Broadly speaking, there are two different ways to go bankrupt: liquidation (Chapter 7) or reorganization (Chapter 11 or Chapter 13). In the next two sections, I will introduce you to these two variations and explain, briefly, how they apply to both individuals and companies. Let’s start with a general overview of liquidation.
Liquidation (Chapter 7): With a “liquidation” bankruptcy, known as Chapter 7, the trustee sells the assets of the debtor and then uses the money to pay back the creditors as much as possible. Once this is done, the debtor is given a discharge, which cancels the rest of the debt permanently.
The entire process takes about three to four months after the bankruptcy paperwork is filed, if everything goes smoothly.
Although the goal of the trustee is to pay back the creditors, it is rare for creditors to get back much of their money. In fact, with a Chapter 7 bankruptcy, a creditor that recovers even 25 cents on the dollar (a quarter of the money that is owed) is considered fortunate. Much of the time, creditors get nothing.
Chapter 7 liquidation can be used by both individuals and by companies. With an individual, the discharge gives the debtor a fresh start, enabling him to continue his or her life more comfortably. With companies, it works differently: Once the assets are liquidated and the proceeds are distributed, the company is dissolved permanently, at which time it ceases to exist.
If a company being liquidated has issued stock, its value goes to zero and the stockholders lose their money. At the same time, because the company is forced to close, the employees lose their jobs and their benefits. This loss can be particularly difficult for retired workers who were depending upon pensions and health insurance that, up to now, had been provided by the company.
If the company going bankrupt is large, the trustee may be able to sell an entire division to another company. In such cases, many of the employees may be able to keep their jobs by working for the new company.
Exempt Property and Priority Debts: The general idea behind Chapter 7 bankruptcy is to liquidate everything in an attempt to pay all the debts. For the most part, this is the principle that guides the overall process. However, I want to mention two significant exceptions.
First, bankruptcy law recognizes that certain types of assets are so important they should not be taken away. Such assets are called “exempt property.” For example, an individual debtor who file for Chapter 7 bankruptcy is, by law, allowed to keep his car, his clothing, and his pension.
Second, bankruptcy law also recognizes that some debts, called “priority debts,” are more important than others. During a Chapter 7 bankruptcy, priority debts must be paid back before any other debts. In other words, creditors who hold non-priority debts will not receive anything unless there is more than enough money to pay back all the priority debts in full.
When an individual files for Chapter 7, priority debts include taxes and other government debts, child support, alimony, student loans, and criminal restitution. When a company files for Chapter 7, priority debts include taxes and other government debts, salaries (subject to fixed limits), and contributions to employee benefit plans.
This is why Chapter 7 debtors often do not receive anything. Before regular debtors can be paid, even partially, the government and all the other priority debtors must by paid in full.
Reorganization: Chapter 13, for Individuals
The second common type of bankruptcy is “reorganization.” With reorganization, the goal is much different than with liquidation. Instead of having to sell assets, the debtor negotiates with the creditors to reorganize finances and to reschedule the payment of the debt. In such cases, individuals use Chapter 13 bankruptcy, while companies use Chapter 11.
Chapter 13 bankruptcy requires an individual debtor to work with a trustee to create a budget and a repayment plan that will enable the debtor to repay all or, at least, part of the debts within a specified amount of time (usually three to five years). This plan must be approved by a bankruptcy judge and by the creditors. As such, Chapter 13 is used primarily by people who have a regular income.
The advantage of a Chapter 13 reorganization over a Chapter 7 bankruptcy is that the debtor is able to keep property that would otherwise be liquidated, such as a home, a second car, investments, and family heirlooms. The disadvantage is that the debtor must have the resources to service the repayment plan and must, ultimately, pay back the money.
Chapter 13 bankruptcy, for individuals, requires a lot of work and planning by the debtor, as well as by his or her trustee. However, the process is straightforward. On the other hand, Chapter 11 bankruptcy, used by companies, works differently and is, in fact, a lot more complicated.
>Reorganization: Chapter 11, for Companies
Chapter 11 was created for the practical reason that many insolvent companies are worth more if they are allowed to remain in business than if they are forced to liquidate. From the creditors’ point of view, the possibility exists that if the company is allowed to stay in business, it will be able to pay back more of its debts than if it is forced to close down and liquidate.
Chapter 11 requires the company to create a plan that describes how it will reorganize its finances, including which debts it intends to pay and when. The plan must be approved by a bankruptcy judge as well as by the creditors, but in most cases there is no need for a bankruptcy trustee: The company simply keeps operating according to the details of the plan. If problems arise, the court can always appoint a trustee to oversee the bankruptcy process.
A Chapter 11 bankruptcy plan is a blueprint for how the company will organize itself in the future. As part of the plan, Chapter 11 allows the company to repudiate a great deal of debt, including obligations such as labor agreements (including union contracts), health care costs, pension responsibilities, vendor contracts, customer contracts, and real estate leases. In addition, filing for Chapter 11 bankruptcy automatically halts all pending litigation.
After a company files for Chapter 11, it is allowed to keep operating under the “protection” (supervision) of the bankruptcy court and the trustee. Then, once the reorganization plan is approved and implemented, the company changes from being bankrupt back into a regular, non-bankrupt business. Now, however, the company is free from the onerous obligations that pulled it under in the first place. When this happens, we say that the company “emerges” from bankruptcy. The time it takes for a company to emerge from bankruptcy depends on the size and complexity of the bankruptcy. Typically it will be from a few months to several years.
As you can imagine, being able to shed such obligations can make a huge difference to the financial well-being of a company suffering under the burden of insolvency. This is usually good for the company and the executives who manage the company.
At the same time, however, Chapter 11 restructuring can create serious financial problems for creditors. For example, suppliers may not be paid for goods they have already shipped. In many cases, the people who suffer the most are, once again, the employees and retired employees, who often lose all or part of their pensions and their health-care benefits.
Still, at least the company is in business. In many cases, a forced Chapter 7 liquidation would end up causing even worse problems, not only for creditors and employees, but for shareholders, customers, and suppliers.
An interesting question is, who runs a company after it files for Chapter 11 bankruptcy?
In most cases, particularly with large companies, the existing management stays and continues to run the company. This is why, even after a large company files for Chapter 11 and goes bankrupt, business seems to continue as usual.
In other cases, the creditors will take over ownership of the company. When this happens, they often appoint a new management team of their own.
Author’s Note: “Understanding Bankruptcy” is a series of seven columns to help you understand our modern bankruptcy system and how it works. I suggest that you start with the first column and read them in order, if you have not already done so. As a reference aid, I have created a comprehensive glossary of bankruptcy-related terms. You can find it in the “Money and Economics” section of my website, harley.com.