What Options Do Creditors Have When a Business Cannot Pay Its Debts?

When businesses face financial distress, both debtors and creditors must navigate a complex legal landscape that determines how remaining assets will be distributed and whether the business can reorganize or must liquidate. The United States Bankruptcy Code provides the primary framework for addressing business insolvency, offering different chapters for different situations and establishing priority rules that govern creditor recoveries. Understanding these options and the rights they provide helps creditors maximize recoveries while enabling businesses to pursue restructuring when viable. In 2025, economic pressures continue driving significant bankruptcy activity across multiple industries, making this knowledge increasingly valuable for businesses on both sides of debtor-creditor relationships.

What Are the Main Types of Business Bankruptcy?

The Bankruptcy Code provides several chapters addressing different situations, with Chapter 7 and Chapter 11 being most relevant for business debtors.

How Does Chapter 7 Liquidation Work?

Chapter 7 bankruptcy involves the orderly liquidation of a debtor's assets to satisfy creditor claims. A trustee is appointed to gather and sell the debtor's property, distribute proceeds to creditors according to statutory priorities, and close the case. The debtor receives a discharge of remaining debts, ending the business's obligations even if creditors were not paid in full.

Chapter 7 is appropriate when the business has no viable future and liquidation will generate more value for creditors than continued operation. The process is typically faster and less expensive than reorganization, but it ends the business as a going concern.

What Is Chapter 11 Reorganization?

Chapter 11 allows businesses to restructure their debts while continuing operations under court supervision. The debtor typically remains in possession of its assets and operates its business as a debtor in possession with fiduciary obligations to creditors. A plan of reorganization is proposed, creditors whose rights are affected vote on the plan, and the court confirms the plan if it satisfies legal requirements and receives necessary approvals.

Chapter 11 preserves going-concern value, protects jobs, and may generate better creditor recoveries than liquidation. However, it involves substantial professional fees and administrative costs that consume estate resources.

When Is Subchapter V Appropriate?

Subchapter V provides a streamlined Chapter 11 process for small business debtors meeting debt limits. This option offers faster timelines, lower costs, and provisions designed to make reorganization more accessible for smaller businesses. Subchapter V has become increasingly popular since its introduction, enabling reorganizations that would not have been economically feasible under traditional Chapter 11.

What Rights Do Secured Creditors Have?

Secured creditors hold claims backed by collateral, giving them preferential treatment in bankruptcy proceedings.

How Does the Automatic Stay Affect Secured Creditors?

Filing a bankruptcy petition triggers an automatic stay that halts most collection actions against the debtor and property of the estate. Secured creditors cannot foreclose, repossess, or otherwise enforce their security interests without court permission. However, secured creditors may seek relief from the stay if their collateral is not adequately protected or the debtor has no equity in the property and it is not necessary for reorganization.

What Is Adequate Protection?

Secured creditors are entitled to adequate protection of their interests during bankruptcy. If collateral is depreciating or losing value, the debtor must provide adequate protection, which may take the form of cash payments, additional collateral, or other relief that preserves the creditor's position. Failure to provide adequate protection can result in the creditor obtaining stay relief to pursue its collateral.

How Do Secured Claims Work in Chapter 11?

Secured claims must generally be paid in full under a Chapter 11 plan, though the debtor may propose extended payment terms or provide substitute collateral. Undersecured creditors, whose claims exceed their collateral value, have secured claims to the extent of collateral value and unsecured deficiency claims for the remainder. The treatment of undersecured claims often becomes a significant negotiating point in Chapter 11 cases.

What Options Do Unsecured Creditors Have?

Unsecured creditors hold claims not backed by specific collateral and generally receive lower priority in distributions than secured creditors.

What Is an Unsecured Creditors Committee?

In larger Chapter 11 cases, the United States Trustee typically appoints an official committee of unsecured creditors to represent the interests of all unsecured creditors. The committee has the power to investigate the debtor's affairs, negotiate with the debtor regarding plan terms, and participate in major case decisions. Committee formation gives unsecured creditors a collective voice they would not have individually.

How Are Unsecured Claims Treated?

Unsecured claims are paid after administrative expenses, priority claims, and secured claims. Trade creditors, bondholders, and other unsecured claimants often receive only partial payment or nothing at all in bankruptcy. However, certain unsecured claims receive priority treatment, including employee wage claims up to statutory limits and certain tax obligations.

What Leverage Do Unsecured Creditors Have?

Despite their lower priority, unsecured creditors can influence case outcomes through their voting power on reorganization plans. A plan generally requires acceptance by each impaired class, and unsecured creditors often constitute the largest creditor constituency. Sophisticated unsecured creditors may also purchase additional claims to increase their voting power or negotiate directly with debtors regarding plan terms.

What Are Avoiding Powers and Preference Claims?

The Bankruptcy Code gives trustees and debtors in possession special powers to recover certain transfers made before bankruptcy.

What Is a Preferential Transfer?

Section 547 of the Bankruptcy Code allows recovery of payments made to creditors within 90 days before bankruptcy that enabled those creditors to receive more than they would have received in a Chapter 7 liquidation. Payments to insiders may be recovered if made within one year before filing. Preference actions serve to equalize treatment among similarly situated creditors by clawing back payments that gave some creditors an unfair advantage.

What Defenses Exist to Preference Claims?

Creditors have several defenses to preference claims. The ordinary course of business defense protects payments made according to terms that were ordinary for both the particular debtor-creditor relationship and the relevant industry. The new value defense protects payments to the extent the creditor subsequently extended new credit to the debtor. The contemporaneous exchange defense protects payments made substantially contemporaneously with the debtor receiving value.

What Are Fraudulent Transfers?

Section 548 allows recovery of transfers made with actual intent to defraud creditors or for which the debtor received less than reasonably equivalent value while insolvent. The look-back period for fraudulent transfers under the Bankruptcy Code is two years, though state fraudulent transfer laws with longer periods may also apply through Section 544.

What Alternatives Exist to Bankruptcy?

Not all financially distressed situations require bankruptcy proceedings. Alternative approaches may achieve creditor goals more efficiently in appropriate circumstances.

How Do Out-of-Court Workouts Differ?

Out-of-court workouts involve direct negotiations between debtors and creditors to restructure obligations without court involvement. These arrangements require creditor consent and work best when the debtor's capital structure is relatively simple and key creditors are willing to negotiate. Workouts avoid the costs and publicity of bankruptcy but lack the automatic stay protection and other tools available in bankruptcy.

When Are Receiverships Appropriate?

State court receiverships provide an alternative to bankruptcy for liquidating or restructuring assets. A court-appointed receiver takes control of the debtor's property and manages it for creditors' benefit. Receiverships may be appropriate when the debtor's assets are concentrated in a single state or when specific creditors have security interests that support receivership remedies.

What Are Assignments for Benefit of Creditors?

An assignment for the benefit of creditors is a state law alternative to bankruptcy liquidation. The debtor transfers assets to an assignee who liquidates them and distributes proceeds to creditors. This process is typically faster and less expensive than Chapter 7 but does not provide a discharge of remaining debts and may not bind all creditors.

What Recent Developments Affect Bankruptcy Practice?

Several significant developments in 2025 have influenced bankruptcy law and practice.

How Did the Supreme Court Address Third-Party Releases?

The Supreme Court's decision in Harrington v. Purdue Pharma limited bankruptcy courts' ability to include non-consensual third-party releases in Chapter 11 plans. These releases had become common in mass tort bankruptcies, protecting non-debtor parties from liability in exchange for their contributions to settlement funds. The decision requires parties to find alternative structures for achieving similar results in complex cases.

What Trends Affect Cross-Border Insolvencies?

Chapter 15 of the Bankruptcy Code provides mechanisms for recognizing foreign insolvency proceedings and coordinating with courts in other countries. Cross-border cases have increased as global business operations create creditor bases and assets spanning multiple jurisdictions. Practitioners must understand how different countries' insolvency regimes interact and how to enforce rights across borders.

How Are Preference Standards Evolving?

Recent decisions have addressed disputes about how preference defenses should be evaluated. Courts continue refining standards for the ordinary course of business defense, including whether to apply a healthy debtor standard or industry practice standard when evaluating whether payment terms were ordinary. These technical distinctions can significantly affect creditor recoveries in preference litigation.

How Should Creditors Protect Their Interests?

Creditors can take several steps to maximize their position in debtor distress situations.

What Pre-Bankruptcy Planning Helps?

Creditors should ensure their security interests are properly perfected before any debtor distress arises. Reviewing credit documentation for protective provisions, monitoring debtor financial condition, and understanding priority positions relative to other creditors all support better outcomes. Creditors with advance warning of potential distress may be able to improve their positions or reduce exposure.

How Should Creditors Participate in Bankruptcy Cases?

Active participation in bankruptcy cases protects creditor interests. Filing proofs of claim before bar dates preserves the right to distributions. Monitoring case developments and participating in creditor committees or voting on plans allows creditors to influence outcomes. Creditors should evaluate the costs of participation against the magnitude of their claims and potential recoveries.

When Should Creditors Object to Debtor Actions?

Creditors may object to various debtor actions including cash collateral use, borrowing, asset sales, and plan confirmation. Objections must be timely filed and supported by legal arguments demonstrating how the proposed action harms the objecting creditor. Strategic objections can leverage concessions from debtors even when the objection is unlikely to succeed on the merits.

Maximizing Outcomes in Financial Distress

Business financial distress creates both challenges and opportunities for creditors. Understanding the bankruptcy process, creditor rights, and available alternatives enables creditors to make informed decisions about how to protect and maximize their recoveries. Whether pursuing enforcement actions outside bankruptcy, participating actively in bankruptcy proceedings, or negotiating out-of-court resolutions, creditors benefit from early engagement and strategic thinking about their options. The bankruptcy landscape continues evolving through judicial decisions and market practices, requiring ongoing attention to developments that may affect creditor rights and remedies.