What Is Commercial Bankruptcy?

Like a consumer, a business sometimes finds itself in the uncomfortable position of being unable to pay its debts. One solution is to file for bankruptcy, a legal process in federal bankruptcy court that releases the business from the obligation to pay all or some of its debts.

Bankruptcy Choices for Small Businesses

Businesses must choose among alternative types of bankruptcies, each of which corresponds to a different chapter of the federal Bankruptcy Code. Businesses usually choose either Chapter 7 or Chapter 11, or occasionally may be eligible for Chapter 13. Sometimes businesses can be involuntary drawn into bankruptcy by their creditors, who face stiff financial penalties if they initiate an involuntary bankruptcy for invalid reasons.

Chapter 7

Chapter 7 bankruptcies are called liquidation bankruptcies. Chapter 7 is usually employed by consumer debtors, but can also be used by businesses that want to liquidate their assets to be relieved of debt. A Chapter 7 bankruptcy is commenced when the business files a petition with the bankruptcy court. The court then orders an automatic stay of all collection action against the business and its property. A court-appointed trustee manages the details of the bankruptcy, selling business assets to satisfy business debt, to the extent possible. At the conclusion of the proceeding, remaining debts of the business are not discharged as with an individual debtor, but generally the business ceases to exist because its assets are gone and it is no longer a profitable concern.

Chapter 11

In Chapter 11 bankruptcies, which are usually filed by businesses and rarely by individuals, the commercial debtor is usually allowed to stay in business throughout the bankruptcy proceedings. A business debtor may only operate independently in its ordinary course; transactions outside the ordinary course of business require court approval.

A Chapter 11 proceeding, like one under Chapter 7, is initiated by filing a petition, but a trustee is not automatically appointed. Although the bankruptcy judge may decide to appoint a trustee in a Chapter 11 case, it is the exception rather than the rule. As in Chapter 7, the filing of the bankruptcy petition stops creditors from attempting to collect their debts.

Although liquidation is a possibility, the debtor usually files a proposed plan of reorganization. The plan of reorganization sets forth in detail how the debtor intends to conduct its business, while continuing to make payments to its creditors. In some situations, creditors may also propose plans of reorganization. Creditors are divided into classes with varying rights depending upon the types of debt they hold. The approval process involves negotiation and input from creditors. Ultimately, a plan must be approved by the court. In some cases, the court approves the plan even though some of the creditors did not. If no plan is approved, however, the bankruptcy may be converted to Chapter 7 liquidation or may be dismissed.

The choice between Chapter 7 and Chapter 11 is not necessarily permanent; once proceedings have begun, a case may be converted to a different chapter, under certain circumstances.

Bankruptcy may not be the best option for every business, but sometimes it is the best choice a business owner can make. Alternatives to bankruptcy include working informally with creditors toward a repayment plan or assigning assets for the benefit of creditors. A lawyer experienced in bankruptcy law can advise a business about whether bankruptcy better meets its needs than other options.

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