Corporate Bankruptcy Explained

When a corporation gets into financial trouble, the company may be able to file for bankruptcy protection. In some ways, corporate bankruptcy is like consumer bankruptcy. But, there are also important differences. In this article, you’ll learn how the two types of business bankruptcy differ, how each works, and how corporate bankruptcy is different from personal bankruptcy.

The Two Business Bankruptcies

The two types of bankruptcy available to a corporation are Chapter 7 and Chapter 11. Chapter 7 is also known as liquidation bankruptcy. Chapter 11 involves a reorganization plan. A corporate Chapter 7 bankruptcy case dissolves the company. A corporate Chapter 11 case is complex and expensive, but may allow the business to keep operating. 

While the two types of bankruptcy serve different purposes and play out very differently, they share some common features. For instance, the U.S. Bankruptcy Code allows for an automatic stay in both Chapter 7 and Chapter 11 cases. The automatic stay is a court order that stops creditors from trying to collect on debts for as long as the order is in effect. 

Business bankruptcy is also unique because creditors can force a company into bankruptcy. Although this is technically true for individuals as well, it is extremely rare for creditors to push an individual into bankruptcy. But, since a corporation that can’t pay its bills may have significant assets, the creditors of a corporation do occasionally start an involuntary bankruptcy proceeding. Through this process, they can push a company into either Chapter 7 or Chapter 11 bankruptcy.

Chapter 7 Bankruptcy for Business

Chapter 7 bankruptcy for businesses is much like a consumer Chapter 7 case in some ways. But, a business doesn’t have to qualify for Chapter 7 bankruptcy based on income--the means test is only for consumers. The means test isn’t the only step corporations that file Chapter 7 get to skip. Consumers have to complete credit counseling and a financial management course. Business filers don't. 

Another difference is that liquidation in a corporate bankruptcy case is complete. A consumer filing Chapter 7 keeps exempt property and is free to move forward, make more money, and rebuild after bankruptcy. But, for a corporation, Chapter 7 liquidation is complete. There are no exemptions. All property of the corporation is used to pay creditors. If the property serves as collateral for a loan, it may be surrendered to the secured creditor. The bankruptcy trustee will sell all of the company’s remaining assets to pay creditors. This includes everything from real estate to intellectual property, business inventory, and even office furniture.

A business filing Chapter 7 bankruptcy doesn’t get a discharge, either. Instead, the corporation ceases to exist. Owners of the business are generally not liable for debt remaining after a Chapter 7 case. However, an owner or other person who has personally guaranteed corporate debt may still be responsible for payment of any remaining balance. 

Of course, companies file bankruptcy when they are in financial trouble. That means that creditors usually won’t be paid in full through the bankruptcy. The amount each creditor receives depends on the company’s assets and how the U.S. Bankruptcy Code prioritizes the type of debt.

Chapter 7 is the more likely option for a small business in financial trouble. This type of bankruptcy allows the leadership of a failing business to wrap up the company’s affairs through a single process. And, the process is relatively quick. 

Chapter 11 Bankruptcy for Businesses

Like Chapter 7, Chapter 11 protection is available to both businesses and individuals. However, very few individuals file Chapter 11 bankruptcy. The complexity and higher cost of Chapter 11 make it a poor choice for most personal bankruptcies. Individuals who want to resolve debt without liquidation typically file Chapter 13 bankruptcy. One reason an individual might file under Chapter 11 would be that their debt was larger than allowed in a Chapter 13 case.

When you see in the news that a large corporation has filed for bankruptcy, it’s usually Chapter 11. General Motors and Chrysler both filed Chapter 11 cases during the Great Recession. Most of us think of a bankrupt company as one that has little value. But, large corporations that file Chapter 11 often have tens or even hundreds of millions of dollars in assets. Many, like both of the auto manufacturers mentioned here, emerge from bankruptcy and continue operating. 

But, the Chapter 11 bankruptcy process is complex. The business may continue to operate while in bankruptcy. Often, the company will operate on a “debtor in possession” (DIP) basis. That means the company’s leadership continues to run operations during the bankruptcy case, often with a new infusion of cash in the form of a DIP loan. But, it’s far from business as usual.

The value of the company will be reassessed, and a reorganization plan will be proposed. The assessed value of the company may be reduced, and the amount of debt may be cut, too. Stockholders generally lose out when that happens. Secured creditors get first priority in a Chapter 11 case. Unsecured creditors, including bondholders, come in second. Stockholders don’t get paid at all unless there’s money left over. So, if the amount of debt the company will pay is cut, there won’t be anything left for shareholders.

Bondholders will stop receiving payments during the bankruptcy. Ultimately, they may be issued new bonds, or issued stock in the reorganized company, in place of the original bonds. Depending on the new valuation of the company and the amount of debt, these replacement bonds or shares may be worth less than the original bonds. 

Approving a Plan of Reorganization

Creditors play a much more active role in Chapter 11 than they do in other types of bankruptcy. The U.S. trustee will appoint certain creditors to serve on a creditors’ committee. This committee represents the interests of unsecured creditors as the plan of reorganization takes shape. The committee may negotiate with the debtor company and with other creditors to create a plan that treats creditors fairly while moving the company toward profitability.

The reorganization may include restructuring, such as selling off part of the company or merging with another entity. It may involve sale of some assets, layoff of employees, new investment capital, changes in product or service offerings, and streamlining of processes. This process can revive a company, but it doesn’t always work that way.

If creditors don’t believe that the company can operate profitably or the reorganization appears to be failing, creditors may be able to force the company into liquidation. That’s what happened in one of the largest retail bankruptcy cases in United States history. Toys R Us entered Chapter 11 to manage $5 billion in outstanding debt. But, after a very weak holiday season, the company defaulted on its DIP loan and creditors decided liquidation was the best way to protect their interests. 

Business Bankruptcy is Complicated

Business bankruptcy is different from personal bankruptcy, for both public companies and smaller businesses. Bankruptcy law doesn’t provide the same protections for businesses that it does for individuals. That means no property is protected in a Chapter 7 case. And, if a company files Chapter 11 planning to restructure and continue operations, it could still be forced into liquidation. 

Chapter 11 bankruptcy proceedings are especially complex. Any company that is considering bankruptcy should seriously consider consulting a business bankruptcy attorney before taking any action. It is also wise to consult an attorney if your company is significantly behind on debt payments, since failure to resolve those debts could result in an involuntary bankruptcy proceeding. Creditors with significant claims in a business bankruptcy case, including bondholders, could also benefit from the guidance of an experienced bankruptcy lawyer or creditors’ attorney. In a Chapter 11 case, a well-prepared creditor with a good-sized claim can often influence the reorganization plan. 

Upsolve Helps Individuals Resolve Debt through Chapter 7 Bankruptcy

Luckily, personal Chapter 7 bankruptcy cases are less complicated than business reorganizations. With the right resources, many individuals and couples successfully file Chapter 7 on their own. Consumers also enjoy greater protections, including exemptions for certain types of property and the bankruptcy discharge. 

If you’re struggling financially and aren’t sure which way to turn, look around. This site is rich with resources to help you understand your options, from credit counseling and debt management plans to Chapter 7 or Chapter 13 bankruptcy. If you decide Chapter 7 is right for you and want to file on your own, we may be able to help. 

Once you’ve learned more about how we help, you can answer a few questions to find out whether you’re eligible for assistance. If you don’t qualify or you just don’t want to go it alone, we can also help you find a local bankruptcy attorney.