Can Creditors Continue to Collect Debts During Bankruptcy Proceedings?

 When a business files for bankruptcy, one of the most critical issues is the legal process that occurs between the debtor and creditors. The goal of bankruptcy is often to provide relief to businesses that are overwhelmed by debt, but it also serves to ensure fair treatment of creditors. A common question among business owners facing bankruptcy is whether creditors can continue to pursue collection efforts while bankruptcy proceedings are ongoing.

In this article, we will explore the circumstances under which creditors may or may not continue their collection activities during a bankruptcy case, including the protections afforded to debtors under the bankruptcy process and how it affects creditors' rights.

What Happens When a Business Files for Bankruptcy?

Filing for bankruptcy triggers a formal legal process that allows businesses (and individuals) to either liquidate their assets to pay creditors (in Chapter 7 bankruptcy) or reorganize and continue operations while restructuring their debts (in Chapter 11 bankruptcy). The filing of bankruptcy provides several legal protections to the debtor business, one of the most significant being an automatic stay.

The Automatic Stay: A Key Protection for the Debtor

When a business files for bankruptcy, one of the first things that happens is the automatic stay comes into effect. The automatic stay is a court order that immediately stops most forms of creditor collection activities. The purpose of the automatic stay is to allow the debtor business a temporary reprieve from creditors so that it can reorganize, liquidate, or work out a plan to resolve its financial issues without ongoing pressure from debt collectors.

What Does the Automatic Stay Do?

• Stops Collection Calls: Creditors are prohibited from making calls to the debtor or sending collection letters seeking payment on debts. This includes third-party collection agencies and original creditors.

• Holds Off Lawsuits: The stay halts any ongoing lawsuits or legal actions taken by creditors to collect debts, including judgments, garnishments, and attachments.

• Freezes Bank Accounts: Creditors can no longer seize or freeze business bank accounts, wages, or assets without the court’s approval.

• Halts Foreclosures and Repossessions: If a business owns property, including real estate or equipment, creditors can’t initiate or proceed with foreclosure or repossession actions during the bankruptcy proceedings.

The automatic stay is a critical part of the bankruptcy process as it offers immediate relief to the debtor, giving the business time to catch its breath and begin the legal steps necessary for resolving the debt.

Can Creditors Continue to Collect Debts During Bankruptcy?

Once a business files for bankruptcy, the automatic stay applies to nearly all collection actions. However, there are some exceptions and nuances to this rule. Below are several important points to consider when it comes to creditors continuing their efforts to collect debts during bankruptcy:

1. Secured Creditors and Collateral

Creditors who hold a secured interest in property (such as a lender with a lien on business assets, equipment, or real estate) may have special rights. These creditors may request relief from the automatic stay if they want to continue pursuing their collateral, such as through foreclosure or repossession.

• Relief from Stay: A secured creditor can file a motion with the bankruptcy court requesting “relief from the automatic stay.” If the court grants this motion, the creditor can continue to collect on the debt secured by the collateral, even while the bankruptcy case is ongoing.

• Adequate Protection: In some cases, the bankruptcy court may provide adequate protection to secured creditors, ensuring that their interests in the collateral are protected while the bankruptcy proceedings unfold. This protection can be in the form of payments or other arrangements to prevent the creditor from being harmed.

2. Certain Types of Debt May Not Be Covered by the Automatic Stay

While the automatic stay stops most collection efforts, there are some debts that are not fully protected by the stay, and certain actions may continue even during bankruptcy proceedings:

• Child Support and Alimony: Creditors seeking to collect child support or alimony payments are generally exempt from the automatic stay. These payments are considered priority debts and can be pursued without interruption.

• Tax Debts: Certain tax debts may still be collected during bankruptcy proceedings. While most tax collections are halted by the automatic stay, the IRS and state tax agencies can continue to pursue certain types of tax obligations, including those related to property taxes or criminal restitution fines. However, the government must typically request relief from the stay to continue collecting.

• Student Loans: In most cases, student loans are non-dischargeable in bankruptcy. While the automatic stay prevents immediate collection, it does not eliminate the debt unless the debtor proves undue hardship, which is very difficult to establish in bankruptcy court.

3. Unsecured Creditors

For unsecured creditors—those creditors with no collateral backing their loans, such as suppliers, vendors, and credit card companies—the automatic stay provides significant relief from collections. These creditors generally cannot continue pursuing collection actions, including calling for payment, filing lawsuits, or taking legal action against the business.

However, unsecured creditors may still file claims in the bankruptcy case to recover a portion of the debt. After the bankruptcy plan is approved, unsecured creditors may receive a portion of any remaining funds, if available, depending on the nature of the bankruptcy and the priority of the claims.

4. Motion to Lift the Automatic Stay

In some cases, creditors may file a motion with the bankruptcy court to lift or modify the automatic stay. This can happen when the creditor can show that continuing the collection effort is justified, such as when there is significant damage to the creditor’s collateral or if the debtor is not acting in good faith.

For example, in a Chapter 11 reorganization, a creditor may argue that the debtor’s inability to pay or the business’s continued operations have led to deterioration of the value of their collateral, and the court may lift the stay to allow them to proceed with collection or foreclosure.

5. Dischargeable vs. Non-Dischargeable Debts

While the automatic stay provides temporary relief from collection activities, it's important to understand that bankruptcy doesn't necessarily eliminate all debts. Some debts may be dischargeable, meaning they can be wiped out at the conclusion of the bankruptcy case, while others are non-dischargeable, meaning they remain after the bankruptcy process.

• Dischargeable Debts: Most unsecured debts, such as credit card debt, medical bills, and personal loans, are typically discharged in bankruptcy, allowing creditors to stop collecting these debts once the bankruptcy process is concluded.

• Non-Dischargeable Debts: Certain debts, like child support, alimony, and most tax debts, are not discharged in bankruptcy. Creditors holding these types of debts may continue to collect even after the bankruptcy case is over.

What Happens if Creditors Violate the Automatic Stay?

If creditors attempt to collect debts after the bankruptcy filing and the automatic stay is in place, they may be in violation of the law. Violating the stay can result in contempt of court charges. The debtor may also request sanctions or other remedies for damages caused by the violation, including the possibility of receiving damages and attorney’s fees as compensation.

What Happens After the Bankruptcy Case Is Over?

Once the bankruptcy case concludes, the court will issue a discharge order for the debtor business, which eliminates the debtor’s responsibility to pay most of its debts. However, the discharge is only applicable to the debts that are eligible for discharge under the specific bankruptcy chapter filed. Creditors may continue their efforts to collect on any non-dischargeable debts even after the bankruptcy case concludes.

Conclusion

In most bankruptcy proceedings, the automatic stay stops creditors from continuing their collection efforts, allowing the debtor business time to restructure or liquidate its assets. However, secured creditors may be able to lift the stay and continue pursuing their collateral, and certain debts, like child support or taxes, may not be subject to the automatic stay. While creditors generally cannot collect during the bankruptcy process, exceptions exist, and creditors may file motions to lift the stay if they can prove valid reasons for doing so.

If you're a business owner facing bankruptcy, it’s essential to understand the rules around creditors' actions during the process. Consulting with an experienced bankruptcy attorney will help you navigate the complexities of the bankruptcy process and ensure that your rights—and the rights of your creditors—are respected.