Difficult Decisions: Whether to file Chapter 7 or Chapter 11 Bankruptcy and What It Will Mean for You and Your Business

By: Maureen Weidman*

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Business owners are faced with a multitude of decisions that need to be made every day. Many of these decisions are to be expected. Some of them aren’t. Sometimes, the weight of business debt can make business owners feel like they are staring down an endless dark tunnel. Unfortunately, business owners around the world are often faced with one of the hardest decisions of all: deciding whether to file bankruptcy.

This Post is aimed at teaching readers about bankruptcy and outlining the major differences between the two types of bankruptcy available for businesses: Chapter 7 and Chapter 11.

What Is Chapter 7 Bankruptcy?

Chapter 7 bankruptcy is a form of liquidation bankruptcy that is available to both individuals and businesses under the Bankruptcy Code. In liquidation bankruptcy, the debtor must put all assets into an estate. The estate is then managed by a trustee who sells the assets and distributes the proceeds to the creditors.

Most people are familiar with Chapter 7 bankruptcy in the individual context, where an individual debtor puts assets into the estate (leaving out certain exempt items like a homestead) and the rest is liquidated and distributed to creditors. Afterwards, the debtor receives a discharge and begins a “fresh start” free from debt.

Chapter 7 does not have the same end result for businesses. For businesses, there is no “fresh start” after Chapter 7 bankruptcy because businesses cannot receive a discharge from Chapter 7. Like in the individual context, the debtor puts all of the business assets into an estate and a trustee manages the estate by selling the assets and distributing the proceeds to the creditors. Meanwhile, the business owner has a passive role in a Chapter 7 bankruptcy.

Because Chapter 7 is the point of no return for business owners, many choose to avoid it for as long as possible. However, there is no shame in deciding that Chapter 7 is the best decision for your business. Many hopeful business owners begin in Chapter 11 and end up in Chapter 7 after multiple unsuccessful attempts to restart their businesses. If you have doubts that you will be able to reorganize, you may save yourself future time and anguish by filing Chapter 7. Click here for information about Chapter 7 for businesses.

How Is Chapter 11 Bankruptcy Different?

Chapter 11 bankruptcy and Chapter 7 bankruptcy have similarities, but their outcomes for businesses are like night and day. Chapter 11 bankruptcy is not liquidation, but reorganization.

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Reorganization in the Chapter 11 context is just what it sounds like: the business gets a new lease at life under the shelter of Chapter 11 bankruptcy. One of the first protections that any debtor receives in bankruptcy is the protection of the automatic stay.  Pursuant to the automatic stay, all collection proceedings must stop.  This means that everything from harassing phone calls to foreclosure proceedings will come to an abrupt end.

Although the automatic stay applies in Chapter 7 as well, it is less meaningful there, since the business is effectively dying when it files for Chapter 7.  In Chapter 11, the automatic stay provides some solace to business owners as they formulate plans to reorganize.

The comfort from the automatic stay is somewhat short-lived because Chapter 11 involves a great deal of work.  Like in Chapter 7 bankruptcy, the business assets are transferred to an estate.  Unlike in Chapter 7, in Chapter 11, the business itself is the trustee.  In the Bankruptcy Code, the business is referred to as the “debtor in possession.”  The debtor in possession has all the rights and powers of a trustee.  This is helpful for business owners who care a great deal about their business and wish to maintain control over it.

There are several hurdles that business owners should be aware of before filing Chapter 11.  One of the first challenges that business owners will have to face in Chapter 11 is creating a plan of repayment and getting that plan confirmed.  In Chapter 11, the unsecured creditors must approve of the plan before it is confirmed.  Also, in order for any business to succeed, it must have financing. Obtaining financing can be tricky even for stable businesses, let alone businesses that are already experiencing financial difficulties. This is why the Bankruptcy Code creates incentives to help Chapter 11 businesses get the financing they need to regroup.  Click here to learn more about chapter 11 and financing.

How Do I Choose?

Choosing whether to file Chapter 7 or Chapter 11 bankruptcy may be one of the most difficult decisions a business owner can make. We have discussed some of the differences between the 2, but there are a few other considerations.

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Chapter 7 bankruptcy is much shorter.  On average, a debtor stays in Chapter 7 for about 6 months.  To the contrary, Chapter 11 can take years to accomplish.  Even then, the success rate of Chapter 11 is rather dismal, some scholars have estimated as little as 10%.  Many businesses attempt to reorganize under Chapter 11, and when they fail, are forced into Chapter 7.

Statistics like these beg the question why any business owner would ever file Chapter 11. However, there are success stories.  For major airlines, filing Chapter 11 bankruptcy may even be considered a right of passage.  Ultimately, business owners must consider the consequences of both Chapter 7 and 11 and decide whether they are willing to put in the effort necessary to succeed in Chapter 11.  As always, if you are considering filing bankruptcy, be sure to consult an attorney to see what options are best for you and your business.

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*This post was checked for currency on September 20, 2018 and reproduced with permission by author Maureen Weidman.  Original post can be found here.

Maureen Weidman is a 2018 graduate of Penn State’s Dickinson Law. She is originally from Rochester, NY and came to Pennsylvania to attend Gettysburg College where she earned her Bachelor’s degree in English. She is now an associate at Smigel, Anderson & Sacks, LLP in Harrisburg, PA, where she practices estate planning, business planning, and tax planning.

Sources

1. See http://www.creditslips.org/creditslips/2015/04/why-has-chapter-11-failed-as-a-reorganizing-chapter-.html.
2. See 11 U.S.C. § 701, et seq.
3. See 11 U.S.C. § 1101, et seq.
4. See Michele M. Arnopol, Why Have Chapter 11 Bankruptcies Failed So Miserably: A Reappraisal of Congressional Attempts to Protect a Corporatin’s Net Operating Losses after Banktruptcy, 68 NOTRE DAME L. REV. 133, 134 n. 6 (2014).

Author: Prof Prince

Professor Samantha Prince is an Associate Professor of Lawyering Skills and Entrepreneurship at Penn State Dickinson Law. She has a Master of Laws in Taxation from Georgetown University Law Center, and was a partner in a regional law firm where she handled transactional matters that ranged from an initial public offering to regular representation of a publicly-traded company. Most of her clients were small to medium sized businesses and entrepreneurs, including start-ups. An expert in entrepreneurship law, she established the Penn State Dickinson Law entrepreneurship program, is an advisor for the Entrepreneurship Law Certificate that is available to students, and is the founder and moderator of the Inside Entrepreneurship Law blog.