Bankruptcy—Advantages and Disadvantages

If bankruptcy is the only viable business solution, a business generally can use two types of bankruptcy proceedings. Under one, the business is liquidated, so that at the conclusion of the process the business no longer exists. Under the other, the business is reorganized and, hopefully, comes out of the bankruptcy as a viable business structure. Each type of bankruptcy has its unique set of advantages and disadvantages.

Chapter 7—Liquidating Bankruptcy. The biggest advantage to filing bankruptcy to liquidate is that the debtor gets a fresh start. All dischargeable debts are eliminated, and the creditors are absolutely prohibited from going back to the debtor to try and collect the debt. In addition, the liquidation is orderly when under the supervision of a single, independent third party. The debtor’s assets are marshaled, the creditor’s claims verified and accepted, the property sold, and the proceeds distributed based on the priority of the claims. Creditors cannot increase their take by taking preemptive collection action. In fact, under the preference rules, payments made to a creditor within 90 days of filing the petition can be recovered from the creditor.The court will also ensure that a reasonable price is obtained for the assets, thus maximizing the value received. This can be particularly important when there are co-debtors or other guarantors that have an obligation to pay the debt if the debtor cannot. The debtor is spared the costs of responding to multiple collection actions, including lawsuits, since the bankruptcy court has jurisdiction over the entire case. But Chapter 7 has disadvantages as well. Perhaps the biggest disadvantage is the cost. Bankruptcy is an expensive process, and the monies paid in professional fees, filing fees, and other costs could arguably have been better spent in reducing the debtor’s liabilities. This may be particularly true when there are few creditors or when related parties have agreed to guarantee the debtor’s liabilities. Another disadvantage is the time and effort of the bankruptcy process. Since the court will direct the liquidation, it is the court, not the debtor, that sets the schedule. If the creditors are also arguing over various issues, the time it takes to liquidate can be increased. This can prove to be inconvenient and frustrating, particularly if the debtor is trying to operate a new business.

Chapter 11—Reorganization. The biggest advantage to using Chapter 11 to reorganize a business is the ability of the court to control the process. The debtor is given breathing room and is normally left in charge of the business. The debtor is also given the opportunity to develop the reorganization plan free of creditor pressure, although the creditors must ultimately approve it. Furthermore, the automatic stay provisions prevent creditors from taking legal action outside the bankruptcy reorganization that could harm the debtor or jeopardize a successful reorganization. Unfortunately, many reorganizations simply do not work and end up converting to liquidating bankruptcies. The main disadvantage of Chapter 11 is the cost of the proceedings and the oversight that will be provided by the court and creditors. The debtor is under a duty to the court and the creditors to operate the business and must seek approval for any action outside the course of business. The debtor effectively operates in a fishbowl, which can be an unpleasant experience since most business owners are not used to having every decision scrutinized and second-guessed.

Obviously, tax and legal advice should be sought when contemplating bankruptcy. Please contact us for further guidance on this topic.

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