Depending on the type, or "chapter," of bankruptcy, debts are treated differently. In Chapter 11 bankruptcy, debts are restructured in a way that debt repayment becomes more achievable. In Chapter 7 bankruptcy, which is the most common form of bankruptcy, many debts are forgiven, and a variety of personal assets are sold — liquidated — to repay as many remaining debts as possible. In general, Chapter 11 bankruptcy is utilized by corporations and other business owners, while Chapter 7 bankruptcy is favored by individuals.
There are 4 types of 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.
When Should Bankruptcy Be Considered?
Bankruptcy is an option for those who feel they will be unable to repay their debts. Even so, bankruptcy should be considered only as a last resort, as it has long-term, negative consequences on credit rating.
Other Ways to Discharge Debt
Often creditors sell their unsecured debts to collection agencies, who then adopt aggressive tactics to collect on the debt, or as much of it as they can. There are ways to use the Fair Credit Reporting Act to get these unsecured debts voided, especially because collection agencies often lack the necessary documentation for legally enforcing debt obligations. This forum post has some good information on how to do that.
Who Should File for Chapter 11 or Chapter 7?
In most cases, individuals will want to file for Chapter 7 or Chapter 13 bankruptcy. Chapter 7 bankruptcy, in particular, is meant for individuals who are seeking a "fresh start," but corporations may also file for Chapter 7 (and commonly do). This form of bankruptcy focuses on discharging as many debts as possible and liquidating assets to pay off a variety of remaining debts that cannot be discharged.
A minimum amount of debt is not required for someone to file either Chapter 11 or Chapter 7 bankruptcy. However, to file for Chapter 7 bankruptcy, individuals need to pass a "means test," usually by having a large amount of unmanageable debt and/or a low income that hinders debt repayment. Those who have a lot of disposable income are less likely to have their Chapter 7 filing approved.
Chapter 11, which is more expensive than Chapter 7, is typically intended for medium- to large-sized businesses, but smaller businesses and sole proprietors may also want to consider this type of bankruptcy. Unlike Chapter 7, Chapter 11 does not liquidate assets, only restructures debts. This allows a debtor to protect an important asset, such as a business, from liquidation. In the case of sole proprietorships and similarly small businesses, Chapter 11 bankruptcy affects both business and personal assets.
Credit Counseling and Debtor Education
Prior to filing either type of bankruptcy, individuals must attend at least 60 minutes of credit counseling and at least two hours of a debtor education course. The U.S. Trustee Program provides a list of government-approved credit counselors and debtor education courses.
During credit counseling, a financial advisor helps a debtor create a budget and look for any possible alternatives to bankruptcy. Debtor education is more of a general educational course that teaches an individual how to properly manage money and credit; the course is intended to help the debtor learn how to avoid bankruptcy in the future.
Upon successful completion of these programs, individuals receive a certificate from program providers. These certificates are part of the evidence required for debtors to file for bankruptcy.
How to File
With the advent of the electronic filing processes, individuals are able to file for bankruptcy without the help of a bankruptcy attorney. Form B200 contains checklists for each type of bankruptcy. However, Chapter 11 and Chapter 7 bankruptcies are very complex for individuals who are unfamiliar with the U.S. Bankruptcy Code, and failing to submit the right information or paperwork may result in a court's rejection of a filing. Worse, inaccurate information in a bankruptcy filing may be considered criminally fraudulent.
Individuals cannot file for bankruptcy when they have had a previous filing dismissed in the last 180 days, so it is very important to have all of the necessary evidence when filing.
As soon as any bankruptcy petition is filed, and prior to its approval or dismissal, an automatic stay is placed on all lenders. An automatic stay restricts creditors from continuing to try to collect payment from the debtor and further restricts creditors from filing lawsuits against the debtor or foreclosing on his home. This provides immediate relief for those seeking bankruptcy. More than anything, it prevents creditors from using abusive, last-minute tactics to try to make back as much of their money as possible. These protections remain in place throughout the bankruptcy process.
Lenders can petition a bankruptcy court to make an exception to this rule for whatever debt dispute they have with a debtor, meaning that, in some cases, debtors may have to juggle bankruptcy filing and several types of debt repayment at the same time.
First Meeting of Creditors and Bankruptcy Court
Barring when creditors dispute a discharge, few must attend a hearing in a bankruptcy court for a personal bankruptcy filing. Instead, there is a "First Meeting of Creditors," which is a meeting that takes place around 30 to 40 days into the filing process. As the name suggests, creditors may attend this meeting, but they rarely do; instead, they tend to have their attorneys work with the debtor's attorney(s) — another reason it is wise to hire an attorney for the bankruptcy process.
This meeting is not overseen by a bankruptcy judge, but by a bankruptcy trustee, a person who is in charge of managing an individual's bankruptcy. Trustees are usually appointed by the U.S. Department of Justice. In some Chapter 11 filings, a chief restructuring officer is used in place of a trustee.
In either type of filing, the person seeking liquidation or reorganization swears an oath to truthfully answer a trustee's questions. Most of the time, this meeting is very short unless the trustee or chief restructuring officer is confused or suspicious about certain information the debtor has provided.
One major difference in a Chapter 11 filing comes with the reorganization of businesses, which the trustee takes over during the bankruptcy process. (There are some exceptions to this; see debtor in possession.) If a business is likely to make money in coming years, the business will often be allowed to continue operations, and income earned from the business will go toward debt repayment. If the business has more debt than it does assets or revenue, however, it is likely the business will be sold to creditor(s) as part of Chapter 11's reorganization process.
Debt Forgiveness vs. Debt Reorganization
Debt forgiveness is the common term for what is legally known as a bankruptcy discharge, a core component of a Chapter 7 filing that is also used to a lesser degree in Chapter 11 filings. Unless a creditor disputes a particular discharge request, most discharges are automatically approved. A bankruptcy court then mails a copy of discharge orders to all applicable creditors. Under a discharge order, the creditor(s) must "forgive" the debts listed by no longer seeking repayment. In the eyes of the law, discharged debt is no longer owed.
This is a different process from debt reorganization, which is used in a Chapter 11 filing. Under debt reorganization, debts are not discharged or forgiven. Instead, loan terms are altered in a way that a debtor will hopefully be able to repay his debt more successfully. For example, debt APR or interest rates may be lowered, or the length of time a debtor has to repay a loan may be extended.
It is worth noting that any debt discharges are issued at different times in Chapter 11 and Chapter 7 filings. For Chapter 11 bankruptcy, any debt forgiveness is typically granted after all reorganized debts have been paid in full. In Chapter 7 bankruptcy, however, there are set periods of time when a creditor can petition to make a debt ineligible for discharge; following this period of time — usually about two to four months into the Chapter 7 filing process — all eligible debts are automatically discharged.
In Chapter 7 bankruptcy, individuals will often be allowed to have some assets exempted from the liquidation process. What can be exempted from liquidation varies by state, but usually exempt property includes assets such as retirement plans, like 401(k)s, a family car, and some savings. A few states, like Texas, are quite lenient when it comes to property exemptions. Others, however, only allow filers to keep a very small amount of cash by the time the process is over.
Mortgages are very rarely exempt from the bankruptcy process. This means that someone filing for Chapter 7 must continue to make payments on his mortgage. If he cannot make these payments, he may also eventually end up going through a judicial or non-judicial foreclosure process on top of his bankruptcy.
Similarly, the bankruptcy process does not allow an individual to stop making alimony or child support payments or to stop paying taxes.
Liquidation vs. Debt Repayment
A trustee takes over a debtor's assets in a Chapter 7 filing. These assets are liquidated — sold by the trustee in exchange for cash — which is then distributed among creditors.
Restructured debt, as found in Chapter 11 bankruptcy, must be repaid according to the new terms agreed upon during the filing process — usually over a period of three to five years.
Chapter 11 bankruptcies are often very expensive because they involve businesses, which complicate matters. Filing for Chapter 11 alone often costs over $1,000. Attorneys' fees are especially expensive as the Chapter 11 process requires more legal input and takes much longer — often up to a year or longer. Moreover, Chapter 11 attorneys are less common than other bankruptcy attorneys, meaning those who take on Chapter 11 filings often charge more by the hour than would attorneys who handle Chapter 7 or Chapter 13 filings.
Comparatively, Chapter 7 bankruptcy is very affordable and some fees, such as the cost to attend credit counseling, may be waived sometimes for those who have no cash to spare. Filing is relatively cheap and tends to stay under $500, though there are additional attorneys' fees.
In most cases, a Chapter 11 bankruptcy will cost many thousands of dollars (often in relation to business size), while a Chapter 7 bankruptcy will cost somewhere between $1,000 and $2,000.
Chapter 11 vs. Chapter 7 Effects on Credit
Both Chapter 11 and Chapter 7 bankruptcies remain on credit reports for 10 years after the filing date. In contrast, Chapter 13 bankruptcy lasts on a credit report for only seven years.
The effect of having a bankruptcy on a credit report can be very negative. It usually prevents individuals from taking out new loans or getting approved for credit cards. It also makes buying a car or home almost impossible. While this can make sense early on in a bankruptcy, many years down the road, long after debts have been forgiven or repaid, it can continue to haunt the filer.
Business Use of Chapter 11 and Chapter 7
Businesses frequently use both types of these bankruptcies. Choosing between these two chapters comes down to what business owners hope to achieve with their business in the long run. If the business is not profitable or worth keeping, Chapter 7 bankruptcy is a reasonable choice. If the business is profitable, Chapter 11 may be a good option. It is worth noting, however, that few small businesses survive the costs of Chapter 11 bankruptcy.
Radio Interview Explaining the Differences
- Average Attorney Fees in Chapter 7 Bankruptcy - Nolo.com
- Discharge in Bankruptcy - USCourts.gov
- Filing for Bankruptcy: What to Know - FTC.gov
- Liquidation Under the Bankruptcy Code - USCourts.gov
- Reorganization Under the Bankruptcy Code - USCourts.gov
- Will I have to go to court? - Bankruptcy Information
- Wikipedia: Chapter 7, Title 11, United States Code
- Wikipedia: Chapter 11, Title 11, United States Code