Business Bankruptcy FAQ

1. What is "bankruptcy" and how does it affect business?
2. What is the effect of filing a bankruptcy petition?
3. What kinds of bankruptcies are there?
4. When should a business file for bankruptcy?
5. Isn't it true that someone can only file for bankruptcy once every seven years?
6. Can a business get a discharge?
7. What happens to my corporation if I file personal bankruptcy?
8. Can all types of debt be discharged?
9. What happens is a debtor or a creditor doesn’t follow the bankruptcy rules?
10. If they can't pay their creditors, how do people afford bankruptcy lawyers?
11. Can a debtor give special treatment to certain creditors ?
12. Can a business be forced into bankruptcy ?

Q: What is "bankruptcy" and how does it affect business?

A: While technical definitions of bankruptcy can vary, the term refers to a situation where an individual or a business has liabilities that exceed assets, or where the person or business is insolvent by reason of not being able to meet financial obligations as they become due.

Virtually anyone or any type of business entity can start a bankruptcy proceeding by filing a petition in federal bankruptcy court. The bankrupt person who files a petition is called the bankruptcy debtor. The filing of a bankruptcy petition affects all creditors of the debtor. There are many different categories of creditors, including:

• Secured creditors (usually those with a lien on a debtor's property)
• Unsecured creditors (usually vendors, credit card companies and anyone else who doesn’t have a security interest in any of the debtor's property)
• Judgment creditors (usually those creditors who have sued and obtained a judgment against the debtor prior to the bankruptcy being filed)
• Creditors with super priority claims (who have higher priority over other creditors because of special rules or proceedings within the bankruptcy)
• Creditors with administrative claims (usually creditors such as accountants or lawyers with claims that are given priority because of their having assisted in the bankruptcy in some manner)
• Post-petition creditors (who have extended credit to the debtor after the bankruptcy has been filed. Bankruptcy generally covers only pre-petition debts (those that were outstanding at the time the petition was filed).

Inevitably, every business is going to run into situations where customers file bankruptcy. Businesses will end up filing bankruptcy, as well.

Q: What is the effect of filing a bankruptcy petition?

A: The filing of a bankruptcy petition is a lot like filing a lawsuit in the sense that the act of filing simply starts a legal proceeding without any guarantees of the outcome. The debtor will make allegations, but there is no guarantee that the court will declare the debtor bankrupt or grant any other requests. The debtor must go through a statutory process, with creditors and other third parties given the opportunity to challenge and object to the relief being sought by the debtor.

Unlike any other type of legal proceeding, though, the filing of a bankruptcy petition immediately gives rise to an "automatic stay” that stops creditors from taking any further action to try to collect their debts unless or until the bankruptcy court decides to the contrary. The automatic stay is an injunction that is issued against all creditors immediately upon filing a bankruptcy petition. The intent behind the automatic stay is to give debtors temporary relief from their financial problems, giving them the opportunity to figure out how to deal with them.

The automatic stay is only temporary, and there are any number of ways that a creditor can get relief from the bankruptcy court to proceed with trying to collect its debt. One common way is to file a petition or motion with the court, asking for relief from the automatic stay. In the case of a secured creditor, a court will look to see if the creditor is adequately protected. For example, a creditor with a lien on real property may still be adequately protected if there is enough equity and/or the debtor starts making "post-petition" payments again after the filing of the bankruptcy. If there isn’t adequate protection, a creditor may be given permission to proceed with foreclosure or other remedies.

Q: What kinds of bankruptcies are there?

A: The Bankruptcy Reform Act provides a number of different options. Generally speaking, though, there are four kinds of bankruptcy proceedings that are commonly referenced by the different chapters of the federal bankruptcy code that covers them:

• Chapter 7 is the most common type of bankruptcy proceeding. Chapter 7 is available to individuals, married couples, corporations and partnerships. In this proceeding, individual debtors may seek a discharge of their unsecured debts, meaning that they are extinguished by order of the bankruptcy court at the end of the proceeding. Unless there are problems in the case, individual debtors are usually able to get a discharge within four to six months of filing the case.

  As in all bankruptcy filings, the filing of a Chapter 7 proceeding imposes an automatic stay on all creditors, which prevents them from trying to collect their debts without first getting approval of the bankruptcy court. A bankruptcy trustee is appointed to the debtor's case, who controls all of the debtor's assets. All creditors must be given notice of the proceeding. The trustee then identifies which assets of the debtor are exempt from the bankruptcy proceeding (such as personal effects, household goods, qualified retirement funds), and those that will be sold to pay off creditor claims.

  A Chapter 7 is a liquidation proceeding, which means that the debtor's non-exempt assets, if any, are sold or otherwise liquidated by the trustee. The proceeds are distributed to creditors according to the priorities rules established by the federal bankruptcy code. Any wages the debtor earns after the case is begun are the debtor's, beyond the reach of creditors who had claims on the date of filing.

• Chapter 11 is a reorganization proceeding, typically for corporations or partnerships. However, a Chapter 11 proceeding may still be an option for some individuals, especially those whose debts exceed the limits allowed by a Chapter 13 proceeding.

  A business in financial trouble may elect to file a Chapter 11 petition to try to reorganize outstanding debts and continue to operate the business. There’s an automatic stay, just like any other bankruptcy proceeding. Unlike a Chapter 7 proceeding, though, a business that files a Chapter 11 proceeding will become a debtor-in-possession, and there will initially be no bankruptcy trustee appointed. The debtor-in-possession is given an opportunity to prepare a plan of reorganization that must be approved by a majority of the creditors. If a plan is approved by the creditors and is confirmed by the court, it binds both the debtor and the creditors to its terms of repayment. Plans can call for repayment out of future profits, sales of some or all of the assets, or a merger or recapitalization. Generally, the plan of reorganization must provide for paying creditors at least as much as they would have been entitled to be paid in a Chapter 7 liquidation proceeding.

  It isn’t easy to salvage a business in a Chapter 11 proceeding, and many of them end up converting to a Chapter 7.

• Chapter 12 is a simplified reorganization for family farmers, modeled after Chapter 13. The debtor retains his property and pays creditors out of future income.

• Chapter 13 is a repayment plan for individuals only. It protects the debtor from collection action during the case and discharges any unpaid balance of dischargeable debts at the end of the plan. It’s a powerful tool for debtors to regain control of their financial lives and to get a meaningful fresh start. As of 2002, a debtor must have a regular income and unsecured debt less than $290,525 and secured debt less than $871,550. The debtor keeps his property and makes regular payments to the Chapter 13 trustee out of future income, to pay creditors over time (3-5 years). Repayment in Chapter 13 can range from 10% to 100% depending on the debtor's income and the makeup of the debt. Certain debts that cannot be discharged in Chapter 7 can be discharged in Chapter 13 (which is one incentive for a debtor to choose this type of proceeding over a straight liquidation under Chapter 7). Chapter 13 also provides a mechanism for individuals to prevent foreclosures and repossessions, while catching up on their secured debts.

Q: When should a business file for bankruptcy?

A: This is not an easy decision and a business owner should first exhaust all other options. There are also different types of bankruptcy proceedings, so the decision may not be as simple as you think. It’s a good idea to get financial and legal advice before taking any action. As a business owner, you may want to file bankruptcy if there’s a black cloud of credit problems hanging over your head that just won't go away. In these situations, the relief of filing bankruptcy will usually outweigh the inevitable drawbacks from doing so (like loss of the business, hurting credit history, embarrassment). In a business setting, though, there may not be quite the stigma to filing bankruptcy and it can actually be an effective tool to save a business enterprise.

In a Chapter 11 proceeding, for example, you can sometimes restructure or consolidate debts and come out of the bankruptcy with a fresh start. In most instances, creditors would rather that a business not file for bankruptcy since they may then get nothing. But creditors are usually of the mindset that none of them is going to accept a compromise on a debt unless they all do. The threat of filing bankruptcy is sometimes just the leverage a business needs. A distressed business may actually be able to work with one or more creditors up front to develop a plan of reorganization prior to filing bankruptcy, and then use a bankruptcy filing as a means to put the plan in place. The bankruptcy will allow for an orderly process to be followed with all claims being addressed within the same proceeding within the exclusive jurisdiction of the bankruptcy court. Otherwise, the creditors working with the debtor would have to worry about other creditors trying to exercise their own remedies by filing separate lawsuits or by trying to foreclose on assets that the debtor would need to reorganize.

Q: Isn’t it true that someone can only file for bankruptcy once every seven years?

A: No. This is a common misinterpretation of the rule that a debtor can file more often, but can only obtain a discharge once every seven years. While you can only file Chapter 7 and obtain a discharge once every 7 years, you can file a Chapter 13 bankruptcy even if you got a Chapter 7 discharge less than 7 years ago. There are other strategies that debtors can utilize, as well. For example, you can file a Chapter 7 to discharge those debts that are dischargeable, and file a subsequent Chapter 13 to repay those debts that were not discharged in Chapter 7.

Q: Can a business get a discharge?

A: If you are operating your business as a sole proprietor, you may still be entitled to a discharge. But corporations and other business entities are not entitled to a discharge. A sole proprietor should keep in mind, though, that a bankruptcy filing must include all of the debtor entity's debts, regardless of how or why they were incurred. So it would be difficult for a sole proprietor to treat business debts separately from his or her personal finances. The assets of a sole proprietorship, like business equipment or receivables, are property of the bankruptcy estate unless they are claimed exempt or abandoned by the trustee in a Chapter 7. But it may be possible to classify business debts separately and pay them in full in a Chapter 13, if necessary to continue to use vendors. An individual debtor can also reaffirm debts.

Q: What happens to my corporation if I file personal bankruptcy?

A: Since the corporation is a legal entity different and distinct from its shareholders, the bankruptcy of a stockholder does not affect the corporation. But the bankrupt shareholder's shares in the corporation are an asset of his or her bankruptcy estate. The value of the shares in the hands of the bankruptcy estate is a function of:

• The share's marketability
• The percentage interest they represent of the corporation
• The net value of the corporation's assets

A corporate bankruptcy shouldn’t directly affect the shareholders. If the officers or shareholders are personally liable for the debts of the business, the automatic stay in the corporation's case doesn’t prevent creditors from trying to collect from others who may be liable.

It makes no difference if you have made an “S” election for your corporation. Such an election is a matter of tax law. For purposes of the bankruptcy laws, an “S” corporation is treated no differently than a “C” corporation. But any taxable income generated by an “S” corporation after bankruptcy may still be taxable to the shareholders, as the corporation isn’t a taxpaying entity.

Q: Can all types of debt be discharged?

A: No. Although the debts that cannot be discharged vary slightly between the different chapters of bankruptcy, the following generally cannot be discharged:

• Debts for taxes owed to local, state or federal agencies
• Debts for money, property, services, or an extension, renewal, or refinancing of credit, which was obtained fraudulently
• Debts which were neither listed nor scheduled or which the debtor waived discharge
• Debts which are owed to a spouse, former spouse, or child of the debtor, for alimony, maintenance, or support of such spouse or child, in connection with a separation agreement, divorce decree or other order of a court of record
• Debts owed for willful and malicious injury by the debtor to another person or property owned by another
• Debts for government sponsored educational loans, unless it can be shown that repayment will cause an undue hardship
• Debts for death or personal injury caused by the debtor's drunk driving or from driving while under the influence of drugs, or other substance
• Debts incurred after the bankruptcy was filed

Q: What happens if a debtor or a creditor doesn’t follow the bankruptcy rules?

A: The bankruptcy rules are very complicated. If a debtor fails to comply with the rules or makes misrepresentations to the bankruptcy court, the court may deny a discharge. Debtors have to be very careful to account for everything and to follow the bankruptcy rules.

In the alternative, a bankruptcy court may simply dismiss a bankruptcy, meaning that the debtor would no longer be entitled to protection of the bankruptcy laws. A debtor could even be prosecuted criminally.

Creditors are not immune, either. They may be subject to similar sanctions if, for example, they collude with the debtor to hide assets. A creditor can also get in big trouble with the bankruptcy court for violating the automatic stay.

Q: If they can’t pay their creditors, how do people afford bankruptcy lawyers?

A: Usually a bankruptcy lawyer is going to insist on being paid up front. When people know that filing bankruptcy is inevitable, they can plan ahead to pay their lawyer. This usually involves paying the lawyer at the expense of and with money that might otherwise have gone to pay unsecured creditors. The logic is that, if someone is going to file bankruptcy anyway, it is better to reallocate the resources to pay for good legal representation rather than continue to pay on an unsecured debt that is going to be discharged or structured in the bankruptcy. Usually a bankruptcy lawyer is not even going to be subject to the same rules that apply to creditors, because he or she will be paid a retainer in advance so that the lawyer is not a creditor of the bankruptcy debtor at the time the petition is filed.

Q: Can a debtor give special treatment to certain creditors?

A: Although the rules can get quite complicated, a debtor cannot give preference to one creditor over another. The preference period for general creditors is three months. It can be as long as a year for family members and other insiders. If a debtor makes a payment in preference to some creditors over other creditors, the bankruptcy court can order the creditors who received the money to pay it back into your bankruptcy estate.

Q: Can a business be forced into bankruptcy?

A: Yes. If enough is at stake, creditors can start an involuntary bankruptcy proceeding against a business. This doesn't happen too often but it does happen when creditors are concerned that a debtor is squandering or misappropriating assets that should otherwise go to pay debts that are owed to them.