This is a very bare-bones description of what bankruptcy is and what you need to know about it. Frankly, if your business is in danger of heading into bankruptcy, you need to speak to a good lawyer who can give you very specific advice based on your particular situation. And if a business that owes your business money has filed for bankruptcy, well, unless it is a lot of money, you can pretty much write off the debt and move on to other matters. This page, then, is a brief introduction to what bankruptcy is in a legal/financial sense, as opposed to the popular notion of “no-clothes-left-except-this-oak-barrel” we all remember from the Warner Brothers cartoons.

When most people use the word “bankruptcy”, they are referring to a financial state of ruin and the end of a business. When legal and financial advisors use the term “bankruptcy”, they are referring to a situation where a business is currently unable to pay its bills as those bills come due or a business whose liabilities exceed its assets.

To a lawyer’s mind or a financial advisor’s mind, bankruptcy is merely another state of existence for a business entity, albeit a undesirable one. And those professionals see a bankrupt entity as one that might be able to continue despite whatever present problems it may be experiencing. Professionals have this view of bankrupt businesses because of their familiarity of the United States Bankruptcy Code (USBC). The USBC offers debtors, both individuals and business entities (i.e., corporations, partnerships, etc.) legal protection from creditors seeking immediate repayment. Since bankruptcy is a legal state, you should always contact a bankruptcy attorney for advice if you fear that you are sliding towards the abyss; he or she should be able to help you decide on the best course of action.

What is bankruptcy? When a business or a person declares bankruptcy, they file a petition with the local United States Bankruptcy Court. The court then forces all creditors to stop collection efforts and legal proceedings in other venues (i.e., other courts) and instead present all demands for payment to the bankruptcy court. This keeps the bankrupt business from having to fight creditors in multiple courts, some of which may be on the other side of the country. With all of the legal proceedings consolidated into one setting, the court then does one of two things:

Repayment Plan: The court sets up a payment schedule which is usually based on a plan presented to it by the bankrupt business. Under the plan, the debtor will pay back the creditors over time (usually a longer period than the original credit terms). The plan needs to show that the creditors will get more of their money back by allowing the business to continue than the creditors would if the assets were liquidated and sold. It is interesting to note that if a repayment schedule is presented and the court approves it, the former managers and/or owners of the business will usually continue to run the business throughout the bankruptcy proceedings unless the management was particularly awful or crooked in some way. After the bankruptcy protection period is over, and debts are repaid, the managers/owners can go on their merry way again (possibly ruining the business a second time).

Liquidation: If no repayment schedule is put forward, or if the repayment schedule is not approved by the court, the assets of the bankrupt business are sold by a person called a trustee who organizes the sale and disposes of the assets. All proceeds from this sale go to the creditors. All remaining debts are then wiped out and the former debtor (now debt-free) is given a clean slate. None of the creditors involved in the bankruptcy proceedings can pursue any legal action against the debtor for the debts that were discharged through the bankruptcy proceedings. That game is over.

From this short synopsis of the bankruptcy laws, you should be able to see that our nation’s bankruptcy laws generally favor debtors; the courts are empowered to force creditors to take what they get from the debtor before the court discharges all remaining debt. The debtor, in effect, gets off “scot free” and does not have to pay back the money he/she/it owes. This idea of giving debtors a clean start is only about one hundred years old, before that people who could not pay their bills went to jail!

But as you probably know, the creditors of the world do not just forgive and forget when a person or business declares bankruptcy. Any business or person who goes through bankruptcy proceedings has little hope of getting credit from any other source for the next ten years or so, unless a painfully high interest rate is paid along with the provision of some sort of collateral.

Who should declare Bankruptcy? Usually, a potentially bankrupt business is one that has been sliding into ruin for some time. Costs are going up, revenues are going down, or the business has just never been able to sustain itself without cash infusions from other sources. Eventually, the business’s poor performance catches up to it and the business becomes so cash-poor that it cannot pay its bills and no one will loan the business any more money (big surprise!). At this point, a business should contact its creditors and try to work out a repayment plan. Make an honest effort to come to terms with all of your creditors. Bankruptcy is a very serious affair, requiring lawyers, courts and more than a little amount of money.

Also, do not use bankruptcy as a threat against creditors who are trying to collect their bills. Word will quickly get out that you and your business are deadbeats who will not pay their bills. Far better to come across as a cash-poor business trying to repay its debts than a broke business trying to strong-arm concessions out of creditors. Only if all creditors will not agree to a repayment plan without court intervention should you consider filing for bankruptcy.

Things to know. Bankruptcy courts are not stupid. Do not try to use them for anything except a true bankruptcy proceeding. We are not going to catalogue all of the ways that the bankruptcy court can punish people and businesses who try to use bankruptcy proceedings for improper reasons, but there are more than enough of them.

Also, in the three months before you go into bankruptcy, do not try to favor one creditor over another when it comes to paying your bills. Bankruptcy courts can go back and recover such money from creditors who received payments from debtors before the debtor filed for bankruptcy if those payments were more than the creditor would receive in a liquidation. Happens all the time. And if there is some sort of fraud involved in the payment of one creditor as opposed to another (i.e., payment is made without the debtor having received something of value in return) in the year prior to the filing of a petition for bankruptcy, the court can void the transaction and force the creditor to repay the money.