Beginner's Guide to Business Bankruptcy

Chair in empty office
Business bankruptcies are different from non-business bankruptcies. Getty Images

Bankruptcy cases can be characterized in different ways. One is by the chapter of the US Bankruptcy Code under which the case is filed. Each chapter has different requirements and different goals. Even more fundamentally, it is necessary to determine if the bankruptcy case is a business or non-business case.

Just like individuals, businesses can file bankruptcy. The rules are a bit different depending on the type of entity and the chapter under which the entity is filing.

In this article we will touch on the four most common types of bankruptcy and provide an overview of how businesses are treated in each one.

To put business bankruptcies in perspective, here is a breakdown of the number of bankruptcy cases classified as “business” vs "non-business" filed during the calendar year 2016. 

2016 Business and Non-Business Bankruptcy Filings
Type of CaseBusiness Cases Non-Business Cases
Chapter 715,033475,846
Chapter 116,1741,118
Chapter 12461 ---
Chapter 132,259294,396
Total24,114770,856

 

As the numbers attest, there are almost two and a half times the number of business Chapter 7 straight bankruptcy cases files as there are business Chapter 11 cases. 

Form of Business Affects Choice of Bankruptcy Chapter

The type of bankruptcy filed depends in part on the form of the business. A sole proprietorship is a business owned by an individual in his own name. For instance, Fred Toomey, d/b/a (doing business as) Fred’s Landscaping Service.

The business is considered an extension of the individual. A sole proprietorship cannot file a bankruptcy case apart from the proprietor. On the other hand, a partnership is considered an entity separate from the partners (who can be corporations, individuals or even other partnerships). A corporation is a business owned by one or more other entities, individuals or other corporations.

The ownership interest is represented by shares.

Business Bankruptcy by Chapter 

     Chapter 7

Chapter 7 is also called straight bankruptcy or liquidation bankruptcy. It is arguably the most available bankruptcy chapter. It usually takes less time from start to finish, and is cheaper to prosecute. It is used by both business entities and individuals. Sole proprietorships can file Chapter 7 but only under the name of its owner, like the aforementioned Fred Toomey, doing business as Fred’s Landscaping.  

     Partnerships and Corporations

Partnerships and corporations will also file Chapter 7, but with a different result. Partnerships and corporations do not receive a discharge of debts. Neither do they exempt any property with which to gain a “fresh start.” In fact, a Chapter 7 case filed by a partnership or corporate entity is expected to be a total liquidation. The Chapter 7 case serves as an orderly vehicle for liquidating the assets and paying as many debts as possible. This is all done under the protection of the bankruptcy court and prevents a race to the courthouse, which favors larger creditors with more sophistication and resources. At the conclusion of the case, the entity that filed the bankruptcy will effectively no longer exist, although its assets, and even its name, customer list and goodwill might have been sold.

     Sole Proprietors

Almost all individual Chapter 7 debtors are looking for a discharge of their debts. The discharge allows them to get a "fresh start" and carry on with their lives. With most business debtors, there is no "fresh start because the business ceases to operate. Whether the business operations of a sole proprietor will cease in a Chapter 7 depends on the type of business. Most businesses like stores or manufacturing operations will cease to operate and exist. For a debtor who does business under his own name, like a consultant, a writer or a lawyer, the debtor will not be required to stop using her gifts and skills on a freelance basis or to style her business, “Susan Weiss, writer and editor”.

Another reason it’s important to determine the business nature of the case from the start is to determine whether the individual debtor will be required to take the means test.

The means test is designed to indicate whether Chapter 7 is appropriate for an individual debtor or whether the individual can afford to make payments through a Chapter 13 payment plan. If at least 50 percent of the debtor's debts are business-related debts, the means test does not apply.

     The Trustee’s Role   

The trustee, who is appointed by the bankruptcy court, is charged with a duty to gather and preserve the assets and oversee the liquidation of those assets. This may entail closing a company immediately, but it could also mean that the trustee will take charge of the company and keeps it as a going concern if that means that the trustee can maximize the assets available to satisfy creditors’ claims.

The trustee will then solicit claims from creditors and issue payment according to a priority scheme set forth in the bankruptcy code. Each class of creditors must be paid in full before any proceeds can be used to pay a lower class. Administrative claims — those that arise from the filing of the bankruptcy itself — are paid first. Administrative claims could include a real estate commission for the sale of property, the cost of preparing a car for sale, or accounting fees, and taxes.

Secured claims are paid from the sale of their collateral. General unsecured claims are then paid on a pro rata basis. If there are any proceeds available after all the general unsecured claims are paid, only then will the owner or shareholders be paid.

     Chapter 13

The utility of Chapter 13 is limited for businesses because it is only available for sole proprietors Corporations and partnerships cannot file a Chapter 13 case, although the partners who are individuals can file independent of the partnership. When individuals file Chapter 13, any corporate shock or partnership interest owned by the debtor is nothing more than an asset of the debtor. The Chapter 13 will not directly affect the asset.

Chapter 13 bankruptcy allows for a reorganization of debt. In a Chapter 13, the debtor proposes a monthly plan for repayment of debts over a period of three to five years. A Chapter 13 plan can last a maximum of 60 months.

It is probably obvious that the feasibility of a business Chapter 13 plan depends on the income of the business. The Chapter 13 trustee will scrutinize the business’s income history to determine if the income can sustain the debtor and the necessary Chapter 13 payments. To learn more about how Chapter 13 works, check out these articles:

Living With a Chapter 13 Case

When to Consider Filing Under Chapter 13 Instead of Chapter 7

     Chapter 12

Chapter 12 is the newest form of bankruptcy. It was enacted in 1986 to combat economic conditions that were strangling small farming and fishing operations.

Chapter 12 is reserved for what is often termed the family farmer or family fisherman, although this is a bit of a misnomer because Chapter 12 can be filed by corporations or partnerships. There are debt and income restrictions, but Chapter 12 is available for entities with regular annual income, even if the income is seasonal. Otherwise, Chapter 12 works much like a Chapter 13 case with more freedom in structuring the repayment plan around the seasonal nature of the business.

To qualify for Chapter 12, a farming debtor must owe at least 50 percent of its debt on farming operations. A fishing debtor will owe at least 80 percent of its debt on fishing operations. derive at least 50 percent of its income from farming operations. If the debtor is a fisherman, at least 80 percent of income comes from fishing. For both farmers and fishermen, the must get at least 50 percent of their income from the farming or fishing business.

     Chapter 11

Chapter 11 is often what people think of when they hear the term “business bankruptcy”. Although Chapter 11 is utilized more in the business context, it is not limited to use by businesses. Some individuals file a Chapter 11 to reorganize debt either because the exceed the debt limits imposed on Chapter 13 or they do not want to be limited by Chapter 13’s strict payment structure. To make things a bit easier, the bankruptcy code has special rules to streamline the process for small businesses. Either way, Chapter 11 is very labor intensive for the debtor and its professionals (attorneys, accountants, etc.) and therefore very expensive to traverse successfully.  

In a Chapter 11 case, the debtor reorganizes its debts under the watchful eye of the bankruptcy court, but the debtor has responsibility for its day-to-day operations. The debtor is called a debtor-in-possession (of its property) and serves as its own trustee.

The debtor-in-possession continues in business while it is working out the details of the debt restructuring. This can change, however. If warranted, a creditor or the US Trustee can request that a trustee be appointed. The debtor may also use Chapter 11 as a vehicle for liquidation under it’s own power or with the help of a trustee.

     Role of the US Trustee and Creditors’ Committee

The debtor is said to be “in possession” because it continues its daily operations under supervision of the court, but it is not required to obtain court permission for every detail of those operations. The debtor is required to obtain court permission for out of the ordinary activities like the purchase or sale of real property and other assets, if that is not the ordinary business of the debtor, layoffs and other major personnel actions, and entering into financing agreements.

The US Trustee is an arm of the Justice Department that provides oversight for certain bankruptcy operations. That office supervises the operations of individual Chapter 7, Chapter 13 and Chapter 12 trustees. It also provides similar supervision of Chapter 11 debtors. In fact, it charges a quarterly fee to the debtor for the privilege of being watched over by the US Trustee.

In addition, in most Chapter 11 cases, the court will form a creditors’ committee of interested creditors from the list of the debtor’s top 20 largest unsecured creditors. The committee is charged with a duty to oversee the case and represent the interests of all the unsecured creditors. This is done at the debtor’s expense in that any expenses incurred by the creditors for serving on the committee and by their approved professionals like attorneys, examiners, are covered by the debtor as an administrative expense.

     The Reorganization Plan

The aim of the Chapter 11 debtor is to propose and secure approval for a reorganization plan. The plan will almost always change whatever terms the debtor and the creditors operated under outside of Chapter 11. Creditors are divided into classes. Each class would be similarly situated. For instance, all unsecured vendors could be placed in the same class. Bondholders could be in a class. All vehicle lenders could be in one class. Some creditors might be sufficiently unusual that they would warrant a separate class. For instance, the mortgage lender on the debtor’s manufacturing plant, or the lender that provide factoring on the debtor’s accounts receivable.

For a plan to pass muster with the bankruptcy court, the plan just first be put to the creditors, who are allowed to vote on whether or not they accept it. At least one impaired class must vote to accept the plan. An impaired class is one in which the creditor’s rights have been changed to its detriment (lowered interest rate, longer terms, partial payment,etc.) There are particular rules for how many creditors must vote to accept, and a creditor’s vote is valued somewhat by the amount of debt it represents. For a class to vote in favor of a plan, at least one half in number and two-thirds in amount of debt must approve it.

Once the creditors vote, the bankruptcy court has the final say on approval of the plan.

Once the plan is confirmed by the court, the debtor will set about to fulfill the terms of the plan. The debtor will generally stay under the watchful eye of the court at least until the plan has been substantially consummated, even if there are still years left until all debt payments are made.