Bankruptcy: For the Small Business, Sole Proprietor or Professional

Planning is important. For example, a person who owns a small business may want to cease doing business before filing a Chapter 7 bankruptcy in order to minimize the impact of creditor actions which will follow shortly after the filing, such as involuntary shut down of bank accounts. Because a corporation's debts are not dischargeable in a Chapter 7 liquidation, Chapter 7 treatment of corporate debt may be deemed unnecessary, but often its owner/s have guaranteed some of the corporate debt and it may be necessary for the owner to file a Chapter 7 case, indicating in his bankruptcy filing that he does business under the corporate name. In this circumstance, the owner's personal assets may be in jeopardy.

Sometimes, when the debtor intends to cease doing business, a careful review of the debtor's financial life will reveal alternatives to bankruptcy that are more advantageous such as corporate or LLC dissolution, other liquidations or peaceful surrender of property.

In situations where a sole proprietor or shareholder of a small corporation or member of an LLC has guaranteed company debts and thus exposed personal assets to collection by the company's creditors, a Chapter 13 bankruptcy filing for the principal may protect the personal assets. Some sole proprietors or other entity principals who wish to remain in business may find that a Chapter 13 filing better meets this goal while gaining control over personal and/or business debt.

A Chapter 13 "debtor engaged in business" case may be helpful to a small corporation/LLC owner or sole proprietor where Chapter 11, with its expense, complexity and ongoing challenges may not be the most practical approach for some small business entities.

Chapter 7: For a sole proprietor with low value personal assets and who may be personally liable for some or all of his business as well as his personal debts and who may not wish to continue operating the business, a Chapter 7 filing may be an appropriate answer to debilitating debt. An owner of a small corporation may also find relief under Chapter 7 appropriate under certain circumstances. A corporation itself, however, is not eligible to receive a discharge of its debt in Chapter 7. In Missouri, a bankruptcy of a member of a partnership effectively dissolves the partnership. On the other hand, a partner's right in specific partnership property will not usually be subject to taking by creditors or a bankruptcy trustee to pay a partner's personal debts. When dissolution is caused by a bankruptcy filing of a partner, each partner, unless otherwise agreed, may have the partnership property applied to discharge its liabilities, and the surplus applied to pay in cash the net amount owing to the respective partners. In this instance, the filing partner's interest would likely be paid to the bankruptcy trustee.

Chapter 13: There are two types of Chapter 13 cases that may apply to self employed and small business owners:

  • The standard individual Chapter 13 case
  • The "debtor engaged in business" Chapter 13 case.

The former may be appropriate for a self employed person in a service business who works out of his home, has little in the way of business assets, has no employees and whose creditors do not extend trade credit to the business.

A "debtor engaged in business" Chapter 13 case, on the other hand, is a type of bankruptcy case appropriate for those persons who own or have a substantial interest in a business which employs others, uses trade credit, has assets or inventory with significant value and likely owns or leases space outside his home to operate the business. This type of Chapter 13 case may be useful for the small business debtor who wishes to remain in business but who may not need or wish to undertake the significant expense associated with a Chapter 11 reorganization.

While there are several advantages to the Chapter 13 business case approach to debt management, there are also responsibilities for periodic reporting of the current income, expenses and operations of the business and providing other information required by the U.S. Trustee or the Court. A Chapter 13 business debtor may continue operating his or her business, obtain unsecured debt or credit and sell or lease property in the ordinary course of business, among other things. If the debtor has pledged accounts receivable or other so-called "cash collateral" as security for bank or other loans, he will need Court approval or the creditor's consent before making use of such assets.

It will be helpful to be able to explain at your first appointment what stock or other interest in any corporation or unincorporated business you my have; what LLCs, joint ventures or partnerships you participate in; what types of business assets your company has such as accounts receivable, furnishings, fixtures, equipment, inventory, interests in other entities, etc. The Chapter 13 Trustee has a form which business debtors must complete on or before the first meeting of creditors. A copy is attached so that you can begin to address some of the Trustee's questions as soon as your first meeting with Mr. Brown. Again, planning is important.

Chapter 11: Chapter 11 permits a person or business to reorganize while obtaining protection from creditors. The goal is to obtain court approval of a plan providing for the restructuring of its debts. The plan is first submitted to creditors accompanied by a disclosure statement describing the debtor's business and the proposed plan. The debtor need not be insolvent to qualify for relief under Chapter 11, but the debtor must have a good faith reorganization purpose. A Chapter 11 debtor, whether an individual, corporation, LLC, or other entity, retains its property and conducts its business, thus serving as a "debtor‑in‑possession."

You are known as a debtor in possession because you keep possession of the bankruptcy estate assets while reorganizing your debts. You remain in possession until one of the following occurs:

  • Your reorganization plan is confirmed
  • Your case is dismissed
  • Your case is converted to a chapter 7 bankruptcy case
  • A bankruptcy trustee is appointed

It is uncommon for a bankruptcy trustee to be appointed in a chapter 11 case unless the court determines that you are incompetent or dishonest, have committed fraud, or have mismanaged the bankruptcy estate.

As a debtor in possession, you would perform many of the duties that a bankruptcy trustee would perform in cases filed under other bankruptcy chapters, such as filing required documents with the court. You also have many of the rights of a bankruptcy trustee, such as the right to hire professionals to assist you, and the right to use, sell or lease property of the bankruptcy estate. The debtor enjoys the exclusive right to file a reorganization plan for the first four months after the filing of the Chapter 11 petition and, if filed within that time period, an additional 60‑day exclusive period in which to solicit acceptances of the proposed plan from creditors.

It may be necessary to file any number of what are called "first day motions" to avoid disruption of the business. A debtor-in-possession must have court approval to make payroll, to continue using business bank accounts, use cash collateral in which a creditor has an interest, among other things. Waiting until the last minute to file bankruptcy may not provide enough time to obtain approval of such payments and procedures and avoid interruption to the business, making any reorganization or even a liquidation of an operating company much more difficult or impossible.

Considerable time may need to be devoted to preparation for such motions and other matters be necessary before the Chapter 11 filing. Again, bankruptcy requires planning.

What follows is a little more detail regarding rights and duties of and restrictions on a debtor in possession. The list is not intended to be exhaustive.

After the Chapter 11 case is filed, the debtor‑in‑possession may, among other things:

  • within the first 4 months after filing, file a plan of reorganization;
  • use, sell, or lease business property‑‑except cash collateral‑‑in the ordinary course of business,
  • bring avoidance actions;
  • obtain unsecured credit and unsecured debt in the ordinary course of business,
  • assume or reject contracts and leases.

Among other things, the debtor‑in‑possession has responsibility to:

  • file a list of its creditors with the 20 largest unsecured claims;
  • file schedules of assets and liabilities and statements of financial affairs;
  • attend a first meeting of creditors;
  • notify institutions holding the debtor's accounts;
  • convert bank accounts to "debtor-in‑possession" bank accounts;
  • safeguard the company's assets, including cash;
  • file monthly operating reports and pay quarterly fees to the Office of the United States Trustee;

Unless the debtor‑in‑possession has first obtained court approval, the debtor may not:

  • pay pre-bankruptcy petition debts,
  • pay its attorneys or other professionals,
  • use cash collateral in which a creditor holds an interest unless the creditor's consent has been obtained,
  • incur secured debt or make unusual use of business property.

Attorney fees in a Chapter 13 and Chapter 11 business cases. A small business debtor considering bankruptcy will generally require legal counsel. The pre-filing factual and legal analysis which must be undertaken to properly advise the debtor is time consuming and can be challenging. The debtor should expect that an initial fee will be charged before a significant analysis is undertaken by counsel.