Contract law is about holding people to their promises. Bankruptcy law does just the opposite. Authorized by the Constitution and created by Congress, the U.S. bankruptcy system consists of an entire body of federal statutory law found in Title 11 of the U.S. Code (known as the Bankruptcy Code). The general aim is to give people and organizations a second chance by allowing them to reduce or eliminate their debts. The flip side to letting debtors out of their promises is that it often leaves creditors “holding the bag.”

The current Bankruptcy Code features three main types of bankruptcies. The first type, known as a “liquidation” or “straight bankruptcy,” is found in Chapter 7 of the Bankruptcy Code. Under Chapter 7, a court-appointed trustee will sell the debtor’s non-exempt assets to pay off creditors. The debtor’s remaining debt, to the extent eligible, is wiped out or “discharged.” Certain types of debt, such as child support, tax debt, and student loans, are generally non-dischargeable. The second type, known as a “reorganization,” is more commonly used by businesses. Under Chapter 11, the business will continue to operate while it negotiates a plan to repay its creditors over time. If the debtor is unable to reach an agreement with creditors, then the bankruptcy court may approve a plan over another party’s objection. Smaller businesses have a streamlined path within Chapter 11 known as Subchapter V, enacted just before the pandemic and temporarily expanded under the CARES Act. It allows a qualifying small business to reorganize faster and at lower cost (generally letting the owners retain control) with a third-party fiduciary (called a trustee) appointed to help broker a consensual plan. Subchapter V proved especially valuable to the many small contractors and other businesses that struggled through COVID-19. A similar scheme that allows individuals to repay their debts over three to five years can be found in Chapter 13.

Congress created an entire court system to oversee enforcement of the Bankruptcy Code. Currently there are over 1,000 bankruptcy trustees and approximately 300 bankruptcy judges scattered throughout the U.S. Those judges have broad power to administer and enforce the Bankruptcy Code, including the power to resolve disputes between debtors and their creditors, to approve or reject reorganization plans, and to convert bankruptcies from one type to another. This happens all the time and is a matter of public record. For example, just last week a federal bankruptcy judge in Colorado ordered that a glass contractor’s bankruptcy be converted from a reorganization under Chapter 11 to a liquidation under Chapter 7. The debtor, JR Butler, Inc. had been in the glass construction business for over 30 years when the COVID-19 pandemic hit. The story is an all too familiar one that many subcontractors did not have adequate resources to overcome.

The Debtor generated significant revenues for decades. However, it faced significant challenges as a result of the COVID pandemic. Because of supply chain disruptions, the price of glass and aluminum, the Debtor’s primary manufacturing inputs, surged dramatically. Prices doubled. Unfortunately, as a subcontractor, the Debtor was unable to pass on or recover such increased costs under its contracts with general contractors. The COVID pandemic also caused substantial uncompensated construction delays, and labor shortages. Later, because of the increase in remote work, the market for new high-rise office structures also deteriorated.

The end result was a bankruptcy filing, first as a reorganization under Chapter 11 that would allow the business to continue. The creditors moved to convert the bankruptcy to a straight liquidation under Chapter 7 arguing that the debtor had engaged in “bad faith” during the bankruptcy proceeding. The court considered the totality of the circumstances and concluded that the debtor indeed lacked good faith when it sold off certain assets to the same individuals that previously operated the debtor. Although the court stopped short of finding that it was a fraudulent conveyance, it noted that no appraisal was done and it was not an arms-length transaction. The court therefore ordered conversion of the case to Chapter 7 and appointment of a new Chapter 7 trustee to liquidate the debtor’s remaining assets. The court’s opinion can be found here. It is but one example of what happens every day in bankruptcy courts throughout the country.