken could change his mind, surrender the arguably now less valuable business to Gary, and pay little or nothing more to Gary. This very real threat sobers up Gary, and makes him more realistic about what he can demand from Ken.

Tangible Evidence of Debtor’s Shallow Pockets

Ken’s bankruptcy documents that are filed on his behalf at court are done so under penalty of perjury. They reveal two things: that 1) Ken has very little in assets, all of which are protected from creditors such as Gary, and 2) Ken has many other debts, including “priority” ones like recent income taxes and back child support, which would have to be paid in full before any money would filter down to Gary. As the consequences of this are explained to Gary, he gets less and less interested in wasting attorney fees on fighting Ken.

Grounds for Non-Dischargeability of Debt

Gary is also advised that IF Ken did indeed violate the purchase agreement by lying about the true amount of his gross receipts, Gary could get a bankruptcy court judgment determining that Ken could not discharge (write off) a certain amount of the debt.

But Gary’s attorney also tells him that getting a bankruptcy court to rule in his favor on this issue would be neither easy nor inexpensive. The legal grounds for establishing that a debt should not be discharged are quite narrow. Gary would have to prove to the bankruptcy court that those narrow grounds are met, NOT just that Ken legally owes a certain amount of money. The portion of the debt that could potentially not be discharged would only include the extra amount supposedly owed because of Ken’s under-reporting of gross receipts. Gary comes to understand that this relatively small amount at stake is very unlikely worth his costs in pursuing the matter.

Settlement

As a result, at this point Gary accepts the reality that pursuing Ken any further into bankruptcy would likely do no good. So he tells his attorney to negotiate a reasonable payment schedule with Ken’s bankruptcy attorney to cure the contract arrearages, along with a more reliable way to monitor the monthly gross receipts into the future.