Chapter 7 vs. Chapter 11
Businesses in dire financial straits where bankruptcy is their best or the only option have two basic choices: Chapter 7 bankruptcy or Chapter 11 bankruptcy. Both are also available to individuals. Here’s how these two types of bankruptcy work and how they differ.
Key points to remember
- Chapter 7 and Chapter 11 are two common forms of bankruptcy.
- In a Chapter 7 bankruptcy, a company’s assets are liquidated to pay off its creditors, with secured debt taking precedence over unsecured debt.
- 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 referred to as “liquidation” bankruptcy. Companies that experience this type of bankruptcy have passed the reorganization stage and must sell assets to pay their creditors. The process works the same for individuals.
The bankruptcy court will appoint a trustee to ensure that creditors are paid in the correct order, following “top priority” rules.
Secured debt takes priority over unsecured debt in bankruptcy and is the first to be repaid. Loans issued by banks or other financial institutions that are secured by a specific asset, such as a building or expensive machine, are examples of secured debt. Whatever assets and liquidity remain after all secured creditors have been paid, they are consolidated and distributed to creditors with unsecured debts. These would include bondholders and shareholders with preferred shares.
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 part of his debts over a period of three to five years under judicial supervision.
Your Chapter 7 Guide to Bankruptcy
Known as “liquidation” bankruptcy
Assets are sold by a trustee to pay off debts
When all assets are sold, the remaining debt is usually written off
Used by businesses and individuals
Known as “reorganization” bankruptcy
The debts are restructured by a trustee and the business continues
Remaining debts must be repaid through future income
Mainly used by businesses
Chapter 11 bankruptcy is also known as “reorganization” or “pardon” bankruptcy. It is the most complex and generally the most expensive form of bankruptcy. For this reason, it is 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 business the chance to reorganize its debt and try to emerge as a healthy business.
A Chapter 11 case begins with filing a petition in a bankruptcy court. The petition can be voluntary, filed by the debtor, or involuntary, filed by creditors who want their money. During Chapter 11 bankruptcy, the debtor will remain in business while taking initiatives to stabilize their finances, such as cutting expenses, selling assets, and attempting to renegotiate their debts with creditors, all under supervision. court.
The Small Business Reorganization Act of 2019, which came into effect on February 19, 2020, added a new subchapter V to Chapter 11 designed to make bankruptcy easier and faster for small businesses, than the U.S. Department of Justice defined it as “entities with less than about $ 2.7 million in debt that also meet other criteria.” The law “imposes shorter deadlines for completing the bankruptcy process, allows 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,” he said. said the Ministry of Justice.
The CARES (Coronavirus Aid, Relief, and Economic Security) law, enacted on March 27, 2020, made a number of temporary changes to bankruptcy laws designed to make the process more accessible to businesses and people economically disadvantaged by COVID. -19. pandemic. These include increasing 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 passage of the CARES Act and for the most part end. , in March 2021.
Chapter 7 vs. Chapter 11: Main differences
Like Chapter 7, Chapter 11 requires the appointment of a trustee. However, rather than selling all of the assets to pay off creditors, the trustee oversees the debtor’s assets and allows business to continue.
It is important to note that debt is not discharged in Chapter 11. Restructuring only changes the terms of the debt, and the company must continue to repay it through future profits.
If a business succeeds in Chapter 11, it is generally expected to continue to operate effectively with its newly structured debt. If he does not succeed, he will file the dossier for Chapter 7 and will be liquidated.
How to prevent bankruptcy
Bankruptcy is usually a last resort, for businesses and individuals alike. Chapter 7 will actually put a business out of business, while Chapter 11 may make lenders wary of dealing with the business after it goes bankrupt. A Chapter 7 bankruptcy will remain on an individual’s credit report for 10 years, a Chapter 13 for seven years.
While bankruptcy can be inevitable in many cases (a severe recession in the case of a business, loss of employment, or high medical bills for an individual), a key to avoiding it is to borrow wisely. For a business, that could mean not using debt to grow too quickly. For an individual, that can mean paying off their credit card balance each month and not buying a bigger house or a more expensive car than they can safely afford.
Before filing for bankruptcy, and depending on their own internal legal resources, businesses may want to consult an outside bankruptcy lawyer and discuss their alternatives.
Individuals are required by law to complete an approved credit counseling course before filing their case. Individuals also have other resources at their disposal, 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.