Is Filing A Chapter 7 The Right Option For Me If I Am Liable On A Personal Guarantee?

---

If a business files a Chapter 7, its assets are liquidated and to the extent possible, the proceeds are used to pay creditors. At that point, the business ceases to exist. Since the business no longer exists it cannot get a discharge of its debts. But suppose, after the liquidation, there are still outstanding debts that were not paid in full. What happens to those obligations? It depends on the facts of the case.

1. The Unincorporated Business
   If the business was a partnership rather than a corporation, then the business owners are liable for the remaining debt.
2. The Incorporated Business
   Even if the business was a corporation, the owners may still be liable for the remaining debt, if either they signed personal guarantees, or the creditor can “pierce the corporate veil.”
   • The Concept Of IncorporationTo understand what’s at work here, let’s start with a simple observation. When a business owner incorporates the business, the owner creates a new person. Obviously, it’s not a biological person, but it is a legal person. That person has its own assets, income, expenses, and debts.Why would someone incorporate? To limit liability. A simple example will illustrate the principle:

     Suppose we’re in the 1970s, and you buy Ford Motor Company stock. As a result, you are a part owner of Ford. Shortly after you purchase the stock, there are many fatal accidents involving the Ford Pinto. Families commence wrongful death suits against Ford. If they are successful, can they garnish your wages, and file judgment liens against your home? No. Why? Because Ford is a corporation. Your liability is limited to the amount you invested in Ford. You are protected from any further liability by the corporate veil — a legal construct, not an actual cloth curtain — between you and Ford.

   • Personal GuaranteesLet’s say the corporate business owner applies for a business loan of $200,000 to get some equipment for the business. The bank states that it will approve the loan if the owner signs the loan documents in two capacities: First as president of the company, and second as a human being.You might feel that the distinction is meaningless. After all, the president of the company is a human being, so one signature should suffice. However, if the bank wants both the business and the president as an individual liable as codebtors, it will insist on the two signatures.

     When the owner signs as president, the company is signing the documents. When the owner signs as a human being, the owner becomes a codebtor of the business; remember that the corporation is a separate person. The second signature constitutes a personal guarantee on the part of the business owner.

     This dual signing provides additional protection for the bank. This means that if the business defaults on the loan, the bank has the recourse of pursuing the owner personally for payment of the debt.

     If the business subsequently fails, and files for Chapter 7 protection, then if the bank is not paid in full after the liquidation, it can collect from the owner who signed the personal guarantee.

   • Piercing The Corporate VeilSuppose the bank didn’t insist on the second signature, and only the corporation had liability. If the business defaults on the loan, is the bank out of luck? Not necessarily.If the bank can show that the business and the owner were mere alter-egos of each other — i.e., the business was not really a separate person — then the bank can pierce the corporate veil and pursue the owner personally. How can the bank establish the alter-ego relationship?

     One way is to show a comingling of personal and business assets. This would establish that the business didn’t have a separate financial life, and was a corporation in name only. For example, if the owner uses corporate funds to cover personal expenses, then the owner is treating corporate funds as personal funds, and is thus destroying the separate personhood of the corporation. Or if the owner uses personal funds to cover the corporation’s expenses, then the owner is treating personal funds as corporate funds, and is thus destroying the separate personhood of the corporation. If there is litigation, then in discovery the bank will demand the business’s bank records to use in a forensic analysis to determine if there was any comingling.

     Another way to pierce the corporate veil includes showing a failure of the corporation to have a normal corporate life. For example, a failure of the board of directors to have regular board meetings, and keep minutes of those meetings, is evidence that the corporation lacks its own life.

     Yet another piece of evidence against the corporation’s separate personhood is undercapitalization at corporate inception: The corporation didn’t have the breath of life in it when it was born.

3. Filing A Personal BankruptcyIf the owner signed personal guarantees, or if the corporate veil is so diaphanous that it is easily pierceable, then the owner may need to file a personal bankruptcy to deal with the portion of the corporation’s debts that remain unpaid after its Chapter 7 case is completed.

Will I Have To Shut Down My Business If I File A Chapter 7 Business Bankruptcy?

The short answer is yes, but it helps to know exactly what happens when you file a Chapter 7 business bankruptcy.

When someone files a bankruptcy under Chapter 7 (or any other chapter), either as an individual or as a business, the act of filing the petition creates a bankruptcy estate. Anything the debtor has on the day of filing goes into that bankruptcy estate (though in the personal case, some or all the assets can be removed from the estate using appropriate exemptions). The prepetition debts become claims against the estate. The Court immediately appoints a Chapter 7 Trustee to administer the estate for the benefit of the creditors.

Thus, when a business files for Chapter 7 protection, all of its assets become the property of the Chapter 7 Trustee appointed to the case by the Bankruptcy Court. They no longer belong to the (former) owners anymore. At that point, it is up to the Chapter 7 trustee to deal with the business.

The Bankruptcy Code permits the Trustee to run the business — with court approval — for a limited time to ensure an orderly shutdown and liquidation of assets. This can allow employees who experience dislocation, time to find alternate employment without their engaging in corporate sabotage. However, since the business no longer belongs to the owners, they cannot continue to run it unless they are temporarily hired by the Trustee to do so.

Things Change If The Owner, Rather Than The Business, Is The Debtor

The situation changes if it is the business owner who files a personal bankruptcy. In that case, the business is NOT the debtor, but merely an asset of the debtor. If the owner can exempt the business in the bankruptcy schedules, then the Trustee won’t seize the business, and the owner can continue to operate the business. This only applies to the situation where the owner files a personal bankruptcy, and the business is the debtor’s asset rather than the debtor. I have had this scenario come up with an individual filing a personal Chapter 7 who has a small web-based business — for example, selling things on eBay — or a cleaning business. The Trustee is probably not going to be interested in that business even if there’s a little bit of equity that’s nonexempt. In a situation like that, the owner can continue to run the business.

In sum, the owner cannot continue to run the business if the business files for a Chapter 7 bankruptcy. If the owner wants to file a business bankruptcy and continue to run the business, then Chapter 11 bankruptcy is the best option.

For more information on Liability For A Personal Guarantee In California, a Free 20 Minute Phone Strategy Session is your best next step. Get the information and legal answers you are seeking by calling (562) 777-9159 today.