In both Chapter 7 and Chapter 11 bankruptcy events, shareholders of the companies filing for bankruptcy will most likely see little, if any, return on their investments. However, there are some significant differences between these two filings.
- Firms in a Chapter 7 bankruptcy are past the stage of reorganization and must sell off any nonexempt assets to pay creditors.
- Creditors with secured debt claims are prioritized over those with unsecured ones in a Chapter 7 bankruptcy.
- Chapter 11 bankruptcy allows the firm the opportunity to reorganize its debt and try to reemerge as a healthy organization.
Chapter 7 bankruptcy is sometimes called “liquidation” bankruptcy. Firms experiencing this form of bankruptcy are past the stage of reorganization and must sell off any nonexempt assets to pay creditors.
In Chapter 7 the creditors collect their debts according to how they lent the money to the firm, also referred to as the “absolute priority.” A trustee is appointed, who ensures that any assets that are secured are sold and that the proceeds are paid to the specific creditors.
For example, secured debt would be loans issued by banks or institutions based upon the value of a specific asset. Whatever assets and residual cash remain after all secured creditors are paid are pooled together to be paid to any outstanding creditors with unsecured loans, such as bondholders and preferred shareholders.
To qualify for chapter 7 relief, a debtor can be a corporation, an individual, or a small business. However, one is forbidden from filing for bankruptcy if within the previous 180 days another bankruptcy petition was dismissed due to the debtor’s failure to show up in court. A debtor likewise forgoes the right to file for bankruptcy if the debtor agrees to dismiss a former case after creditors asked the bankruptcy court to grant them the right to seize properties on which they hold the liens.
Your Guide To Chapter 7 Bankruptcy
Known as “liquidation” bankruptcy
Assets are sold off by a trustee to pay debts
When all assets are sold, the remaining debt generally is forgiven
Most often filed by individuals
Known as “reorganization” bankruptcy
Debts are restructured by a trustee and business continues
All debt must be paid back through future earnings
Most often filed by businesses
Chapter 11 bankruptcy is also known as “reorganization” or “rehabilitation” bankruptcy. Nearly everyone can file for Chapter 11 bankruptcy, including individuals, businesses, partnerships, joint ventures, and limited liability companies (LLCs). There is no specified debt-level limit and no required income. However, Chapter 11 is the most complex form of bankruptcy and generally the most expensive. Thus, it’s most often used by businesses and not individuals.
It’s much more involved than Chapter 7 because it allows the firm the opportunity to reorganize its debt and try to reemerge as a healthy organization. What this means is that the firm will contact its creditors in an attempt to change the terms on loans, such as the interest rate and dollar value of payments.
A Chapter 11 case starts with the filing of a petition to the bankruptcy court where the debtor lives. The petition may be a voluntary one, which is filed by the debtor, or an involuntary one, which is filed by creditors that meet certain requirements.
The Small Business Reorganization Act of 2019, which went into effect on Feb. 19, 2020, added a new subchapter V to Chapter 11 designed to make bankruptcy easier for small businesses, which are “defined as entities with less than about $2.7 million in debts that also meet other criteria,” according to the U.S. Department of Justice. The act “imposes shorter deadlines for completing the bankruptcy process, allows for greater flexibility in negotiating restructuring plans with creditors, and provides for a private trustee who will work with the small business debtor and its creditors to facilitate the development of a consensual plan of reorganization.”
The Coronavirus Aid, Relief, and Economic Security (CARES) Act, signed into law by President Trump on March 27, 2020, made a number of changes to bankruptcy laws designed to make the process more available to businesses and individuals economically disadvantaged by the COVID-19 pandemic. These include raising the Chapter 11 subchapter V debt limit to $7,500,000 and excluding federal emergency relief payments due to COVID-19 from “current monthly income” in Chapter 7. The changes apply to bankruptcies filed after the CARES Act was enacted and sunset one year later.
Chapter 7 vs. Chapter 11
Like Chapter 7, Chapter 11 requires that a trustee be appointed. However, rather than selling off all assets to pay back creditors, the trustee supervises the assets of the debtor and allows business to continue. It’s important to note that debt is not absolved in Chapter 11. The restructuring only changes the terms of the debt, and the firm must continue to pay it back through future earnings.
If a company is successful in Chapter 11, it will typically be expected to continue operating in an efficient manner with its newly structured debt. If it is not successful, then it will file for Chapter 7 and liquidate.