Why Corporations and LLCs Should NOT File Chapter 7

By: Donald L Swanson

Here’s a hard-knocks rule for debtor attorneys:

• Never file Chapter 7 for a corporation or an LLC.

Chapter 7 has always been a grave yard for failed Chapter 11s: that’s where Chapter 11 cases go when debtors can’t get a Chapter 11 plan confirmed. For example, 35.4% of Chapter 11 cases filed between 1989 and 1995 converted to Chapter 7. [Fn. 1]

But Chapter 7 is rarely a good first-choice for corporations and LLCs who want/need to liquidate.

Reasons why, explained below, are categorized as: Practicality, Two Goals, and Insider Exposure, along with an Exception that illustrates the rule.

Practicality

A Chapter 7 trustee will not liquidate a fully-encumbered asset—will abandon it, instead, as “burdensome” or of “inconsequential value and benefit.” [Fn. 2]

Such reality is explained in an opinion, from long ago, like this [fn. 3]:

• QUESTION: May a Chapter 7 trustee “serve as the handmaiden of consenting secured creditors in the collection of their security”?
• ANSWER: No.  That’s because:
  • “It is only where the secured property has a potential equity for general creditors . . . that the trustee should become involved”; and
  • “Secured creditors by consent and the trustee by acquiescence cannot impose upon the Court the duty to serve as a foreclosure . . . forum.”

Two Goals

Every individual who files Chapter 7 is focused on two goals:

1. Discharging all debts (or as much debt as possible); and
2. Keeping all assets (or as many assets as possible).

However, neither of these two goals can be achieved by a corporation or LLC in Chapter 7.  Here’s why.

–No discharge for corporations or LLCs

Individuals can discharge most or all of their debts in Chapter 7—that’s part of their fresh start.

Corporations and LLCs, however, can’t.  That’s because of the Chapter 7 statute that says: “the court shall grant the debtor a discharge, unless—(1) the debtor is not an individual.” [Fn. 4]

–No exemptions or reaffirmations for corporations or LLCs

Individuals retain assets, in Chapter 7, through a combination of exemptions and reaffirmation agreements.  Corporations and LLCs can’t.  Here’s why:

• Exemptions.  Corporations and LLCs don’t have exemptions in bankruptcy, because a statute says: “an individual debtor may exempt from property of the estate the property listed in . . . “ [Fn. 5]; and
• Reaffirmation Agreements.  Corporations and LLCs can’t use reaffirmations—only individuals can.  That’s because,
  • a statute says: reaffirmation agreement is “between a holder of a claim and the debtor, the consideration for which, in whole or in part, is based on a debt that is dischargeable . . . “ [Fn. 6]; and 
  • since no debt of a corporation or LLC is dischargeable in Chapter 7, reaffirmation agreements have no application.

Insider Exposure

Upon a Chapter 7 filing, a trustee is appointed with the duty (and power) to recover assets for creditors.  Fraudulent transfer and preference claims against insiders are often among those assets.

Whether a bankruptcy is filed or not, every insider faces fraudulent transfer and insider-preference exposure, under state laws. 

What the Chapter 7 bankruptcy filing adds to the equation, to insiders’ detriment, are: (i) new disclosure requirements, and (ii) new liability exposures.

–New disclosure requirements

Every bankruptcy debtor, under any chapter of the Bankruptcy Code, must disclose all assets, all debts, all creditors, and extensive financial history (including transactions with insiders)—under penalty of perjury and with the U.S. Trustee assigned to enforcement.

Most contexts outside bankruptcy have no corresponding disclosure requirement.   

–New liability exposures

Insiders, under the laws of most states, are already exposed to:

• fraudulent transfer claims—both actual intent and constructive fraud; and
• insider preference claims—i.e., received a transfer when should have known of debtor’s insolvency.

What a Chapter 7 bankruptcy filing adds is this:

1. a new type of strict preference liability, with a one-year reach back measured from bankruptcy filing; and
2. appointment of a Chapter 7 trustee empowered (and motivated) to investigate and pursue claims against insiders.

Summary

The foregoing makes a Chapter 7 bankruptcy filing inadvisable for the vast majority of corporations and LLCs who want/need to liquidate—in fact, prospects of such a filing can be downright scary for insiders.

An Exception

Many years ago, I read about a Chapter 7 case, filed by a corporation, that stands-out as an exception to the hard-knocks rule noted above.  Here’s how I remember it:

• Debtor is a non-profit corporation with unencumbered assets and lots of debt;
• Debtor’s entire leadership team resigns—except for one guy who is trying to turn out the lights (“the Guy”);
• Every liquidation suggestion the Guy makes is torpedoed by a different group of creditors—complete with threats to sue him; and
• So . . . the Guy throws up his hands, throws in the towel, [add other applicable expressions,] and puts Debtor into Chapter 7 with this purpose: “Let the Trustee liquidate this thing, I’m through!!!”

And the Trustee does just that. 

Before filing the Chapter 7, the Guy knows he has no fraudulent transfer exposure, knows he has no preference exposure, and wants to avoid the threatened lawsuits against him.

Good for him.  That’s brilliant!  What the Guy did, with the non-profit corporation and Chapter 7, serves as both:

• an exception to the hard-knocks rule noted above; and
• proof of the rule’s validity.

Conclusion

A debtor attorney should never file Chapter 7 for a corporation or LLC—unless there’s an exception like the one noted above.

———————

Footnote 1.  This data is from a report by Dr. Gordon Bermant and Ed Flynn of the Executive Office for United States Trustees titled, Bankruptcy by the Numbers.

Footnote 2.  See 11 U.S.C. § 544(a)&(b).

Footnote 3.  From the opinion, In re Crisp, Case No. 82-0058, Western Kentucky Bankruptcy Court (issued 11/12/1982).

Footnote 4.  11 U.S.C. § 727(a)(1) (emphasis added).

Footnote 5.  11 U.S.C. § 522(b)(1) (emphasis added).

Footnote 6.  11 U.S.C. § 524(c) (emphasis added).

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