Most people think of Chapter 7 bankruptcy as something only for individuals. But businesses can use it to get rid of their debt burdens.
Chapter 7 is the only chapter of bankruptcy that permits the liquidation of assets in order to repay the debtor’s obligations. When an individual debtor files for Chapter 7, their assets are divided into those assets their state allows them to keep (called exempt assets) and those assets that state does not permit them to keep (called nonexempt assets). Once all of the debtor’s nonexempt assets have been liquidated, the money will be used to repay as many of the debtor’s obligations as possible. Any obligations not repaid are then dismissed by the court.
When a business, whether it’s a corporation or a sole proprietorship, files for bankruptcy the procedure is generally the same. The company’s assets are liquidated to repay their debts and any unpaid debts are discharged. However, whether the business owner or the stockholders will lose their asset depends on the type of business.
If the business is a sole proprietorship then there won’t be any stockholders, just the owners of the business. In this case, creditors can and will reach the owner’s personal assets to repay the business’s debts during Chapter 7 if the business’s assets prove insufficient.
If the business is a partnership then who will lose assets depends on the type of partnership it is. General partners will usually be personally liable for the partnership’s debts while limited partners and investors will only be held liable up to the amount they invested in the business.
Something similar will happen with corporations (publicly traded corporations). The stockholders will always be held liable up to the amount of their investment. This means that if a corporation files for Chapter 7, the stockholders could potentially lose all their stock when it becomes worthless.
The board of directors on the other hand, may not lose anything. Unless the creditors or stockholders can show that the board of directors did something grossly negligent that led the company into Chapter 7, the board of directors will not be personally liable for the corporation’s debts.
The owners of a limited liability company (LLC) will also be personally liable for the company’s debts, and depending on creditor or managerial requirements, shareholders may be at risk too. Some creditors of new LLCs will require shareholders to co-sign the company’s obligations, thus making them personally liable for the company’s debt.
Another difference, and perhaps the most important difference, between Chapter 7 for businesses and Chapter 7 for individuals is what happens after the debtor’s assets are liquidated and the debts forgiven. Once an individual’s debts have been repaid or discharged, they are free to rebuild their finances and their credit.
However, if a business files for Chapter 7 there is no chance for the company to recover and rebuild. While under Chapter 11, a business can and is encouraged to continue their operations, Chapter 7 is a company’s swan song.
Once a company files for Chapter 7 protection the owners are required to wrap up the company’s affairs as part of the proceedings. All contracts and agreements have to be concluded and the company can no longer enter into contracts or agreements. Finally, the proceeds from the company’s assets are distributed as if the company was undergoing normal dissolution proceedings. This means that secured creditors will be paid first, then unsecured creditors, stockholders according to dividend preference, and if there are any assets left, to the owners.