Chapter 7 is a liquidating bankruptcy. It is a liquidation of debts as well as assets. In the context of a business, a Chapter 7 is most often filed in order to close a business. In fact, if the business is a separate legal entity, such as an LLC or a corporation, it must shut down as soon as the Chapter 7 is filed. An LLC or corporation that has filed a Chapter 7 is not permitted to operate. In a Chapter 7 filed by an LLC or a corporation, collections by business creditors immediately halt. A Trustee is appointed by the Bankruptcy Court and that Trustee will collect any and all assets of the business, such as outstanding receivables, money in the bank, tools, equipment etc. The non-cash assets will then be sold by the Trustee, often times at an auction.
After all assets of the business that can be sold are turned into cash, the Trustee pays as much of the business debt as possible. Creditors of the business are then forever barred from collecting against the LLC or corporation and the LLC or corporation is effectively shut down forever.
Alternatively, when an individual who owns a business as a sole proprietor files a Chapter 7 bankruptcy, the sole proprietorship can continue to operate. Remember, as stated above, this is now the individual filing for bankruptcy, as the sole-proprietorship is not eligible. A Trustee is still appointed by the Court, assets are still collected over and above what the law will allow an individual to protect, those assets are still sold, and all collections are still halted by creditors. However, if the business owner is able to operate the business after a potential sale of assets, the law allows the business to continue if the owner so wishes.
In either instance, using a Chapter 7 as a means to wind down and close a business is often an effective way to do so. The assets are sold and creditor collections halt and there is a clean break, allowing the business owner to walk away without further complications.
You have likely heard of Chapter 11 bankruptcy in terms of very large companies such as US Air, General Motors, and Westinghouse. However, Chapter 11 is also often utilized by small and medium size businesses that want to continue to operate, but need to restructure debt. In fact, sole proprietors can even file an individual Chapter 11 bankruptcy as a means to assist with burdensome business debt. Here the focus will be on separate legal entities such as LLC’s or corporations, as these are the most likely filers of a Chapter 11 case.
In general, for a small or medium size business, a Chapter 11 halts collections by creditors for a matter of months, or even years in some instances, so the business can operate without having to pay those debts. The idea is to allow the business to operate with as little overhead as possible in order to make sure the business is viable (i.e. it can make money sufficient to operate without paying any debt) and to allow the business to stockpile cash. Certain secured types of debt, such as mortgages and vehicle loans, must continue to be paid during the Chapter 11 proceeding, but often times at a much reduced rate.
The goal of most Chapter 11 bankruptcy cases is to eventually file a reorganization plan that proposes to pay the business debts over a certain time period. A Chapter 11 plan will often call for the elimination of some or all of some types of debts. This is best explained by using an example. Let’s use the example of our friend, John Smith, and his business “Smith’s Plumbing, LLC”. This example is oversimplified in some ways, but the general ideas in the example are exactly how a Chapter 11 works.
Smith’s Plumbing, LLC has the following debts; a lease for his business space that has three years remaining at $3,000.00 per month, a vehicle loan for his work van that has 2 years remaining at $600.00 per month, an unsecured (no collateral) line of credit with a bank in the amount of $50,000.00, credit card debt of $10,000.00, and vendor debt of $40,000.00. Smith’s Plumbing, LLC makes money but the business is having a down year and it is becoming increasingly difficult to make the payments required by the creditors. The vendor debt is over 90 days old, the bank loan is a month behind, and it’s becoming a struggle to pay the rent.
Smith’s Plumbing, LLC files a Chapter 11 bankruptcy. Immediately, collections halt on the line of credit, credit cards, and the vendor debt. The business still has to pay the rent and the vehicle loan, but that is now possible without having to pay the other debts. The business then operates for about four months under those circumstances. The good news is that business is picking up and is profitable. In even better news, while in the bankruptcy, John, and his counsel, was able to negotiate a new lease with the landlord that extends the term of the lease but reduces payments to $2,000.00 per month. The business was able to do this with the landlord because the bankruptcy gives the business the ability to reject the lease and move to another location with minimal financial repercussions. The landlord decided he would rather have the rent even at a reduced monthly rate.
The business then files a Chapter 11 Plan which proposes to pay the following:
- The landlord will be paid $2,000 per month under the terms of the new lease that was negotiated while in the bankruptcy;
- The van loan will be extended from 2 years to 5 years and the payment will be reduced from $600.00 per month to $240.00 per month;
- The line of credit, credit cards, and vendor debt, which total $100,000.00, will be paid 25% of what they are owed over a 5 year period. After that 5 year period, the other 75% will be permanently eliminated. This requires a monthly payment of $416.00 per month total to those creditors. This saves the business money on a monthly basis and also eliminates $75,000.00 of debt.
After the Plan is filed, the creditors have the opportunity to vote on it. If enough creditors say yes, the Plan can be confirmed by the Court. The creditors all vote yes. Why would they do that? It’s simple. Getting something is better than getting nothing. If the business shuts down, the creditors will most likely get very little if anything, as a plumbing business generally has very little in the way of assets to liquidate. The creditors figure that getting 25% of what they are owed is better than getting 0%.
After the creditors vote, there is a confirmation hearing in the bankruptcy court, and the Plan is officially confirmed. The business is then removed from the bankruptcy and the payments to the creditors begin. Smith’s Plumbing, LLC is now able to operate, cover its debts, and is out of the bankruptcy case.
Every Chapter 11 case is different and presents its own complexities. However, this simple example is a good reflection of what many Chapter 11 cases for small businesses look like. As you can see it can be an extremely useful and effective means of saving what may be a failing business due to crushing debt.
A Chapter 13 is another type of reorganization bankruptcy. A separate legal entity, such as an LLC or a corporation, cannot file a Chapter 13. A Chapter 13 case can only be filed by individuals. This means that even though an LLC or a corporation cannot file a Chapter 13, a sole proprietor can.
A Chapter 13 for a sole proprietor can do similar things that a Chapter 11 can do. It can reduce the amount of debt, reduce monthly payments, and extend the time period to pay certain debts. However, structurally a Chapter 13 is very different than a Chapter 11. In a Chapter 13, the payment plan is filed at the beginning of the case, not towards the end as in a Chapter 11. This means payments start immediately. In a Chapter 13, payments are made to a Court appointed Trustee and those payments are distributed by the Trustee according to the payment plan.
There are various factors that lead to whether a sole proprietor would be better off filing a Chapter 11 or a Chapter 13 that are impossible to list here because they vary by situation. However, Chapter 13 is a viable tool for a sole proprietor to get relief from creditors and continue to operate their business.