Filing a Chapter 7 bankruptcy for a failed business can be a good way to tie up loose ends and put an end to inquiries from creditors. But if your business is a partnership, bankruptcy might have some negative consequences for the partners. This is because the bankruptcy trustee, under certain conditions, can sue the partners of a bankrupt partnership.
When a Partnership Files for Chapter 7 Bankruptcy
Chapter 7 is a liquidation bankruptcy which is available to both individuals and business entities, including partnerships. Generally, when a partnership files for bankruptcy
- all business operations cease
- a Chapter 7 trustee is appointed, and
- all assets of the partnership are sold or otherwise liquidated.
The proceeds from the liquidation of the assets are used to the pay the debts of the partnership, but if the proceeds are not sufficient to pay the debts in full, the partners may not be off the hook.
Partners May Be Responsible for Any Deficiency
Outside of bankruptcy, the partners of a general partnership and the general partners of a limited partnership are personally responsible for the debts of the partnership. When a partnership goes out of business, creditors who are not paid in full can sue the general partners to recover the money they are owed. (Learn more about business partnerships.)
The bankruptcy law takes this a step further and allows a Chapter 7 trustee to sue each of the general partners for the remaining amounts due to all creditors who filed claims in the bankruptcy if the proceeds from the sale of the partnership assets is not enough to pay the claims in full (in this article, we will refer to these amounts as the deficiency).
The trustee is not restricted by the percentage of each partner's interest in the partnership. The trustee can sue each general partner for the full amount of the shortfall, or deficiency, or only sue the general partner that is most likely to have the money to pay. It doesn’t matter whether you own 50% of the partnership or 10%, you could end up paying the entire amount.
More Risks for General Partners in Bankruptcy
There are differences which make filing a partnership bankruptcy more risky for general partners than just liquidating the partnership without filing for bankruptcy.
Entire Deficiency Can Be Sought in One Lawsuit
The bankruptcy trustee can sue for the entire deficiency, while outside of bankruptcy, a creditor that was not paid in full could only sue for any unpaid amount owed to that one creditor. As a practical matter, if the partnership has a lot of creditors, it is unlikely that every creditor would choose to sue the partners for the unpaid partnership debt outside of bankruptcy.
Potential Restrictions on Transfer of Personal Assets
Even before the bankruptcy court determines the amount of the deficiency, it can impose restrictions on a partner’s right to dispose of his or her own personal assets if it appears that the partnership assets will not be enough to cover the creditors' claims. The court can
- prohibit a partner from transferring personal assets
- order the general partners to indemnify (compensate) the bankruptcy estate for the potential deficiency, or
- require the general partners to provide assurance of performance.
Assurance of performance can take any form that the court finds adequate. Examples include posting a bond or giving the trustee a lien on property to secure the payment of any potential deficiency.
What If a General Partner Also Files for Bankruptcy?
If a general partner files for bankruptcy on his or her own, this could be bad news for the other general partners. The trustee for the partnership bankruptcy may file claims in the general partner's bankruptcy. But that trustee must first (to the extent practicable) try to collect the entire deficiency from the general partners who have not filed their own bankruptcies. If a non-bankrupt partner pays the deficiency to the trustee, he or she would likely have a claim in the partner’s bankruptcy for the bankrupt partner’s fair share, but like most bankruptcy claims, it may not be paid in full.