Written by attorney Vincent Peter White

Should a Failed Small Business File Chapter 7 Bankruptcy or Simply Wind Down?

There are some underpinning rules that the owners of a failing business should adhere to, regardless of their decision to pursue bankruptcy or simply wind down their business:

  • The board of directors of an insolvent company owes its duty of loyalty to the creditors, not the owners.
  • Creditors claims get paid before the claims of equity holders
  • Management can legally pay some creditors and not others.

The Choice

Chapter 7 Bankruptcy is a liquidation proceeding. During Chapter 7, a Trustee will be appointed by the bankruptcy court to liquidate the company's assets and pay creditors as per the laws of creditor priority. The decision to go bankrupt or to allow the company's management to wind down depends heavily on the value and nature of the assets; the attitudes of creditors; and the availability of management to oversee the process.

Companies can go out of business without filing bankruptcy: they liquidate their assets and cease operations. Creditors have a right to recover their claims from the assets of the corporation. If there are no assets, the corporation cannot be further harmed by lawsuits that try to collect from the corporation.

The danger to management in this approach is the tendency of some creditors to assume that the business's failure to pay means that there is some sort of underhanded activity taking place, and sue the officers as well as the corporation to collect the debt. While the claim against the individuals may be invalid, the individual has to appear and defend in the lawsuit, or a judgment will be entered against him. Sometimes, the individuals are liable.

Personally managing the wind up has advantages, if you are willing to devote the time and energy to the process. On the other hand, filing bankruptcy may protect assets from creditor action, preserving value for the payment of taxes and employees.

Advantages of Management Handling the End

  • Management has experience in the field, and so can usually obtain better prices for assets since they know the market, know the asset and are motivated to get highest recovery
  • Outside of bankruptcy, Management controls who gets paid with the available funds
  • You can act swiftly to limit exposure of management or investors by addressing debts guaranteed by insiders first, subletting space, returning leased equipment, etc.
  • Creditors are protected from having to give back payments that could be considered preferential to the bankruptcy trustee
  • Assets can be sold to insiders so long as the price is fair

Disadvantages of Management Handling the End

  • May prevent management from accepting new employment
  • May require cooperation from creditors and lessors
  • May increase likelihood that a disgruntled creditor will sue individuals too

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