Am I personally liable for my business debts?
It depends on your business structure. If you run your business as a sole proprietorship, your business is not a separate legal entity – you and your business are considered to be the same. You are responsible for your business debts. If the business cannot pay its debts, creditors may come after your personal assets.
Owners of a limited liability company or an S-corp are separate from their business entities, but they still may be liable for some of the company’s debts. If an owner personally guaranteed a loan or other business account, the owner is liable if the business can’t repay. For non-guaranteed debts, in most business bankruptcies, including chapter 11 cases, LLC and corporate business owners are not personally liable for the debts of their business. There are rare exceptions for this rule when owners have not been careful to keep their business distinct from their personal affairs.
For many small business owners, it is not unusual to pledge personal assets, like equity in a home, when they take out a loan for the business. A bankruptcy case may allow you to protect those personal assets from the business’s creditors.
What types of bankruptcy cases can businesses file?
Chapter 7 Liquidation
A chapter 7 case is for individuals or business entities who cannot make regular payments towards their debts. For most businesses, though, a chapter case requires you to close the business.
If you are a sole proprietor, you will be filing a personal bankruptcy case, even if your debts primarily arise from your business activities. Even though a chapter 7 case is known as a liquidating bankruptcy, you won’t necessarily see everything you own be sold: state law allows you to keep certain assets (known as “exempt” assets), instead of having them sold by a trustee to create money to pay back at least some of your debts. Some sole proprietorships can continue operating their business even after a personal chapter 7 case.
If the business is an LLC or S-corp, there are no non-exempt assets, so the bankruptcy trustee will liquidate all of the assets of the business. Frequently, this means that a bank or other lender with a lien on the business assets will simply take them over. In very rare cases, a trustee will decide to operate the business for long enough for it to be sold as a going concern, but most often the business will close.
Chapter 11 Reorganization
If a business wants to continue operations, owners and management may consider a debt restructuring process through chapter 11. Smaller business generally do not pursue this option, though, because a chapter 11 case can be very complex and expensive. It is an option, though, if you are a corporation, partnership, or LLC. The theory behind chapter 11 is that the business can make greater payments to its creditors through continued operations than the creditors would receive in a chapter 7 liquidation.
In a chapter 11 case, a reorganization plan must be submitted and approved by the bankruptcy court. To be approved, the court must consider the vote of the creditors. The business’s reorganization plan generally involves modifying payment terms for existing debts, restructuring debt, or selling assets to generate money to repay some debts. A plan of reorganization can also allow a business to reject burdensome leases and some other contracts, pay tax obligations over time, and to have claims that are in dispute determined by the Bankruptcy Court.
Chapter 11 Subchapter 5 Bankruptcy
In 2019, Congress created a new form of chapter 11 case specifically for small businesses who would find the main type of chapter 11 case to be too expensive and complex. The new small business bankruptcy is enacted under subchapter V of chapter 11 of the Bankruptcy Code, so these new cases are known as “Subchapter 5” cases. The original new statutes provided a streamlined and less expensive bankruptcy reorganization process for small businesses with less than $2,725,625 in debt. When Congress passed the CARES Act in March 2020 to respond to the COVID-19 pandemic, it temporarily raised the debt limit for Subchapter 5 bankruptcies to $7.5 million. This increased debt limit will remain in place through March 27, 2021, although many in the bankruptcy world expect Congress to extend this date if the economy is still feeling the effects of the pandemic.
In a Subchapter 5 case, like a “traditional” chapter 11, management retains control of the company, but it does so under the supervision of a trustee who will be appointed for the case. The trustee’s duties are narrow, but its primary goal is to “ensure that the debtor commences making timely payments required by a plan” and “facilitate the development of a consensual plan of reorganization.”
In a standard chapter 11 case, the company itself has a limited window within which it has the exclusive right to file a plan of reorganization; after that window expires, any other interested party may file a plan, which frequently will conflict with existing management’s goals. In a Subchapter 5 case, only the debtor is permitted to file a plan. Once a plan is filed, there is also a streamlined plan approval process. The debtor must file its plan within 90 days of the date the case is filed. This date can be extended in limited circumstances, but only if the debtor can show that the need for an extension is due to circumstances it could not control. The requirements for the plan itself are streamlined, as well.
Subchapter 5 cases also provide a significant benefit to small business owners over the rules that apply in standard chapter 11 cases. In a standard chapter 11 case, a rule known as the “absolute priority rule” means that holders of equity in a business are not typically allowed to retain their interests in a company unless either all creditors have been paid in full, or the equity owners have paid some form of new value in exchange for the right to retain their ownership interests. This absolute priority rule does not apply in a Subchapter 5 case. Owners may retain their interests without providing new value even if creditors are not paid in full. The plan only has to show that it is “fair and equitable” to holders of unsecured claims. Broadly speaking, this means that a small business in Subchapter 5 must show that it is devoting all of its excess income (over what is required to maintain the business’s operations, including reasonable compensation to its employees and owners) to pay creditors for a period of three to five years.
What rights do creditors have in a bankruptcy case?
Once a company files for bankruptcy court protection, creditors have wide access to all of a debtor’s financial information and other matters that relate to the company’s operation – anything is fair game if it impacts the company’s ability to pay debts. Creditors have the opportunity to object to various transactions if the company’s activities do not meet the requirements set by the Bankruptcy Code and Rules. In large chapter 11 reorganizations, a committee of unsecured creditors is likely to be appointed to monitor the debtor’s case. Debtors are required to file a report of their operations on a monthly basis, and from time to time report other matters regarding the status of the case to the Court. The Court gives careful consideration to the creditors’ reasonable concerns and tries to balance them with the debtor’s rights.