Companies that find themselves in a dire financial situation where bankruptcy is their best, or only, option have two basic choices: Chapter 7 bankruptcy or Chapter 11 bankruptcy. Both are also available to individuals. Here is how these two types of bankruptcy work and how they differ.
- Chapter 7 and Chapter 11 are two common forms of bankruptcy.
- In a Chapter 7 bankruptcy, the assets of a business are liquidated to pay its creditors, with secured debts taking precedence over unsecured ones.
- In a Chapter 11 bankruptcy, the company continues to operate and restructures under the supervision of a court-appointed trustee, with the goal of emerging from bankruptcy as a viable business.
Chapter 7 bankruptcy is sometimes called “liquidation” bankruptcy. Businesses going through this type of bankruptcy are past the stage of reorganization and must sell off assets to pay their creditors. The process works much the same for individuals.
Secured debt takes precedence over unsecured debt in a bankruptcy and is first in line to be paid off. Loans issued by banks or other financial institutions that are secured by a specific asset, such as a building or a piece of expensive machinery, are examples of secured debt. Whatever assets and cash remain after all the secured creditors have been paid are pooled together and distributed to creditors with unsecured debt. Those would include bondholders and shareholders with preferred stock.
To qualify for Chapter 7 bankruptcy, the debtor can be a corporation, a small business, or an individual. Individuals are also eligible for another form of bankruptcy, Chapter 13, in which the debtor agrees to repay at least a portion of their debts over a three- to five-year period under court supervision.
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
Used by both businesses and individuals
Known as “reorganization” bankruptcy
Debts are restructured by a trustee and the business continues
Remaining debts must be paid back through future earnings
Used primarily by businesses
Chapter 11 bankruptcy is also known as a “reorganization” or “rehabilitation” bankruptcy. It is the the most complex form of bankruptcy and generally the most expensive. For that reason, it’s most often used by businesses, rather than individuals, including corporations, partnerships, joint ventures, and limited liability companies (LLCs).
Unlike Chapter 7, Chapter 11 gives a company the opportunity to reorganize its debt and try to reemerge as a healthy business.
A Chapter 11 case starts with the filing of a petition in a bankruptcy court. The petition may be a voluntary one, filed by the debtor, or an involuntary one, filed by creditors who want their money. During the Chapter 11 bankruptcy, the debtor will remain in business, while taking initiatives to stabilize its finances, such as cutting expenses, selling off assets, and attempting to renegotiate its debts with creditors, all under the court's supervision.
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 and faster for small businesses, which the U.S. Department of Justice defined as "entities with less than about $2.7 million in debts that also meet other criteria.” 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,” the Justice Department says.
The Coronavirus Aid, Relief, and Economic Security (CARES) Act, signed into law on March 27, 2020, made a number of temporary 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 end, for the most part, in March 2021.
Chapter 7 vs. Chapter 11: Key Differences
Like Chapter 7, Chapter 11 requires the appointment of a trustee. 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 company 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.
How to Prevent Bankruptcy
Bankruptcy is generally a last resort, for both businesses and individuals alike. A Chapter 7 will, in effect, put a business out of business, while a Chapter 11 may make lenders wary of dealing with the company after it emerges from bankruptcy. A Chapter 7 bankruptcy will remain on an individual's credit report for 10 years, a Chapter 13 for seven.
While bankruptcy may be unavoidable in many instances (a severe recession in the case of a business, job loss or high medical bills for an individual), one key to preventing it is borrowing judiciously. For a business that could mean not using debt to expand too rapidly. For an individual it might mean paying off their credit card balances every month and not buying a larger home or costlier car than they can safely afford.
Before filing for bankruptcy, and depending on their own internal legal resources, businesses may want to consult with an outside attorney who specializes in bankruptcy law and discuss any alternatives that are available to them.
Individuals are required by law to take an approved credit-counseling course before they file. Individuals also have other resources available to them, such as a reputable debt relief company, which can help them negotiate with their creditors. Investopedia publishes an annual list of the best debt relief companies.