The Different Types of Bankruptcy: Which is the Right Option for You?

Whether you are voluntarily considering filing for bankruptcy or the proceedings have been set into motion by your creditors, it is essential to understand the differences between the three most common types of bankruptcy in the United States: Chapter 7, or “straight bankruptcy,” and Chapters 11 and 13, which allow for reorganization and rehabilitation of a debtor’s finances.

Bankruptcy provides debtors, be they individuals or corporations, who are unable to pay their creditors with an opportunity to resolve their debts through the supervised division of their assets among those creditors. This allows for immediate relief, as creditors may not try to collect their debts outside of a bankruptcy proceeding once it has been filed, as well as eventual permanent freedom from most debt, and may be the only option for many who are struggling with their financial obligations. Since bankruptcy is a federal matter, the Bankruptcy Code was passed by Congress and proceedings take place in the United States Bankruptcy Courts. Much of the administrative duties of these proceedings are supervised and handled by United States Trustees, who are appointed by Congress.

Chapter 7 bankruptcy is the most common type in the United States; it refers to the liquidation of a debtor’s assets. Essentially, a trustee, appointed by the courts, collects the debtor’s non-exempt property, sells it and distributes the proceeds to the creditors. Both businesses and individuals may file for Chapter 7.

Businesses who file in this manner cease all operations; this may or may not lead to job loss for employees – for instance, in large companies, entire divisions or branches of the company may be sold to other companies completely intact, with employees retaining their jobs. Fully-secured creditors, including bondholders and mortgage lenders, for whom the value of the collateral for their loan to the debtor equals or exceeds the amount of the debt, have a legal right to the collateral securing their loans or the equivalent value which cannot be defeated by bankruptcy. Thus, such creditors are not entitled to participate in the distribution of liquidated assets by the trustee.  It is also worth noting that businesses that have filed for Chapter 7 do not receive a full bankruptcy discharge; although the case is closed once all assets have been administered to creditors, the debts still theoretically exist until statutory periods of limitations expire.

Individuals who file for Chapter 7 will find that many types of debt are legally discharged by bankruptcy proceedings, although several are exempt from such discharge. These include child support, most taxes, most student loans, and fines or restitution imposed by a court for crimes committed by the debtor. It must also be taken into account that bankruptcy stays on an individual’s credit report for 10 years, although high debt can also negatively affect credit to an equal, if not greater, degree. Debtors considering Chapter 7 must also consider the possibility of a trustee choosing to challenge their filing as abusive, particularly considering the newly enacted Bankruptcy Abuse Prevention Act of 2005, which offers more extensive and thorough protections to creditors. The changes to Chapter 7 under the new Bankruptcy Reform Laws have been extensive, and include the implementation of means testing, which attempts to determine the extent of a debtor’s ability to repay unsecured creditors, a longer waiting period between filings, required budget and credit counseling prior to filing and the requisite completion of an instructional course on personal financial management. All of these new laws must be carefully considered and fully understood by anyone considering Chapter 7 bankruptcy.

Chapter 11 bankruptcy, in contrast to the liquidation of Chapter 7, refers to the reorganization, or debt adjustment, of a debtor’s assets and obligations. This type of bankruptcy is most commonly used by corporate entities; individuals may file for Chapter 11, but it is rare. Chapter 11 allows debtors to use future earnings to pay off creditors – it is an attempt by the debtor to stay in business while undergoing a supervised reorganization of its debts, rather than the dismantling and dispersal of assets offered by Chapter 7. 

If a company’s debts exceed its assets, Chapter 11 terminates all rights and interests of that company’s owners and stockholders, transferring ownership of the newly reorganized company to the creditors. One of the advantages of this type of bankruptcy over Chapter 7 is its ability to save the jobs of many, if not most, employees of the company; creditors, too, often end up with more money than if the company’s assets were broken down and sold individually. Depending on the size and complexity of the bankruptcy, debtors may emerge from Chapter 11 anywhere from a few months to several years later; under Chapter 11, debtors also have the exclusive right to propose a plan of reorganization to the court and their creditors for a certain period of time.  This allows the debtor more options than in a Chapter 7 proceeding.

Due to the complex and expensive nature of Chapter 11 proceedings, individuals rarely choose this type of bankruptcy over Chapters 7 or 13. In fact, even corporations may opt for an insolvency proceeding under state law, which is usually a faster, less expensive and much more private option for dealing with insurmountable debt.

Chapter 13 bankruptcy, not unlike Chapter 11, deals with individuals who are to undergo financial reorganization as supervised by a federal bankruptcy court; the goal of Chapter 13 is to provide income-receiving debtors with a rehabilitation period, provided that they fulfill a court-approved plan. Creditors cannot force debtors into this type of bankruptcy as they can with Chapters 7 and 11, and this type of bankruptcy does not offer the immediate relief from debt set forth by Chapter 7.

When filing for Chapter 13, a debtor proposes a plan to pay creditors over a 3 to 5 year period; as with other types of bankruptcy, creditors may not attempt to collect on their debts outside of the bankruptcy courts during this period. The debtor generally keeps his or her property and the creditors may end up with less than what they are owed. A debtor’s Chapter 13 plan must meet many requirements, which include assuring that unsecured creditors will receive at least as much as they would in a Chapter 7 liquidation, and committing the debtor’s disposable income to the plan for either 3 to 5 years or until all creditors have been paid in full. As with other types of bankruptcy, Chapter 13 filings stay on an individuals credit report for 10 years, and no additional credit can be obtained without the permission of a bankruptcy court.

Each type of bankruptcy has its advantages and its disadvantages for both individuals and corporations struggling with debt; one must carefully consider which type best meets his or her specific needs. We’re here to provide you with the information you need in order to help you make this important decision.