Business failure is an inevitable—even necessary—part of our capitalist economy. That is truer than ever in today’s volatile economic climate. The law provides several means to usher failed enterprises into their next life, such as assignments for the benefit of creditors; loan workouts; foreclosures by secured creditors; voluntary, judicial or administrative dissolutions under state law; and other methods. When it comes to winding up a business burdened with substantial debt, however, bankruptcy is the first thought that comes to mind for many attorneys and business persons.
Business bankruptcies primarily occur under either Chapter 11 or Chapter 7 of the Bankruptcy Code.1 Chapter 11 is for businesses that wish to either: (a) restructure their debt and continue as a going concern; or (b) exert more control over the liquidation process than they would have in a Chapter 7 case.
Chapter 7 relates exclusively to liquidation, at least with respect to business bankruptcy. Individuals may also file for Chapter 7—indeed, the vast majority of consumer bankruptcy cases are filed under Chapter 7—but consumer Chapter 7 cases differ significantly from business Chapter 7 cases. The essence of the business Chapter 7 is the liquidation of the business’s assets by a bankruptcy Trustee, which results in the business effectively ceasing to exist.
This article focuses on Chapter 7 bankruptcy as it applies to legally-organized business entities such as corporations and limited liability companies. Specifically, this article highlights what business Chapter 7 is—and what it is not.
The Bad News: No Discharge in Business Chapter 7
Discharge is the most powerful relief available to debtors under the Bankruptcy Code. A discharge is essentially the elimination of the debtor’s liability for many types of pre-bankruptcy debt.2 After the bankruptcy court enters a discharge order, the debtor’s creditors are permanently barred from taking action to enforce or collect discharged debts.
The catch is that non-individuals are prohibited from receiving a discharge in Chapter 7.3 The discharge prohibition applies to corporations, limited liability companies, and other entities that are not individuals.
As a consequence, after a business Chapter 7 case is over, the business’s creditors may resume their efforts to enforce and collect their debts from the business.
More Bad News: No Elimination of Personal Liability for Business Debt
Chapter 7 bankruptcy does not eliminate the personal liability of shareholders, officers, employees, affiliated companies, or others for a business debtor’s debts. There are many different kinds of business debts for which individuals can be held personally liable. For example:4
(a) Small business owners and officers commonly personally guaranty business debts, such as business lines of credit, credit cards, and even some vendor contracts and other business debts.
(b) A "responsible person" can be held personally liable for employee wages, tax debts and other government obligations that the business fails to pay.5
(c) Corporate officers can be held personally liable for torts that they actively participate in, such as acts of negligence, fraud, or conversion.
In other words, a business Chapter 7 will not stop a creditor from pursuing a shareholder in connection with the shareholder’s personal guaranty of a business line of credit or preclude an action for the liability associated with the business’s debts. As such, individuals facing personal liability for substantial business debt often consider filing for personal bankruptcy in coordination with the business bankruptcy, in order to eliminate personal liability for the business debt.
Even More Bad News: Preferential and Fraudulent Transfers
For business owners, the realization that their ship is sinking usually does not dawn on them overnight. It is a realization that comes to them gradually over time. Once they realize that their ship is taking on water, however, they may begin behaving differently. The business owner may start paying some preferred creditors instead of others, especially if they intend to start a new company after closing the current failed enterprise. Even worse, they may start taking some company property for themselves or transferring property out of the business for no (or far below-market) consideration. Others may even hide property in order to keep it from creditors.
While such "preferential" or "fraudulent" transfers may benefit the debtor and the creditors who were paid, they are considered unfair to the creditors who were not fairly paid. In many cases, the bankruptcy Trustee has the power to undo (or "avoid") such preferential or fraudulent transfers by suing the transferee for recovery of the money or property.6 With respect to fraudulent transfers, the debtor and the transferee may be subject to even harsher consequences, including incarceration in extreme circumstances.7
Finally, Some Good News: The Practical Discharge
While Chapter 7 business debtors cannot receive a "discharge" as defined by the Bankruptcy Code,8 the result of the business Chapter 7 case will effectively be the same for the debtor as if a discharge had been granted.
At the end of a Chapter 7 case, a business debtor has no income or assets left for creditors to pursue. The debtor has closed its doors, secured creditors have taken possession of their collateral, and the bankruptcy Trustee has liquidated any remaining valuable property and distributed the proceeds to creditors. Nothing will be left for creditors except possibly assets of nominal value, such as used office furniture, uncollectible receivables, office supplies, etc.
At this point, while creditors are free to pursue the business debtor, any such pursuit would be futile because the debtor will have nothing of value left to satisfy the creditors’ claims. In essence, the debtor has "practically" received a discharge. While creditors could pursue their claims, they have no incentive do so when there is no practical means to recover.
Another "practical" discharge effect is that many creditors will stop trying to enforce their claims under the mistaken belief that Chapter 7 business debtors do receive a discharge.
Of course, as discussed above, the business Chapter 7 case will not stop creditors from enforcing their claims against individuals and others who may be personally liable for some or all of the debtor’s debts.
Make It Somebody Else’s Problem
It can take a lot of work to wind up a business—terminating contracts, liquidating inventory and equipment, paying employees, taxes, and other creditors, etc. For business owners, it makes sense to jump through those hoops if they expect the process to be clean and smooth, especially if they expect to be able to take cash out of the business after all debts are paid.
If, however, the business has significant operations to shut down, substantial assets to liquidate, claims that eclipse its assets, and pending or likely litigation against the business, then the benefit of expending the effort to wind up the business may not justify the time, expense and heartache of doing so.
In such cases, it may make sense for the business to file for Chapter 7 bankruptcy. In a Chapter 7 case, a Trustee is appointed by the bankruptcy court to oversee the liquidation process. The Chapter 7 Trustee’s primary responsibility is to liquidate property for the benefit of creditors. The filing of a Chapter 7 bankruptcy case creates a constructive "bankruptcy estate,"9 and most or all of the debtor’s property is constructively transferred into the bankruptcy estate. The Trustee is responsible for administering the bankruptcy estate,10 and the Trustee—not the debtor—controls the property of the bankruptcy estate. The Trustee can even continue to operate the business, if the Trustee believes the business has value as a going concern.11
Secured creditors have a right to take possession of their collateral or receive the value of their collateral,12 and the Trustee will be responsible for liquidating any remaining valuable property and distributing proceeds to creditors.13 Often, a Trustee will sell all or substantially all of a debtor’s assets in a lot to a single purchaser at a substantial discount from market value.
The Trustee distributes the proceeds from the liquidation of the bankruptcy estate to creditors according to a well-defined priority system.14 For example, tax claims are generally paid in full before general trade creditors receive a single penny.15
Also, the Trustee may "abandon" property that does not have value to creditors.16 For example, the Trustee is probably not going to take the time to sell a single $50 used office chair and distribute separate checks for $1 each to 50 different creditors.
Automatic Termination of Contracts and Leases
In bankruptcy, most contracts and leases are automatically terminated ("rejected," in bankruptcy parlance), unless the Trustee specifically assumes them.17 Therefore, the debtor does not have to go through the effort of notifying individual contract parties of their intent to terminate, and then bickering about early termination fees and damages, and suffering threatened lawsuits.
If the other contract party would suffer damages as a result of the contract termination, then it will be entitled to a claim in the Chapter 7 case.18 In most cases, contract damages receive the same priority as claims of general trade creditors—in other words, they generally receive nothing unless most other types of creditors are paid in full.
If the debtor has valuable contracts, the Trustee may have the right to "assume and assign" those contracts.19 Common examples of contracts that Trustees assume and assign are leases on desirable real estate that are substantially below-market or license agreements under which the debtor receives royalties. The Trustee can essentially sell the debtor’s valuable contract rights to a third party and distribute the proceeds to creditors.
While the most powerful remedy in bankruptcy—the discharge—is unavailable to business Chapter 7 debtors, businesses in Chapter 7 can enjoy the second-most powerful protection of the Bankruptcy Code: the automatic stay.20
The automatic stay is the absolute prohibition against creditors for most types of debt collection activities, including collection calls and letters, law suits, and enforcement of judgments.21 The automatic stay commences by operation of law the very moment a bankruptcy case is filed. The automatic stay is designed to give debtors a break from their creditors and an opportunity to regroup.
Under some circumstances, creditors can get relief from the automatic stay to continue to pursue their claims against the debtor. The most common circumstances where creditors seek relief from the automatic stay is to take possession of collateral for secured debt.
Chapter 7 can provide some protections and remedies to businesses that are unavailable outside of bankruptcy, such as the "practical" discharge, the transfer of liquidation responsibilities to the Trustee, automatic termination of contracts and leases, and the automatic stay. Nonetheless, Chapter 7 bankruptcy is not a cure-all for businesses burdened with heavy debt that intend to liquidate. It is inappropriate in many circumstances and other non-bankruptcy alternatives should also be weighed when deciding whether to file for Chapter 7.
1 Title 11 of the United States Code, 11 U.S.C. § 101, et seq.
2 11 U.S.C. §§ 524, 727(b).
3 11 U.S.C. § 727(a)(1).
4 A detailed discussion of personal liability for business debts can be found in a previous article by this author, The Limits of Limited Liability for Corporate Officers, Directors, and Shareholders: Eleven Things You Need To Know, DCBA Brief, vol. 21, iss. 4 (Jan. 2009).
5 "Responsible persons" have been defined as "[p]ersons who are required to collect, truthfully account for, and pay over any tax." McLean v. Department of Revenue, 326 Ill.App.3d 667, 761 N.E.2d 226 (1st Dist. 2001).
6 11 U.S.C. §§ 547, 548.
7 18 U.S.C. § 152.
8 11 U.S.C. §§ 524, 727(b).
9 11 U.S.C. § 541.
10 11 U.S.C. § 704.
11 11 U.S.C. §§ 704, 721.
12 11 U.S.C. § 362, 725.
13 11 U.S.C. § 704.
14 11 U.S.C. § 507.
16 11 U.S.C. § 554.
17 11 U.S.C. § 365.
20 11 U.S.C. § 362.
David M. Madden, Of Counsel, Hanson Peters Nye, Barring-ton, Illinois, focusing in business and consumer bankruptcy, creditors’ rights, business litigation, business services, and estate planning; BA, 1998, Michigan State University; JD, 2003, DePaul.