A Bankruptcy Primer (Yes, you really do need to read this.)

Having seen this month’s title, you probably are thinking, “But my company is thriving. It will never file bankruptcy! Why should I read this?” No matter how successful you and your company may be, companies that owe you money will file bankruptcy and leave you out of luck.
A review of almost 20 years of this column in both AVN Online and AVN reveals bankruptcy may be the one topic that regularly crops up in adult commerce without being addressed. It should be considered because, in addition to knowing how to guard against getting stuck if one of your debtors files bankruptcy, you also need to know where you stand if one of them does. Very successful companies often wind up in bankruptcy court: Video manufacturers all know about Tower Records, a stalwart company that recently folded.
Bankruptcy is strictly a federal thing, although states have a procedure called “assignment for the benefit of the creditors.” The results are similar, but the topic is beyond the scope of this article because it is used very rarely.
The Constitution allows Congress to create a bankruptcy system (Art. 3, § 8, cl. 4), but does not require it. The current federal bankruptcy laws have existed for more than a century and hold that bankruptcy is the province of the federal bankruptcy courts; previously, federal bankruptcy laws had varying effects, at first primarily for the benefit of creditors.
The two most common types of bankruptcy are Chapter 7 and Chapter 11; other types are rare. Chapters 7 and 11 can apply to corporations and individuals. Most bankruptcies are voluntary, although creditors can force an individual or corporation into bankruptcy if its debts are sufficient. The latter case is rare.
Chapter 7 is what most people are thinking about when they discuss bankruptcy. For an individual, Chapter 7 discharges most debts and lets the individual start anew — supposedly. However, because bankruptcy is a product of Congress, some categories of debts, as a matter of policy, cannot be discharged. Income taxes and child support cannot be discharged, nor can debts arising from intentional wrongs such as fraud and copyright infringement.
Individuals can retain certain assets, but the categories of things that can be kept and the amounts in each category are a function of state law. In Texas — the best place for a person to file bankruptcy — a bankrupt is allowed to keep his entire “homestead,” no matter how many millions it is worth. This also is true in a few other states. Some states, on the other hand, limit the homestead exemption to small amounts like $10,000. State legislatures normally decide such things.
The Bankruptcy Reform Act of 2005 drastically limited what could be discharged in a personal bankruptcy. Most significantly, the credit-card lobby, which represents greedy companies that issue credit cards to millions who shouldn’t have them, convinced Congress to exempt most consumer debt from Chapter 7 discharge and to limit the homestead exemption to $125,000.
For a corporation, Chapter 7 essentially is suicide. As a practical matter, when the Chapter 7 petition is filed, the corporation’s business is shut down and all of the company’s assets are distributed to the creditors.
Actually, it is a little more complex than that. The filing of any bankruptcy creates a “bankruptcy estate” that is operated by a trustee who is appointed by the court. A bankruptcy estate is an artificial entity, like a corporation: It can buy and sell things, sue people, be sued in “adversary proceedings” and so on. So, for example, if a corporate owner of a business files a Chapter 7 petition, the trustee takes over the business. The trustee may decide to sell the business intact or liquidate the assets, depending on what is in the creditors’ best interests, which he or she represents. Unsecured creditors rarely realize as much as 50 cents on the dollar; in a personal bankruptcy, unsecured creditors usually are shut out altogether.
Important to this industry is the fact that, in a business bankruptcy, copyrights are assets, just like computers and buildings. However, copyright licenses — the right to use the copyrights of others — are personal to the licensee, so they are extinguished by a bankruptcy. They cannot be sold to satisfy debts.
Another important concept is that of “secured creditors.” An example of a secured creditor is the bank that has the “pink slip” to secure payment of your car loan or the mortgage company that owns the note on your house. If you file bankruptcy, secured creditors have a right to reclaim the secured property. The bank can repossess your boat and sell it at auction, keeping the amount owed on the note; what remains after payment of expenses goes into the bankruptcy estate to pay the unsecured creditors.
Since being a secured creditor is important, you should know that you can secure all kinds of things to guarantee payment of a debt or loan. Examples include inventory, copyrights and receivables — almost anything that can be sold.
Chapter 11 bankruptcy is quite an involved topic, but a basic understanding of it is important. The core principle of a Chapter 11 bankruptcy is that the court stops creditors from collecting anything until the bankruptcy court approves a “plan” to repay the debts at a rate the bankrupt can manage. Notably, most Chapter 11 filings eventually become Chapter 7s, because the bankrupt usually is too optimistic at the outset.
There are several things you should know. First, many corporations in this industry have only one owner or, at most, two or three. It is not particularly difficult for a sole owner, for example, to “loot” the corporation and leave the creditors holding the bag. For that reason, banks never extend credit to small businesses without personal guarantee(s) from the owner(s). If you do business with a company that you expect will owe you money, the contract involved should include a guarantee from the principal(s). A personal guarantee isn’t bulletproof, because the principals could declare bankruptcy, too. But that is less likely. Being a secured creditor, of course, is better.
On that note, joint-venture agreements and the like often include provisions voiding the agreement if either party files bankruptcy or an assignment for the benefit of the creditors. Such provisions are doubtful with respect to bankruptcy because they frustrate the purpose of the Bankruptcy Act, so don’t count on them.
This is one more of many reasons why having an attorney examine your business arrangements is a good practice. If you have not taken steps to deal with the potential bankruptcy of one of your important sources of income, you could find yourself in bankruptcy court, too.