The fate of a corporation in bankruptcy — whether it goes out of business or is reorganizing in order to recover from crippling debt — is determined by federal bankruptcy law. The bankrupt corporation (i.e., "the debtor") can use Chapter 7 of the Bankruptcy Code to liquidate or Chapter 11 to reorganize the business in hopes of turning things around and becoming profitable again.
Under Chapter 7, the corporation must stop conducting all operations. A court-appointed trustee liquidates the company's assets and the money is used to pay off the debt. The company goes completely out of business.
In Chapter 11, management continues to run the daily business operations, but the bankruptcy court must approve all significant business decisions. Publicly held companies usually choose to file under Chapter 11 rather than Chapter 7 because it allows them to continue to run their business as well as maintain some control over the bankruptcy. The U.S. Trustee appoints one or more committees to represent the creditors and stockholders in working with the corporation. A reorganization plan is developed to get the company out of debt. The plan must be confirmed by the court and agreed to by the creditors, bondholders, and stockholders. The court can confirm the plan over the rejection of the creditors or stockholders if it finds that the plan treats them fairly.
The plan relieves the corporation from paying a portion of its debt so that the company can make a recovery. A committee is formed to represent the unsecured creditors, including bondholders. An additional committee may be created to represent stockholders. The trustee may also create a committee to represent other creditors, such as secured creditors and employees.
After the committees develop a plan with the corporation, the bankruptcy court must find that it complies with the Bankruptcy Code before the plan can be implemented. Known as plan confirmation, this process is usually completed in a few months.
Corporations that are in too much trouble to continue business operations often file under Chapter 7 and liquidate. The assets of these companies are sold for cash by the trustee, who sees to it that administrative and legal expenses are paid first. Whatever remains goes to creditors. The collateral of secured creditors is returned to them. If the value of the collateral is not sufficient, they are put together with other unsecured creditors for the remainder of their claim. Other unsecured creditors and bondholders are notified of the Chapter 7 and need to file a claim in the event that any money is left for them. Stockholders generally don't receive anything in return for their investment and so do not have to be notified of the Chapter 7.
Those investors whose investments were backed by collateral, such as a mortgage or other assets of the company, are paid first. Stockholders, who own the company, have taken a greater risk and are less likely to recover their loss than bondholders, because bonds represent the debt of the company and the company has agreed to pay bondholders interest and to return their principal. The owners are the last to be repaid if the company fails.
A company's stocks can still be traded even after the business has filed for Chapter 11 bankruptcy. Generally, companies that file under Chapter 11 do not meet the listing standards of the major stock exchanges, such as Nasdaq or the New York Stock Exchange, but their shares may continue to trade on either the OTCBB or the Pink Sheets.
Bondholders will stop receiving interest and principal payments during bankruptcy, and stockholders will stop receiving dividends. The bondholder may receive new stock or bonds in exchange for their bonds. The trustee may ask the stockholder to send back their stock in exchange for new shares in the reorganized company. These may be fewer in number and lower in value than the original shares. If the corporation is insolvent, the bankruptcy court may determine that the stockholders get nothing.
When a corporation becomes insolvent and files for bankruptcy, the IRS will usually go after unpaid federal taxes, and it is possible for the IRS to break through the corporate firewall and pursue the owners' personal assets for payment. In general, a corporate officer or director won't be held personally liable for corporate income taxes. But if employment taxes are due, the IRS has the power to seize company cars, bank accounts, or any other assets.