In the United States, companies, married couples and individuals are all eligible to file for bankruptcy if they cannot meet their debt obligations.
There are 4 bankruptcy filings in the Federal Bankruptcy Code (Title 11 of the United States Code):
- Chapter 7 - Liquidation
- Chapter 11 - Reorganization (or Rehabilitation bankruptcy)
- Chapter 12 - Adjustment of Debts of a Family Farmer with Regular Annual Income
- Chapter 13 - Adjustment of Debts of an Individual with Regular Income
The main difference between Chapter 7 and Chapter 11 bankruptcy is that under a Chapter 7 bankruptcy filing, the debtor's assets are sold off to pay the lenders (creditors) whereas in Chapter 11, the debtor negotiates with creditors to alter the terms of the loan without having to liquidate (sell off) assets.
edit Salient Features of Chapter 7 bankruptcy
A Chapter 7 filing is a fresh start for the debtor, with a clean financial slate. After the debtor files under Chapter 7, a trustee is appointed to sell the debtor's assets. This is why Chapter 7 is called liquidation. However, not all assets are sold off. State and federal laws deem certain property exempt from such confiscation, such as an individual's primary residence or personal items like clothing. Once the debtor's assets are liquidated, the trustee pays certain creditors a portion of the money raised. It is important to note that not all creditors receive money from the liquidation proceeds. Many of the financial obligations are, therefore, forgiven or “discharged”. Certain debts are never (or rarely) discharged (forgiven), such as alimony, child support, student loans and taxes.
Chapter 7 is the most commonly used bankruptcy filing in the U.S. Once an individual or company has filed for bankruptcy under Chapter 7, they cannot file again for 7 years.
edit How Creditors are paid in Chapter 7 bankruptcy
Creditors with secured debt (loans backed by a specific asset e.g. auto loan) are paid first when the assets are sold off. Whatever assets and residual cash remain after all secured creditors are paid are pooled together to repay any outstanding creditors with unsecured loans e.g. bondholders and preferred shareholders.
edit Salient Features of Chapter 11 bankruptcy
Chapter 11 was originally intended for large corporations. However, individuals are also now allowed to file for bankruptcy under Chapter 11. Once a debtor files for Chapter 11 bankruptcy, a trustee is appointed to handle the bankruptcy. The trustee and the debtor work together to develop a repayment plan for the debtors outstanding loans. This plan is presented to the bankruptcy court, which decides whether to accept the plan, modify it or dictate an altogether new repayment plan. The repayment of outstanding loans usually occurs over 3 to 5 years. Note that the debtors assets are not liquidated under a Chapter 11 bankruptcy filing. So if the debtor is a business, they can continue to operate and potentially emerge from bankruptcy as a healthy company.
edit Other types of bankruptcy
Chapter 12 and Chapter 13 are the other kinds of bankruptcy filings. They are similar to each other except that Chapter 12 is for farmers and Chapter 13 for individuals. The main difference between Chapter 13 and Chapter 11 bankruptcy for an individual is the limit on amount owed. You can file under Chapter 13 only if you owe less than $336,900 in unsecured debt and less than $1,010,650 in secured debt.
edit How Creditors are paid in Chapter 11 bankruptcy
Debt is not absolved in Chapter 11. Only the terms of the loan are changed so that it is easier for the debtor to repay (e.g. extending the term of the loan or reducing the interest rate so that EMI is reduced.). It is also possible that the final repayment plan under a Chapter 11 filing reduces the debt obligations of the debtor. Under the repayment plan, creditors may recover an amount much lower than (about 50%) the outstanding loan amount. The remaining loan may be forgiven (discharged).