Collecting debts is one of the most difficult parts of running a business, especially a small business. Cash flow is important for a company’s vitality. When customers don’t pay, the negative drain on a business’s finances can spill over into other areas, restricting growth and potentially delivering a fatal blow to a struggling company. One of the scariest parts of collecting debts is navigating the bankruptcy process once a business is notified about a debtor’s bankruptcy filing. Part of this process involves understanding the difference between Chapter 7 and Chapter 11 — two of the three main bankruptcy proceedings that can come into play in debt collection.
Understanding how bankruptcy works
Bankruptcy is a legal proceeding to eliminate, modify, and manage debt. In most cases, a debtor (someone who owes money to another) voluntarily files bankruptcy to obtain protection in the debt collection process. Bankruptcy filings can also be involuntary where creditors request that a person or business enter a bankruptcy proceeding, but this is relatively rare. This component, however, illustrates how bankruptcy is not necessarily a bad thing for creditors, as a bankruptcy proceeding can provide the structure for repayment of debts in many cases. The key to understanding how the bankruptcy of a debtor affects your business is knowing the purpose of different bankruptcy chapters.
Chapter 7: Liquidation
Chapter 7 bankruptcies are liquidations. That means that the purpose is to get a fresh start for the debtor. Chapter 7 involves selling all of a debtor’s non-exempt property (things that a debtor is allowed to keep during insolvency). The sales proceeds go towards paying off debts, following a priority system established in a combination of federal and state laws. If the debtor is an individual (and not a business), there is a system of qualification for filing that must be completed. This “means testing” is intended to weed out individuals who might not understand the bankruptcy process or those who have sufficient assets to pay some or all of their debts.
For individual debtors, it’s common to see filings under either Chapter 7 or 13 of the Bankruptcy Code. Unlike Chapter 7, which is intended to zero-out all “dischargeable” debt, a chapter 13 filing anticipates a repayment plan. Sometimes chapter 13 filings are referred to as “wage-earner” bankruptcies, with the idea that a debtor has gotten in over their head in debt, but need assistance restructuring the debt to allow for the repayment of some or all of the obligations.
If a debtor is a business, chapter 7 is a path for dissolving the business entity and discharging obligations. But, sometimes a business debtor, or an individual who operates a business, might want to keep the business going while restructuring debt. Another chapter of the bankruptcy code permits this course of action.
Chapter 11 Bankruptcy: Reorganization of Business Debt
Chapter 11 is generally the path for business debtors to obtain relief from certain debts, while continuing to operate their business. Chapter 11 often involves a corporation, partnership, or other business entity as the debtor, but an individual can also use this chapter to propose a plan of reorganization to keep a business alive while paying creditors over time. Under chapter 7, certain non-exempt property becomes the property of a trustee for liquidation purposes. For example, if an individual files for protection under chapter 7 while having a large sum of cash reserves in the bank, such as $10,000, the bankruptcy trustee will take control of the cash and distribute it to creditors. Under chapter 11, the debtor becomes a “debtor in possession” and owns and manages assets of the business, much as a trustee would.
How Creditors Should Proceed
If your business received notification that a customer or other party that owes your business money is the subject of a bankruptcy proceeding under chapters 7 or 11, there are a few key steps for ensuring that you are protected to the fullest extent of the law. The notification will usually be in the form of a notice of filing received in the mail. It is crucial to know that bankruptcy filing creates an “automatic stay.” This is a legal concept that halts collection most collection activities directed at a debtor. It will stop, at least temporarily, your ability to collect. If you are suing a debtor in state court, your lawsuit will be halted. The automatic stay happens immediately upon filing, so even if you don’t yet know about the filing, it may affect your activities regarding the debt.
Because of the automatic stay and potential liabilities for violating it, businesses should consult with legal counsel about how to proceed in the bankruptcy action. There are methods for lifting the stay, such as in the case of enforcing certain liens, such as a mortgage lien.
It is important for a business to make sure it can substantiate the amount owed, as documentation and payment records may be scrutinized in bankruptcy court. Creditors are also allowed to obtain information directly from the debtor in a meeting, called the meeting of creditors, where the debtor must appear. While many creditors skip attending these meetings, it can be a source of information on how to best get paid.
In addition, creditors should obtain a full copy of the bankruptcy petition. There may be information contained in the filing that is inaccurate and contradictory to your records. As a creditor, you have the ability to object to the discharge of debts under certain circumstances.
While bankruptcy may seem like a scary topic for business owners, it can light a clear path to repayment. With some understanding about the process, business creditors can quickly determine the effect of the bankruptcy filing and protect their rights.
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