Bankruptcy is a legal proceeding, guided by federal law, designed to address situations wherein a debtor—either an individual or a business—has accumulated debts so great that the individual or business is unable to pay them off. Bankruptcy law does not require filers to be financially insolvent at the time of the filing, but rather applies a criterion in which approval is granted if the filer is "unable to pay debts as they come due." Once a company is granted bankruptcy protection, it can terminate contractual obligations with workers and clients, avoid litigation claims, and explore possible reorganization avenues.
Bankruptcy laws are designed to distribute those assets held by the debtor as equitably as possible among creditors. Most of the time it also frees the debtor or "bankrupt" from further liability, but there are exceptions to this. Bankruptcy proceedings may be initiated either by the debtor—a voluntary process—or by creditors—an involuntary process. "The Bankruptcy Code is a world of its own," wrote Lawrence Tuller in Getting Out: A Step-by-Step Guide to Selling a Business or Professional Practice. "A completely separate set of laws come into play under which a business or an individual must perform. State and federal laws that we all live by from day-to-day are not applicable. New laws, mysterious to all except the bankruptcy lawyers, concerning contracts, wages, debtor/creditor relations, individual rights, and so on, go into effect." For this reason, business consultants commonly urge their clients—whether debtor or creditor—to secure legal help in all instances in which bankruptcy comes into play.
Certainly, client/customer bankruptcy is a reality that many small business owners confront if they are in business for any length of time. Declarations of personal bankruptcy in the United States reached a record 1.35 million in 1997, and analysts expect that this surge will continue. "Bankruptcy in the United States is a form of credit insurance," explained Michelle Clark Neely in Business Perspectives. "Bankruptcy rates are rising because more Americans are living closer to the financial edge. For a variety of reasons—a strong economy, easier credit, a desire to not just keep up with, but also surpass, the Joneses—many households are biting off more than they can chew. Throw in a couple of curveballs like a divorce or a major medical illness, and it's not surprising that so many Americans are striking out."
Individuals may file either Chapter 7 or Chapter 13 bankruptcy. Under Chapter 7 bankruptcy law, all of the debtor's assets—including any unincorporated businesses that he or she owns—are totally liquidated (with the exception of exempt assets that the law deems necessary to support the debtor and his dependents, such as home equity). This "liquidation bankruptcy" is the most common filing for business failures, accounting for about 75 percent of all business bankruptcy filings.
In these cases, the federal bankruptcy court hearing the case is provided with a full listing of all the debtor's assets and liabilities. The court then undertakes the process of dividing those assets among the various creditors by appointing a trustee to oversee distribution of proceeds. Unpaid taxes are given top priority, and secured creditors are generally the next entities to be considered. Indeed, the best protection that a small business can have when a customer enters bankruptcy is to obtain collateral for that debt (in the form of equipment, real estate property, etc.). According to many experts, secured creditors can expect to receive an average of 75 percent of what is owed them, whereas unsecured creditors receive less than 3 percent of owed monies from debtors that go bankrupt. "Because all assets are sold to pay outstanding debt, a liquidation bankruptcy terminates a business," observed John Pearce II and Samuel DiLullo in Business Horizons. "This type of filing is critically important to sole proprietors or partnerships, whose owners are personally liable for all business debts not covered by the sale of the assets unless they can secure a Chapter 7 bankruptcy allowing them to cancel any debt in excess of exempt assets. Although they will be left with little personal property, the liquidated debtor is discharged from paying the remaining debt."
In March 2001, however, the Bush Administration signed into law new regulations making it more difficult for individuals to file for Chapter 7 bankruptcy. Applicants for this type of protection must now meet a means test showing that they are unable to pay their creditors. If a bankruptcy court determines that the debtor can repay $10,000 or 25 percent of the total debt (whichever is less) over the course of five years, the debtor is required to file instead for Chapter 13 bankruptcy protection. The legislation also provides some shielding of retirement funds from creditors. Up to $1 million in IRA accounts is off-limits to creditors, as is all money in 401 (k) retirement accounts. Finally, the new laws shield up to $100,000 of a home's value if it is purchased within two years of a bankruptcy filing, and the entire value of the home if it was purchased more than two years before the bankruptcy filing.
A far less severe bankruptcy option for individuals and businesses whose straits are not quite so hopeless is Chapter 13. Under Chapter 13 laws, debtors turn over their finances to the court, which subsequently allocates funds and payment plans at its discretion. "Chapter 13 filers …are allowed to retain more assets than Chapter 7 filers, but must agree to pay creditors their outstanding debt—in full or in part—over a period of three to five years," stated Michelle Clark Neely in Business Perspectives. "In both types of bankruptcy, certain types of debt are not eligible for discharge, including alimony, recent income taxes, child support, and government-backed student loans." As with Chapter 7 bankruptcy cases, unsecured creditors are least likely to be compensated for their losses.
"Chapter 11 laws exist to protect the company, pure and simple," commented Tuller. "The individual has no rights, the unsecured creditors have few rights, and the secured bank creditors have substantial rights. The court places the company's interests first, secured creditors second, and leaves the rest to fend for themselves, including the owner." This bankruptcy option is open to incorporated businesses who still hope to recover from their financial difficulties. It is utilized in situations wherein business operations can reasonably recover if granted a reduction in debt load and an opportunity to implement new strategic initiatives. Since there is no financial test to determine eligibility, a business can voluntarily elect to file for Chapter 11 protection at any time (involuntary Chapter 11 status can also be placed on a company if three or more creditors holding undisputed claims choose to take such a step). "Reorganization bankruptcy is a reasonable alternative for an endangered firm," wrote Pearce and DiLullo. "Chosen for the right reasons, and implemented in the right way, it can provide a financially, strategically, and ethically sound basis for advancing the interests of all the company's stake-olders."
Companies generally turn to Chapter 11 protection after they are no longer able to pay their creditors, but in some instances, businesses have been known to act proactively in anticipation of future liabilities. Once a company has filed under Chapter 11, its creditors are notified that they cannot press suits for repayment (though secured creditors may ask the court for a "hardship" exemption from the general debt freeze that is imposed). Creditors are, however, permitted to appear before the court to discuss their claims and provide data on the debtor's ability to reorganize. In addition, unsecured creditors may appoint representatives to negotiate a settlement with the debtor company. Finally, creditors who feel that the debtor company's financial straits are due to mismanagement or fraud may ask the court to appoint an examiner to look into such possibilities.
Once a company asks for Chapter 11 protection, it provides the court, lenders, and creditors with a wide range of financial information on its operations for analysis even as it continues with its day-to-day operations (during this period, major business expenditures must be approved by the court). The business will also prepare a reorganization plan, which, according to CPA Journal contributor Nancy Baldiga, "details the amount and timing of all creditor payments, the means for effectuating such payments (such as the sale of assets, refinancing, or compromise of disputed claims), and the essential legal and business structure of the debtor as it emerges from Chapter 11 protection." Another important component of this plan is the disclosure statement, which presents projected business fortunes, proposed financial settlements with creditors and equity holders, and estimates of the liquidation value of the company. "The information included in the disclosure statement is critical to a creditor's evaluation of the reorganization plans offered for acceptance, as compared to possible other plans or even liquidation," wrote Baldiga.
The reorganization plan, if approved by the court and a majority of creditors, becomes the blueprint for the company's future. Principal factors considered in determining the feasibility of reorganization proposals include:
Small businesses that find themselves unable to collect on money owed them because of bankruptcy proceedings generally have few options with which to protect themselves. There are instances, however—usually when the debtor is engaged in questionable or fraudulent business activities—when small business creditors do have additional legal avenues that they can explore. In situations where the debtor has incurred debt only a short time before filing before bankruptcy, creditors can sometimes obtain judgments that put added pressure on the debtor to make good on that liability. In addition, noted the Entrepreneur Magazine Small Business Advisor, "the law provides for a '60-day preference'rule. This rule is designed to prevent debtors from paying off their friends right before they file bankruptcy while leaving others stiffed. The 60-day rule allows the court to set aside any payments made up to 60 days before the actual filing of bankruptcy. Creditors who have been paid must return the money to the bankruptcy court for it to be placed in the pot. Business owners should keep in close contact with their ongoing customers so that they will have a good enough relationship to know far in advance to avoid being caught up in this rule." Indeed, small business owners in particular should always be watching for clients/customers who show signs of being in financial distress. If such indications become present, the owner needs to determine the depth of that distress and whether his or her small business can withstand the likely financial repercussions if that client/customer declares bankruptcy. If a bankruptcy declaration would be a significant blow, then the business owner should weigh various alternatives to protect his/her business, such as cutting back on business dealings with the endangered company or tightening up credit arrangements with the firm.
Finally, advisors typically counsel small business creditors to file confirmations of debt with the court even if it seems highly unlikely that they will ever be compensated. This filing allows creditors to write off the bad debts on their taxes.
Companies that run into serious financial difficulties have several options other than bankruptcy that they can pursue, depending on their individual situations. One possibility is for the company to liquidate its own business assets in order to make payments to creditors. "Such action may be achieved efficiently if [the business's] creditors and assets are few in number and the assets are of a type that can readily be converted to cash," wrote Pearce and DiLullo. "If the number of creditors is large and the assets are numerous and difficult or time-consuming to sell (such as real estate), the protection, structure, and authority of the court may be needed."
Another option is for the company to voluntarily place liquidation of assets in the hands of a trustee, who subsequently pays creditors. The principal advantage of this avenue, say Pearce and DiLullo, is that the assets are thus protected from individual creditors who might otherwise file liens on the assets. "Composition agreements," meanwhile, can be used in situations where creditors agree to receive proportional (pro rata) payments of their claims in return for freeing the debtor company from the remainder of its debts.
These alternative strategies may enable some business owners to avoid the stigma of filing for bankruptcy But Pearce and DiLullo note that pursuing these options involves considerable risk: "astute creditors will recognize such actions as precursors to bankruptcy and may modify their relationships with [the company], which could precipitate a bankruptcy filing. If creditors believe that continuing in business will result in reduced assets, they may force a bankruptcy in order to stop operations and preserve the existing assets to pay outstanding debts."
Baldiga, Nancy R. "Practice Opportunities in Chapter 11." CPA Journal. May 1998.
Elias, Stephen, Albin Renauer, and Robin Leonard. How to File for Chapter 7 Bankruptcy. Nolo Press, 1999.
The Entrepreneur Magazine Small Business Advisor. John Wiley, 1995.
Neely, Michelle Clark. "Personal Bankruptcy: The New American Pastime?" Business Perspectives. January 1999.
Pearce II, John A, and Samuel A. DiLullo. "When a Strategic Plan Includes Bankruptcy." Business Horizons. September/October 1998.
Sheppard, J.P. "When the Going Gets Tough, the Tough Go Bankrupt: The Questionable Use of Chapter 11 as a Strategy." Journal of Management Inquiry. No. 1, 1992.
Snyder, Stephen. Credit After Bankruptcy. Bellwether, 2000.
Tuller, Lawrence W. Getting Out: A Step-by-Step Guide to Selling a Business or Professional Practice. Liberty Hall, 1990.
SEE ALSO: Business Failure/Dissolution