How Can a Company Go Bankrupt? 5 Ways a Case Begins, Including One the Company Does Not Choose

A business ends up in bankruptcy court in one of two ways: the company chooses to file bankruptcy, or its creditors force it into bankruptcy. The difference is simple, but the implications can be dramatic. If the company chooses to file, this is called a voluntary bankruptcy filing. If creditors force the company to file bankruptcy, it is known as an involuntary bankruptcy filing.

Depending on the circumstances, company directors will consider five different ways to start a bankruptcy case. They will file Chapter 7 if the best path is to close the company, or Chapter 11 if the best outcome is to reorganize. If the company is a small business, they may consider Subchapter V. If the business is unincorporated, its owner may choose Chapter 13. The other option is that creditors force the company into bankruptcy through an involuntary filing.

It’s when the petition is filed that a bankruptcy case begins and the “automatic stay” goes into effect. That’s the feature of the bankruptcy law that stops most lawsuits, foreclosures, repossessions and debt collection.

Chapter 7

When a company’s directors decide that the business should close, they will file a petition for bankruptcy relief under Chapter 7 of the bankruptcy code. When a company files Chapter 7, in effect the bankruptcy code gives power over the company to a court-appointed trustee who serves as the bankruptcy equivalent of a receiver. The trustee takes over the company bank accounts, sells the assets, and pays company obligations that arose before the bankruptcy filing (the bankrupt company’s creditors) according to the Chapter 7 priority system. A voluntary Chapter 7 filing makes sense when a company doesn’t have the resources to keep its doors open, or if its directors conclude the company will struggle unsuccessfully in the future.

In a Chapter 7 case, the bankruptcy is for the company that filed; it’s the LLC or corporation that is the “debtor” in the case. Business entities don’t get a discharge. If a business is a corporation and files Chapter 7, its creditors may still turn around and sue the people who signed their personal guarantees.

Reorganization

If the company’s directors conclude the company should keep its doors open to rehabilitate, then the better choice may be to file for bankruptcy relief under Chapter 11. A company that elects Chapter 11 does so to stay in business and develop a long term plan for repaying debt - a “reorganization.” In a Chapter 11 case, the company and its board of directors usually stay in control during the bankruptcy process as a ”debtor in possession.” Its reorganization is normally approved by the company’s creditors and by the bankruptcy court, after which the reorganized company can continue operating under the terms of its confirmed reorganization plan. Chapter 11 lets your company unload bad contracts and rebalance its cost structure. This gives you leverage in negotiating a new lease deal that both you and the landlord can live with.

Creditors vote on the plan and they can vote to reject it. If they do, the court still has the option to confirm the plan anyway in a maneuver bankruptcy practitioners call a “cramdown.” But to make that happen, you have to show that your plan is fair to the creditor or creditors you are jamming, so they don’t get a raw deal. A court can also value collateral. If the debt is higher than its value, then some of the debt can be declared an unsecured debt, and that often results in paying only part of the debt back. On the other hand, Chapter 11 is complicated and expensive, and may take years.

If a company wants to reorganize but doesn’t want the expense and delay of a full Chapter 11, Subchapter V provides a road to a simpler reorganization for businesses under certain size limitations. The most a company can owe and still be eligible for a Subchapter V bankruptcy is $3,424,000 in debt. That debt ceiling goes up every three years with inflation. Another limitation is that over half of the company’s debt has to come from business activities. In a Subchapter V case, a bankruptcy court trustee is assigned to the case and works with everyone to reach a deal. The company that files only has 90 days to submit a bankruptcy reorganization plan, but the company’s owner may be able to keep their equity stake. Generally, no disclosure statement is required, there’s no creditors committee, and quarterly fees to the U.S. trustee aren’t owed.

The fourth way, Chapter 13, is not for companies, but for individuals, including business owners. A sole proprietor may be able to reorganize their business affairs under Chapter 13 as long as their unsecured debt is less than $526,700.

File an Involuntary Bankruptcy Petition Against the Company

The fifth way a company ends up in bankruptcy court is when one or more of its creditors start the case and file an involuntary bankruptcy petition against the company. The filing of an involuntary petition can only be done under Chapter 7 or 11. Creditors have to meet a few qualifications to do this. They have to hold undisputed, unsecured claims against the company that together total at least $21,050, and at least three creditors must get together to file the case if the company has twelve or more creditors total. If there are fewer than twelve creditors, one creditor is enough to initiate an involuntary bankruptcy.

After the creditors file an involuntary petition, the company can fight the petition. When the bankruptcy court decides whether or not to grant the creditors relief, it will look at whether the company is generally not paying its debts as they come due. When you receive notice of an involuntary bankruptcy, the clock starts ticking. You’ll only have 21 days from the date the summons is served to file the paperwork contesting it. If creditors are gunning for your business in an involuntary bankruptcy filing, the business may try to defeat the creditors’ petition by showing that it is current on its obligations and that it pays its bills on time.

If you have questions about filing or defending a bankruptcy, attorneys with experience in business bankruptcy can help you get answers.