Bankruptcy occurs when a business owes more money to its creditors than it has in assets (which would include cash, real estate, inventory, equipment and other items of tangible value). It is a legal process that ultimately results in either the business closing its doors, liquidating its assets and paying its creditors, or the business attempting to reorganize itself into a financially stable organization while at the same time repaying at least a portion of the debt owed to creditors.

There are three types of bankruptcy options available to small business owners.

Chapter 7 bankruptcy is also known as a liquidation proceeding. When a company files for Chapter 7 bankruptcy, its assets are sold and the proceeds are used to pay any creditors to whom money is owed.

Chapter 11 bankruptcy is also known as a reorganization. When a company files for Chapter 11, it makes an effort to reorganize its outstanding debts and reorganize the company so that the business can continue to operate. A company in Chapter 11 bankruptcy will create a plan that is then presented to its creditors. If most of those creditors agree to the plan, the company can continue to operate. Reorganization plans may include the following:

  • Creditors are paid a portion of the amount that is owed to them (usually an amount equal to at least what the creditor would have received from a Chapter 7 liquidation)
  • The company can break contracts that are financially burdensome
  • The company may scale back operations (for example, by closing locations) to a point where the company can be profitable

If your small business is a sole-proprietorship, then you as the owner must file for personal bankruptcy. As an individual, you can file for Chapter 7, Chapter 11 or Chapter 13 bankruptcy. Chapter 13 bankruptcy enables individuals to create a 3 to 5 year debt repayment plan, assuming your debt does not exceed a certain limit.

In any type of bankruptcy filing, the bankruptcy court must approve the debtor's petition and proposed solutions. If the court believes that bankruptcy is not appropriate, or if the debtor makes misrepresentations to the court, then the bankruptcy petition can be dismissed, and the company will have to find another way to resolve its financial problems.

Bankruptcy Process

Regardless of whether your business is filing for Chapter 7 or Chapter 11 bankruptcy or you are individually filing for Chapter 13 bankruptcy, the legal process usually starts when your bankruptcy attorney files a petition on your company's behalf in federal bankruptcy court. After the petition is filed, creditors must stop efforts to collect money that your business owes them until instructed otherwise by the bankruptcy court. During this period (called an automatic stay) a debtor has the opportunity to figure out how to address its financial problems.

Although bankruptcy is a legal process, much of the work takes place outside of the courtroom. In Chapter 7 and 13 bankruptcy cases, a trustee is often appointed to oversee the case and report back to the bankruptcy judge. In a Chapter 7 bankruptcy, for example, the trustee will be responsible for liquidating any assets and distributing money to creditors. Trustees are less common in Chapter 11 reorganizations, where the debtor is responsible for working with creditors to develop a reorganization plan.

During the bankruptcy process, the debtor may only be required to appear before the bankruptcy judge in a couple of situations, such as if an objection has been raised or when a reorganization/repayment plan is confirmed by the court.

Automatic Stay

The filing of a bankruptcy petition automatically stays all lawsuits that were or could have been brought against the debtor before the bankruptcy petition was filed. The automatic stay also prevents a creditor from taking any action to obtain or control property of or from the bankruptcy estate. This includes any attempt to obtain property that the estate possesses but does not own or have any interest in, such as leased or bailed property.

The automatic stay also:

  • Prohibits a creditor from retaining property lawfully seized from the debtor before the filing of the debtor's bankruptcy petition, or seized before the creditor had notice or knowledge of a filing
  • Prohibits a landlord from filing a petition to remove a debtor/lessee from the leased premises
  • Bars creditors from seizing property in the possession of the debtor's agent
  • Prohibits a derivative action by a shareholder of a corporate debtor brought on the debtor's behalf

The stay has to be lifted by the bankruptcy court in order for any adverse actions against the debtor or the debtor's property to proceed.

Questions for Your Attorney

  • How much experience do you have handling bankruptcy cases?
  • Have you previously handled bankruptcy cases similar to mine?
  • What type of bankruptcy is best for my company?
  • What are the advantages and disadvantages of each type of bankruptcy?