What Happens When a Company Files for Bankruptcy: 7 Consequences for Owners and Creditors

If your company files, the first step is for most collection efforts to stop. You can then choose between Chapter 7 bankruptcy, in which a trustee sells its nonexempt assets, and Chapter 11 bankruptcy, where you keep running it but propose a plan to repay creditors. In either case, owners are paid last, if at all.

You’ll need a statement of financial affairs and schedules of your assets, liabilities, contracts and leases. As soon as you file, an “automatic stay” usually kicks in. All at once, almost everything stops: phone calls, lawsuits, harassment. You don’t need a court order; it’s automatic.

In Chapter 11, at first, you are the “debtor in possession,” which is a fancy way of saying you get to keep running things. Generally, a confirmed plan wipes out most of the company’s old debts.

In Chapter 7, a trustee takes over the business and may keep it running for a brief time. Usually, though, the business closes for good, and the trustee sells its assets to pay creditors. The trustee works for the unsecured creditors and the owners usually get nothing. Within 21 to 40 days after filing, a meeting of creditors occurs. Someone from your company will testify under oath about the financial affairs of your business.

You can let go of many contracts you no longer want to keep if they haven’t been fully performed yet on both sides. This includes leases for equipment or real estate, which can be huge expenses. However, commercial leases generally need to be kept or rejected within 120 days of filing (though a court can add 90 days), or they are rejected automatically. The landlord would be left with only an unsecured claim for damages, which may be worth far less. But it’s an advantage: they might rather work out a better deal with you.

In a Chapter 11 bankruptcy, the amount you pay secured creditors is based on the value of the property, not the loan amount. So it can be far less than what they’re owed. The lender could file an unsecured claim against the bankruptcy estate for the difference, and that’s often repaid at a steep discount.

Certain creditors get to vote on the plan. The plan must pass muster on a number of criteria, but it doesn’t have to be approved by everyone. Each class of “impaired creditors” must either accept the plan or, in a “cramdown,” the plan must be “fair and equitable” to that class.

In general, secured creditors are paid before unsecured creditors. While some creditors can be left with nothing, employees come ahead of most unsecured creditors. Wages earned in the 180 days before filing are a priority claim, up to $17,150 per worker. At the very end, owners share any remaining assets.

Small Business Bankruptcy

There is an option for small businesses with no more than $3,424,000 in debts (and meets a few other requirements). They can go through the “small business bankruptcy” process under Subchapter V of the bankruptcy code, in which they can enjoy the benefits of Chapter 11 but in a less expensive and quicker process. Under it, you may still keep the company, and continue to have equity in it, even if the creditors don’t get paid in full as long as you dedicate all your projected disposable income to making the plan payments.

In a Subchapter V bankruptcy, only the owner’s company may file a plan of reorganization. And the plan usually needs to be filed within 90 days, which is a short period. However, there are also some advantages to this smaller and faster type of bankruptcy, such as that there will usually be no unsecured creditors committee appointed that you need to negotiate with, and there are no quarterly fees due to the U.S. Trustee. A trustee is always appointed, though. Typically, there’s a status conference before the judge within 60 days to see how things are going. A disadvantage of Subchapter V is that because it’s a new process, the courts have not yet had the chance to resolve how to deal with many of the issues that arise during the bankruptcy case. Another disadvantage is the strict debt cap.

In Chapter 7, only individuals can get a discharge. A business entity (LLC, corporation, partnership) cannot. And if you signed a personal guarantee, a creditor could sue you directly. The IRS can go after you even if you have filed bankruptcy, if the money withheld from your employees’ paychecks was never paid over. The debts that arose from fraud can also usually survive a bankruptcy.

In some cases, a trustee may go after cash you or your company paid to other creditors. The trustee can then take it back, up to 90 days before filing in a regular Chapter 11 or 7 case, and 365 days if it went to an “insider” (such as an owner or officer). Some payments are protected and may not be clawed back. You can defend any payments that were made in the ordinary course of business. In a business case, transfers under $8,575 total can’t be clawed back.

You pay the Chapter 11 court fees up front: $1,738. The case can take months or years. There will be substantial legal fees for lawyers and for your financial advisors, your accountant, and other professionals. The unsecured creditors may be represented by a committee that can fight back against the terms of the plan. There may be conflict and opposition between you and your creditors.

To compare options, reorganizing can make sense if the business is basically sound but buried in debt. If there’s no viable way forward and few valuable assets, liquidation may be the better option. It takes time to gather the information needed, especially if you’re trying to choose the right options before you file. In any type of bankruptcy, you will need to get and keep good legal advice in order to understand and protect your rights.