Jonah Patel
Corporations and LLCs are separate legal entities from their owners, protecting them from business liabilities. However, bankruptcy is a situation where owners may be forced to confront the financial fallout. In the US, corporations can file for bankruptcy under Chapter 7 or Chapter 11. Chapter 7 involves the liquidation of assets and the dissolution of the company, with proceeds going to creditors. Chapter 11 allows the company to reorganise and continue operating, paying creditors over time. Shareholders are often left with little to no compensation in either scenario. This introduction will explore the nuances of corporate bankruptcy, the impact on investors, and the legal framework surrounding it.
| Characteristics | Values |
|---|---|
| Types of bankruptcy | Chapter 7, Chapter 11, Chapter 12, Chapter 13, Chapter 15 |
| Chapter 7 | Company stops all operations, trustee sells assets, proceeds go to pay off debt |
| Chapter 11 | Company reorganises, continues to operate, may be sold in a Section 363 sale |
| Chapter 11 shareholders | Usually little to no compensation, rarely receive shares in the new company |
| Chapter 12 | For family farmers and fishermen |
| Chapter 13 | For individuals with regular income to adjust debts |
| Chapter 15 | For international cases |
| Trustee | Can recover money or property using "avoiding powers" |
| Trustee's "avoiding powers" | Setting aside preferential transfers to creditors, undoing security interests, pursuing non-bankruptcy claims |
| Bankruptcy court | May authorise trustee to operate the business for a limited time |
| Bankruptcy reorganisation plan | Explains investors' rights and what they will receive |
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What You'll Learn
Chapter 7 bankruptcy
When a corporation or LLC files for Chapter 7 bankruptcy, a trustee is appointed to liquidate the company's assets and distribute the proceeds to creditors. The company's operations are halted, and it goes out of business. The appointed trustee has the power to recover assets for creditors and investigate the company's financial dealings. The trustee may also bring suits against officers for the recovery of loans or advances made to them.
There are a couple of situations where filing for Chapter 7 bankruptcy for a corporation may be advantageous. Firstly, when a creditor is about to lien or levy on assets that could be used to pay off debts for which shareholders or officers are personally liable. Secondly, when the services of a bankruptcy trustee are required to liquidate assets and oversee the winding up of the business, allowing the corporation's officers to seek employment elsewhere. Lastly, filing for bankruptcy may discourage creditor suits against the corporation, which often involve officers and shareholders, regardless of their legal liability for the debt.
It is important to note that Chapter 7 bankruptcy for corporations and LLCs does not discharge their debts. This means that the company's debts remain, but there is no longer a business entity to pay them. This can result in creditors collecting from individuals who agreed to be personally liable for the business's debts.
Before filing for Chapter 7 bankruptcy, it is recommended to consult with a bankruptcy lawyer to understand the specific circumstances and explore alternative options, such as Chapter 11 or 13 bankruptcies.
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Chapter 11 bankruptcy
A corporation or LLC has two options for filing bankruptcy: Chapter 7 liquidation or Chapter 11 reorganisation. Chapter 11 bankruptcy allows a company to continue operating under a reorganisation plan. This type of bankruptcy is generally filed by corporations that need time to restructure debt that has become unmanageable.
A Chapter 11 case begins with the filing of a petition with the bankruptcy court serving the area where the debtor has a domicile, residence, or principal place of business. A petition may be a voluntary petition, filed by the debtor, or an involuntary petition, filed by creditors that meet certain requirements.
A Chapter 11 bankruptcy will result in one of three outcomes for the debtor: reorganisation, conversion to Chapter 7 bankruptcy, or dismissal. In order for a Chapter 11 debtor to reorganise, the debtor must file (and the court must confirm) a plan of reorganisation. Most Chapter 11 cases aim to confirm a plan, but that may not always be possible. If the judge approves the reorganisation plan and the creditors all agree, then the plan can be confirmed.
Chapter 11 of the United States Bankruptcy Code permits reorganisation under the bankruptcy laws of the United States. This type of reorganisation is available to every business, whether organised as a corporation or partnership.
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Shareholder and investor rights
When a company files for bankruptcy, it is usually because it is in deep financial trouble and unable to pay its immediate obligations. The rights of shareholders and investors are affected by the type of bankruptcy filed, which could be Chapter 7 or Chapter 11.
Chapter 7 bankruptcy is a more terminal option for a company. It involves the complete cessation of operations and liquidation of the company's assets to pay off its debts. A trustee is appointed to sell the company's assets, and the proceeds are used to pay off creditors and debtors. Shareholders are third in line for repayment, after secured creditors and bondholders, and may not be fully compensated for the value of their shares.
Chapter 11 bankruptcy allows a company to reorganise and restructure its debts while continuing operations. The company's management still oversees daily operations, but significant decisions are directed to the bankruptcy court for approval. In this scenario, common stock shares become practically worthless and stop paying dividends. Shareholders may not receive any compensation for their shares and will lose their investment entirely.
In both cases, the value of the company's stock often declines significantly or becomes worthless. Shareholders may receive some compensation, but this is dependent on the proportion of ownership they hold in the company and the overall value of the company's assets.
It is important to note that bankruptcy does not always mean the end of a company. Some companies can make successful comebacks after restructuring, and investors can learn from the bankruptcy reorganisation plan what their rights are and what they can expect to receive. However, the securities of companies in bankruptcy often continue to trade, and investors should be aware that trading in the shares of a bankrupt company is incredibly risky.
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Debt discharge
Chapter 7 bankruptcy covers or "discharges" credit card balances, medical bills, past-due rent payments, payday loans, overdue cellphone and utility bills, car loan balances, and even home mortgages in as little as four months. It is important to note that not all debts are discharged under Chapter 7. Debts that are not discharged include alimony, child support, certain taxes, certain educational benefit overpayments or loans guaranteed by a governmental unit, debts for willful and malicious injury, debts for death or personal injury caused by the debtor's intoxicated operation of a vehicle, and certain criminal restitution orders. Additionally, Chapter 7 filers should be aware that they may not receive a discharge for all their debts and that their credit report will show the debt "discharged in bankruptcy" for up to ten years.
In contrast, Chapter 11 bankruptcy allows for the reorganization of a company's debts without liquidating its assets. This option is suitable for corporations that need time to restructure their debts and return to normal business operations. While Chapter 11 does not result in the immediate discharge of debts, it provides a framework for the company to address its financial obligations and work towards a sustainable future.
The availability of debt discharge in bankruptcy proceedings offers a crucial safety net for individuals and businesses facing financial distress. By eliminating or restructuring overwhelming debts, debtors can regain their financial footing and work towards a more stable future. However, it is important to carefully consider the specific circumstances and seek legal advice before initiating bankruptcy proceedings.
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Personal liability
Corporations are separate legal entities from their owners, which means that the business itself is liable for its debts. However, there are certain situations in which a business owner can be held personally liable for corporate debt.
Firstly, if a business owner has signed a "personal guarantee" for a loan or debt, they become personally liable for it. Financial institutions often require small corporations to secure loans with personal property, such as a house, boat, or car. If the business defaults on the loan, the lender can sue to foreclose on the property and use the proceeds to repay the debt. Filing for Chapter 7 personal bankruptcy can discharge this type of personal liability, but the lender's lien on the collateral remains, meaning the debt must be paid off if the property is sold.
Secondly, a creditor can attempt to hold a business owner personally liable by "piercing the corporate veil". This occurs when a court finds that the corporation is a sham and the owner is operating the business as if it didn't exist, or when the business is inseparable from its owner. Creditors may argue that corporate formalities were not followed, such as holding annual meetings and keeping minutes, or that owners commingled personal and company funds. If the court pierces the corporate veil, the owner may lose the limited liability protection and become personally liable for corporate debts.
Additionally, business owners can be held personally liable if they misrepresented or lied about facts when applying for a loan or credit on behalf of the corporation. This includes making fraudulent representations or omissions that harm the creditor.
It is important to note that personal liability for business debts depends on the business structure and how it was formed. While corporations and LLCs offer limited liability, sole proprietors and partners are generally responsible for business debts. In the case of bankruptcy, the business structure determines the process and whether personal assets are used to pay business debts. Under Chapter 7, the company ceases operations, and a trustee liquidates its assets to pay off debts. Chapter 11 allows the business to continue operating under a reorganization plan, giving it a chance to restructure its debt.
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Frequently asked questions
Chapter 7 and Chapter 11.
The corporation stops operating and a trustee is appointed to liquidate its assets. The proceeds are then used to pay off the corporation's debts.
Chapter 7 bankruptcy results in the end of the corporation, whereas Chapter 11 allows the corporation to reorganise and continue operating.
Shareholders are often left with little to no compensation for their investments. In the case of Chapter 7 bankruptcy, shareholders may not be fully compensated for the value of their shares.
Corporations must file for bankruptcy under Chapter 7 or Chapter 11 of the bankruptcy code. This can be done by contacting the U.S. Bankruptcy Courts or by calling the IRS to speak with a bankruptcy specialist.
