When an individual files for Chapter 7 relief, the goal is to keep their exempt property and discharge their dischargable debts. A corporation does not receive either of these benefits in Chapter 7, meaning that it turns over all of its property to be liquidated and still owes the remainder of its debts after the case is over. So why would a corporation ever for Chapter 7?
Bad Stuff Can Happen
Before going into the reasons for a company to file Chapter 7,let me talk about some more of the negatives. When a company files Chapter 7, the Trustee gets to look into its financial affairs. If the owners have been paying themselves back in the year before bankruptcy, the Trustee can sue to recover that money. If the board has breached its fiduciary duty, the Trustee can sue them. Additionally, when a company files for Chapter 7, the attorney-client privilege now belongs to the Trustee so the Trustee can ask the lawyer what the company's insiders discussed with counsel. These are all reasons why filing Chapter 7 can have negative consequences for the people who made the decision to file. Finally, filing Chapter 7 does not dissolve a company under state law so that once the case is over, there is still a corporate shell
Considerations for a Corporate Chapter 7
So why would a corporation file Chapter 7? Over the years, I have given clients several reasons why a company might file Chapter 7.
If a company still has assets, management might elect to file Chapter 7 to turn over the liquidation process to a third party. Under the corporate trust fund doctrine, management of an insolvent company can be personally liable if they take those assets and put them in their own pockets. Collections lawyers are always looking for someone else to sue and letting a Trustee investigate the company's finances and then do the actual liquidation gives some protection to the Board. If a company has third party investors, they might be quick to question management's decision to handle the wind-up on their own (especially when the Board forgot to mention that the company was in financial peril).
A second reason is when a company is facing multiple lawsuits and doesn't have the money to pay defense counsel. If the company does nothing, judgments will be entered and the company will be served with post-judgment discovery. If the post-judgment discovery is ignored, a court may compel the officers and directors to answer it. Bankruptcy schedules and the statement of financial affairs contain much of the same information as would be provided in post-judgment discovery but the information just has to be provided one time. Yes, judgment creditors could pursue the company after Chapter 7, but a collections lawyer with a contingent fee agreement is likely to close the file once bankruptcy is filed.
Filing Chapter 7 may be of particular value where the insiders would like to purchase the assets. If the board authorizes a sale of technology that hasn't been monetized to an insider, they are setting themselves up for a breach of fiduciary duty suit. On the other hand, if the insider negotiates a deal with the Trustee and gets a court order approving the sale, both the board and the purchasing insider should be protected. Of course, someone else could always bid more but at least the Board would have done its duty by letting a third party Trustee handle the sale.
A third reason to file Chapter 7 is where a creditor is bringing weak alter ego or fraudulent transfer claims against the owners for the sake of harassment. If the company files Chapter 7, the targets of these suits can negotiate a deal with the Trustee. However, this is not a sure thing. The Fifth Circuit treats a motion to compromise claims as being equivalent to a sale of the cause of action. Cadle Company v. Mims (In re Moore), 608 F.3d 253 (5th Cir. 2010). The annoying creditor can always come in and bid more for the claim, knowing that part of its purchase price will come back to it when the Trustee pays claims.This strategy only works if the creditor lacks the sophistication or ability to outbid the target of the litigation. Additionally, sometimes the Trustee will hire the state court lawyer as special counsel to pursue the insiders which just transfers the fight to the bankruptcy court.
Does It Make Sense?
The takeaway here is that filing Chapter 7 for a company is not always the answer. Sometimes a bankruptcy filing just creates more trouble for the people authorizing the case. Before authorizing a corporate Chapter 7 it is important to think about both the benefits and the detriments. Once the case is filed it can't easily be withdrawn. As one Western District Judge once said:
Chapter 7 bankruptcy is not something that you can dip your toe into in order to check the temperature of the water. It is something you jump into and you can only be rescued from it if you can show cause.
In re Dreamstreet, Inc., 221 B.R. 724, 725-26 (Bankr. W.D. Tex. 1998).
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