Business Bankruptcy -- Chapter 7 or Chapter 11

Business bankruptcy usually involves Chapter 7 bankruptcy or Chapter 11 bankruptcy. Both can include debt settlement and creditor negotiations to reduce or pay off debt.

Businesses Filing Chapter 7

By filing a Chapter 7 bankruptcy, a business will stop operating, its assets will be liquidated and the proceeds of the sale will be used to pay creditors. Chapter 7 bankruptcy results: 1) debts are reduced and 2) company is eventually closed -- the court issues deadlines for debt payment and business liquidation.

If a business intends to cease its operations, Chapter 7 is the choice, which allows an orderly termination of the business and provides a liquidation of company’s assets and payment of its debts. 

Federal bankruptcy laws have changed. Starting in October 2005, it is more difficult to file under Chapter 7.

Chapter 11 Bankruptcy

Under Chapter 11 bankruptcy, a company is allowed to reorganize under a court-arranged debt repayment plan and remain in business. Management continues to run the day-to-day business operations, but all significant business decisions must be approved by the bankruptcy court.  

In a Chapter 11 bankruptcy, the court supervises the reorganization of the business and payment of the business’s debts. The goal is to restore the financial health and viability of the business. If this is impossible, the court or creditors may force a Chapter 7 filing.

Alternatives to Bankruptcy -- Workout

Sometimes, a business can re-structure itself and avoid bankruptcy court altogether, through a workout. In a workout, experts help the business to analyze its operations, cash flow, debts, and contractual obligations. Then experts negotiate with creditors to arrange reductions in debt and extended payment terms.

Bankruptcy Considerations

When a company considers bankruptcy, several things need to be aware.

First, the form of a business is important.  Corporations, limited liability companies and partnerships are legal entities separate from their shareholders or partners.  The company can file Chapter 7 or Chapter 11 bankruptcy in its own right.  In partnership situation, however, the trustee can sue the general partners if the partnership’s assets are insufficient to pay all debts.  As a result, partners may be facing a suit by a well funded trustee on behalf of all creditors. 

Proprietorships are just an extension of the owner. The business can't file bankruptcy alone. The proprietor must file bankruptcy, because the assets and the liabilities of the business are also the assets and the liabilities of the proprietor.  The individual owner may file Chapter 7, Chapter 11 or Chapter 13 (if the debt limits are met).

Second, the cause of the problems is also a key and the business should have known the problem and prospects for change, if any.  This is because reorganization can’t create a market, increase revenue, or get the best people to run the business.  It only frees up some cash from rearranging the old debt or rejecting certain contracts that are not advantageous.  It does provide a breathing space for the owners to sell the business as a going concern.  The extra cash can be used to pay taxes or salaries.  Later, Chapter 11 can be converted to Chapter 7 or be dismissed if things are going well with the creditors. 

Still, Chapter 11 requires significant time and effort on the part of the owners/shareholders and managers, such as complying with the bankruptcy process, interfacing with counsel, and negotiating with creditors.  This will create expenses.  Therefore, it is no surprise that most reorganization fail.

There is an option call "bankruptcy bargain.”  In essence, the debtor, in exchange for the protection of the “automatic stay” and other bankruptcy protections, provides full disclosure of its financial condition to creditors and the court.  Moreover, the debtor needs to act as a fiduciary for its creditors while the bankruptcy is ongoing. 

Third, the prospect of starting up another new business after bankruptcy is also a consideration.  For those businesses that require little capital, have few assets, or are just extensions of the owner's skills are ones that it may not pay to reorganize.  The owners may be better off for filing a Chapter 7 to liquidate the business and start over in a fresh entity. 

Bankruptcy can be a complex maneuver and requires good professional advice to do correctly. 

Lei Jiang LLC provides legal service in bankruptcy and other business and corporate law. For more detailed information and tailored analysis, please contact us.