In a recent rather nerdy conversation with a friend, I was discussing some recent changes to bankruptcy law that a large portion of the population could benefit from. Without realizing I kept saying phrases like “Chapter 13,” “Chapter 7,” and “Chapter 11” without realizing that my friend had very little idea what each of these terms meant. A quick review of news headlines will show things like “Consumer Bankruptcy Expected to Increase” and “ABC Corporation Files for Chapter 11 Bankruptcy.” Neither of which explains what is going on.

In simple terms, there are two very broad areas of bankruptcy. The first, and most common, is Consumer Bankruptcy. Consumer bankruptcy is what individuals and families use when they can no longer make ends meet or something catastrophic happens that they can’t afford. Business Bankruptcy involves the restructuring or termination of businesses that were struggling to meet their obligations. There is a little overlap between the two but by and large, they are two different ideas.

Before jumping into an explanation of the two broad types of bankruptcy it is important to distinguish when businesses or consumers can declare bankruptcy. In order to declare bankruptcy, the Debtor must fill out a collection of paperwork that details their financial condition, this paperwork lists the property, money, debts, and other important issues for the Debtor, Court, and Creditors. These documents help show that the Debtor is insolvent, the Debtor cannot pay their obligations as they come due. There is no requirement that Debtors be insolvent, however, Debtors are unlikely to file for bankruptcy if they are solvent, since there are better solutions.

Consumer Bankruptcy:

When people refer to consumer bankruptcy, they are often referring to Chapters 7 and 13 which are used primarily by non-businesses, though some businesses do use Chapter 7. Chapter 7 is often referred to as a no-asset bankruptcy, this is the form of bankruptcy that is frequently portrayed in the media since it often means the debtor (person who has no money) sells off their property and distributes their assets to their creditors (the people and businesses they owe money to). However, the Debtor does not need to sell off everything they own. That would be rather unfair, imagine having to sell your old socks or your wedding ring, both of which should be left to the debtor for very different reasons. Each state provides a set of exemptions that protect property that debtors own, there are exemptions provided by federal law, but they tend to be less generous than the exemptions provided by the states. You may already be familiar with some of these exemptions, for example, people in Texas and Florida have an exemption on their homes and so they cannot be forced to sell them. Other states have less generous exemptions so that after the sale of the house a specific dollar amount is set aside for the debtor with the remainder going to the debt.

The money that was received for the sale of the Debtor’s property is collected into a pot, known as the estate, before being distributed to the Creditors. Some of the creditors will be able to collect before other creditors based on contractual agreements and federal law. For those who did not have the chance to collect early, known as Priority, they are paid pro-rata from the contents of the estate. So they are paid in proportion to the amount of debt they are owed. For example, if X is owed $120,000 of the $500,000 of the remaining debt, X would receive $0.24 of every $1 that is paid out. Often there is very little available to pay out and so creditors will receive far less than they are owed. They may and often are very angry about this. However once the Debtor has paid out what they can and the local Bankruptcy Court has reviewed the Debtors Case, the Debtor is given a discharge order. The discharge order means the debtor is no longer “in” bankruptcy, it also means they no longer need to pay for those debts that were incurred before they filed bankruptcy.

I mentioned that some Creditors may be unhappy about a Debtor filing bankruptcy because they will get less than they are owed, so there are some rules in place that protect Debtors against overly aggressive Creditors. Once a Debtor files bankruptcy they receive automatic legal protection, known as the Automatic Stay, which prevents creditors from trying to collect on their debt. What is often under-appreciated is the Automatic Stay protects against almost all collection efforts. An example many people are familiar with is student loan debt collection, letters from a loan servicer (the organization that owns the debt) reminding a Debtor how much they owe can qualify as a collection attempt. The penalties for these collection attempts can be harsh since Creditors in violation of the Automatic Stay may not be able to collect anything for their debt even if there is money to pay out, they may be fined, jailed, and many more. Similar protection exists after the bankruptcy, known as the Discharge Injunction, which prevents creditors from collecting on debts that were discharged by the bankruptcy.

On the other end of the Consumer Bankruptcy spectrum is Chapter 13 bankruptcy. While Chapter 7 involves the selling off of the Debtor’s assets, Chapter 13 allows the Debtor to make payments of all of their excess income beyond their living expenses over the next 3-5 years in satisfaction of their debt. After the 3-5-year payment period has ended the debts that existed before bankruptcy is discharged. For Debtors who want to hold on to their property, this may be a better alternative. However, if a Debtor misses payments during that payment period there is a very real risk that their debt will not be discharged. This is a particular issue for Debtors who have an unexpected change in circumstance, like a medical bill that prevents the Debtor from paying all of their excess income towards their debt.

Business Bankruptcy:

Business Bankruptcy is similar to Consumer Bankruptcy in a couple of different ways. Businesses can file for Bankruptcy under Chapter 7, and thereby dissolve after they pay what they can. However, most businesses and business owners would prefer to continue in operation because their business still has the capability of producing a profit. The caveat of Chapter 7 is that businesses that use this Chapter must cease operations immediately and prepare to liquidate.

Unlike normal people, businesses cannot file for Chapter 13 and so cannot make payments over a period of time to have their debts discharged. However, their alternative is Chapter 11 which allows businesses to reorganize to limit debt burdens. If a business is unable to find the funding and work with its Creditors, it may be liquidated.

Businesses that file for Bankruptcy can continue to operate while in Bankruptcy, in other circumstances the businesses would be forced to cease operations. In most instances, the management of the bankrupt business controls the business before, during, and after bankruptcy. However, some decisions can only be made with the approval of the court overseeing that business’s bankruptcy case. For businesses using Chapter 11 they must provide a plan that explains how the company plans to pay back its debt.

The mechanics of Chapter 11 can be very complex. When a business files Chapter 11 bankruptcy it is assigned a committee made up of the Creditors and Owners who represent the interests of these groups during the Bankruptcy. The Committee works with the Debtor to develop a plan for reorganizing the business and pay off the debt. Once a plan to reorganize has been proposed, the Creditors have an opportunity to vote on the plan. If a majority of Creditors do not approve the plan, Creditors may propose their plan. These cases often involve dozens, if not hundreds, of creditors which makes getting approval of a plan difficult. If no agreement can be reached, then the business’s assets may be sold off reducing the likelihood of a successful reorganization. Due to the complex nature of these cases, the bankruptcy court overseeing the business’s case must approve the reorganization plan.