Business Bankruptcy FAQs

Chapter 7 bankruptcy of a business involves its liquidation and should be viewed as a last resort when all other reasonable and realistic alternatives to chapter 7 have been explored and exhausted. Alternatives to chapter 7 for a business may include obtaining new sources of debt financing or capital investment, sale of assets or sale of the business in whole or in part, an out-of-court workout with creditors, or a restructuring under chapter 11 bankruptcy. If none of these alternatives are viable, management or owners of a business may want to file a chapter 7 liquidation for a financially troubled business that is unable to pay its debts or has debts greater than assets (i.e., insolvent). If a business is insolvent or in the zone of insolvency, there is a developing body of case law that holds that management no longer has a duty to the owners (i.e., shareholders or other equity holders) of the business, but rather to its creditors. By filing a chapter 7 bankruptcy, management can ensure that creditors’ claims are dealt with in a single unified proceeding and that the debtor’s assets are not stripped apart by different creditors pursuing their individual legal remedies, such as by judgment enforcement. The decision whether a chapter 7 is appropriate for a particular business must be made based on the facts applicable to that business.

The filing of a chapter 7 bankruptcy creates an automatic stay (discussed further above) which is comprehensive and bars virtually all creditor collection activity, including commencement and continuation of lawsuits and enforcement of judgments against the debtor’s assets. When a business files chapter 7 bankruptcy an interim trustee is appointed by the U.S. Trustee’s office to marshal and liquidate the debtor’s assets and distribute them to creditors. The interim trustee becomes the permanent trustee unless a different trustee is elected by creditors. The trustee has the ability to collect and pursue the receivables and claims (including legal claims and causes of action) of the debtor. In order to promote equality of treatment of similarly situated creditors, the Bankruptcy Code gives the trustee the ability to recover certain pre-bankruptcy transfers of the debtor as preferential or fraudulent transfers (discussed further above).

Chapter 11 can permit management or owners of a business to restructure the debt of the business and reorganize the business. The filing of bankruptcy creates an automatic stay (discussed further below) which is comprehensive and bars virtually all creditor collection activity, including commencement and continuation of lawsuits and enforcement of judgments against the debtor’s assets. In chapter 11 the business can seek to reorganize as a going concern, or to sell its assets in whole or in part. Chapter 11 is an attractive method for asset purchasers to acquire assets because through a sale in the bankruptcy court pursuant to section 363 of the Bankruptcy Code they can ensure that they are acquiring assets free and clear of all liens and claims (including tax claims). A chapter 11 bankruptcy also provides a mechanism for a business to reject burdensome leases and contracts (discussed further below). Chapter 11 should not be viewed as a panacea or first resort. However, it can be a very useful way for a financially troubled business to restructure its debts in appropriate situations, force creditors to accept a repayment plan over time when they are not willing to do so out-of-court, or attempt to preserve the “going concern” value of its assets in a sale. The decision whether chapter 11 is appropriate for a particular business must be made based on the facts applicable to that business and it will not work for all companies.

One of the benefits of chapter 11 to a business debtor is that it has the choice to assume or reject its ongoing contracts and unexpired leases, and can reject financially burdensome ongoing contracts and unexpired leases. The claims of the other side to the contract or unexpired leases (such as a real estate landlord that leases space to the chapter 11 debtor or a company that leases trucks to the chapter 11 debtor) for rejection damages are treated as pre-petition unsecured claims in the bankruptcy. The Bankruptcy Code also caps a landlord’s lease rejection damages claim (to one year’s rent or 15%, not exceeding 3 years, of the remaining term of the lease).

Unlike chapter 7, when a business files for chapter 11, a trustee will usually not be appointed and the debtor will remain a “debtor in possession” (DIP) with the same management in place unless the bankruptcy court orders a trustee appointed for “cause” (including fraud, dishonesty, incompetence or gross mismanagement of the affairs of the debtor by its current management), or if the court determines that appointment of a trustee is in the best interest of creditors.

A branch of the Department of Justice tasked with overseeing the administration of bankruptcy cases, the U.S. Trustee plays an oversight role, particularly in chapter 11 cases. It does this primarily through reviewing operating reports the debtor is required to file and tracking the progress of the case against benchmarks set in the early stage of the case.

A creditors’ committee is routinely appointed in chapter 11 cases by the U.S. Trustee and ordinarily consists of unsecured creditors who hold the seven largest unsecured claims against the debtor. The creditors’ committee consults with the debtor on administration of the case, investigates the debtor’s conduct and operation of the business and participates in developing a reorganization plan. The creditors’ committee in a chapter 11 case may, with the approval of the Bankruptcy Court, hire attorneys, accountants, and other professionals (such as financial advisors).

The main goal of a chapter 11 case is to obtain approval of a plan of reorganization to restructure the the debtor’s financial affairs. The Bankruptcy Code gives the debtor the exclusive right to file a plan for the first 120 days of the case (which can be extended not more than 20 months from the date the case was filed). A creditors’ committee, or even individual creditors, can file a plan of reorganization once the debtor’s exclusive filing period has lapsed (or been lifted by the Court). Debtors in chapter 11 must be represented by attorneys. Creditors committees typically also hire attorneys.

An assignment for the benefit of creditors is a state law alternative to bankruptcy. Article 2 of the New York Debtor & Creditor Law specifies the procedures and requirements for an assignment for the benefit of creditors. It involves the assignment by a debtor to an assignee of all of the debtor’s property pursuant to a written assignment agreement. The assignee then collects and liquidates the property and satisfies creditor’s claims in accordance with the procedures specified in the Debtor & Creditor Law. The New York Supreme Court has jurisdiction over the proceeding. Unlike some states where they are regularly used, assignment for the benefit of creditors is a rarely used device in New York. One draw back with it, compared to bankruptcy, is that there is no nationwide automatic stay created by the commencement of the case. However, in certain circumstances the overall costs of administration may be cheaper than in a bankruptcy case thereby resulting in a greater return to creditors. In addition, the administration of the case may also be faster than in a bankruptcy case.

A receivership is a proceeding in which a receiver is appointed for an insolvent corporation, partnership, limited liability company or other business entity, or individual, to preserve and/or recover its assets for the benefit of the affected parties. New York law provides for appointment of a temporary receiver to preserve property that is the subject of a lawsuit prior to judgment where there is danger that the property will be removed from the state, lost, materially injured or destroyed. A receiver can also be appointed in connection with enforcement of a judgment in certain instances. For NY corporations, Article 12 of the NY Business Corporation law provides for appointment of a receiver to preserve assets or in connection with the dissolution of a corporation. Similar provisions exist under the laws of other jurisdictions. A receivership is a non-bankruptcy alternative that can be particularly useful to preserve the rights of creditor pending judgment. It is a remedy commonly utilized by mortgage lenders to collect real property rents in buildings against which they hold a mortgage.

An involuntary bankruptcy filing is a bankruptcy filing that it commenced against a debtor by petitioning creditors. An involuntary bankruptcy case may be commenced under chapter 7 or chapter 11 against a person or business entity by three or more petitioning creditors (or 1 or more creditors if the debtor has less than 12 creditors) holding noncontingent, undisputed claims aggregating at least $16,750 (as of April 1, 2019 and to be adjusted every 3 years) based on the debtor’s failure to pay debts as they become due, or the appointment of a custodian over substantially all of the debtor’s assets (such as an assignee for the benefit of creditors)