When closing down the troubled business or sale of the business are not practical alternatives, you should consider bankruptcy. Bankruptcy in the United States is governed by federal statute and is administered by a special part of the federal court system. The chapters included in the Bankruptcy Reform Act of 1978 that are most applicable to businesses are Chapters 7 (Liquidation) and 11 (Reorganization). If the business has many creditors, a formal bankruptcy process may be the most effective way to prepare the business for exit (through a reorganization under Chapter 11) or to close the business (through a liquidation under Chapter 7).
The bankruptcy process starts with a petition. Petitions for court protection can be either voluntary or involuntary in Chapters 7 and 11 proceedings. A voluntary petition is filed by the troubled company. If the company will not petition voluntarily and if there are 12 or more creditors, at least three creditors with unsecured claims totaling at least $5,000 must join to file an involuntary petition. When there are fewer than 12 creditors, a single creditor with unsecured claims greater than $5,000 is sufficient to file an involuntary petition. The only requirement is that either the debtor is in equitable insolvency – meaning that bills are not being paid as they come due – or that, within 90 days before the petition, a receiver, assignee, or custodian has taken possession of substantially all property. If, in the court’s opinion, the required circumstances do not exist, the judge may grant judgment to the company for costs, attorney fees, damages, and even sentence the petitioner to jail. Thus, an error in filing an involuntary petition can be very severe.
Upon the filing of a petition, an automatic stay takes effect. The stay halts the efforts of creditors to collect funds due to them, to obtain a lien or seize assets, or otherwise to gain any unfair advantage. It restricts secured creditors from taking further actions to collect claims or to enforce liens, but, unlike unsecured creditors, their interest continues to accumulate while the stay is in effect. Creditors are prohibited from sending dunning letters, using set offs, or enforcing pre-petition judgments against the debtor. A secured creditor can gain relief from a stay only if the creditor can prove the debtor has no “equity interest” in the secured property, the property is not necessary for an effective reorganization, or the protection of the property value is insufficient. The court has broad latitude in providing adequate protection of a creditor’s security in the property.
Covenants or clauses that place a debtor in automatic default are nullified by the automatic stay when a debtor files for bankruptcy. Also, a trustee may assume, reject, or assign executory contracts and unexpired leases even if prohibited by the contract or lease. These creditors, however, may file claims for proven damages, subject to certain limitations. Limitations are also placed on claims under employment contracts. Because many small businesses use secured forms of financing such as accounts receivable lines, the priority of secured creditors can have a major impact on a business in bankruptcy. Property pledged as security is not supposed to be taken for the benefit of any other party until the secured debts have been satisfied. Consequently, businesses in Chapter 11 bankruptcy reorganization usually seek to have secured creditors forgo foreclosing on their collateral while the business is in reorganization.
The law establishes classes of creditors (listed in their order on the priorities “ladder” on liquidation). They are secured creditors, administrative and priority claims, general creditors, and equity holders. The law, which is highly technical in this area, also creates subgroups in these major classifications, which are relevant in allocating distributions and in related negotiations.
The secured creditors are taken care of first with the proceeds of the assets they hold as security. Any portion of the secured debt unsatisfied by the secured assets becomes part of the company’s unsecured-debt pool. Any value more than the debt remains with the company. Then, the bankruptcy process turns to the unsecured creditors, working down the liquidation priority ladder. First on the priority ladder is the administrative classification. This group includes the administrative expenses of the bankruptcy proceeding itself, expenses of the trustee, and any legal fees. This priority group also includes:
- Creditors whose claims stem from activities occurring following the court’s determining it has jurisdiction
- Creditors whose claims arose between the date of filing and this determination or the appointment of a trustee
- Wages, including vacation and severance pay, from 90 days before the petition was filed to the present time or from 90 days before the business ceased operations
- Liabilities to benefit plans incurred within 180 days of the petition filing
- Customer deposits
Distributions to the general creditors, including secured creditors’ deficiency claims, come after distributions to the priority creditors. Equity holders rank last and are often wiped out.