Bankruptcy: Types of Bankruptcy

The Bankruptcy Process

[Photo] Bankruptcy in the United States is federal: all bankruptcy cases are handled through the federal court system, and the relevant laws apply equally in all states (although state laws can apply when calculating exemptions, as explained below). Bankruptcy law is codified in Title 11 of the United States Code (“11 U.S.C.”). Title 11 currently consists of 9 chapters, which are assigned numbers between 1 and 15 for administrative purposes. Three of these chapters deal with administrative matters like definitions and general provisions. Each of the other 6 chapters creates a set of rules under which petitioners may file for bankruptcy. Of these 6 chapters, the vast majority of bankruptcies in the United States are filed under three: chapter 7, chapter 11, and chapter 13.

A chapter 7 bankruptcy, also known as straight bankruptcy, is available to both individuals and businesses. A chapter 7 bankruptcy is a liquidation process, which means slightly different things depending on whether an individual or a business is filing for bankruptcy.
- When a business files under chapter 7, the business is literally liquidated: it goes out of business permanently. The trustee sells off all of the filer’s assets, and the proceeds go to pay the creditors. At the conclusion of the bankruptcy process, the business no longer exists as a legal entity. (Note, however, that brands and trademarks are considered saleable assets, which often survive the demise of the business that created them.)
- When an individual (or a husband and wife filing jointly) files under chapter 7, the trustee accounts for any exemptions the filer is entitled to before determining what assets, if any, should be auctioned off to pay the creditors. The bankruptcy process isn’t intended to ruin people, so exemptions allow the individual to keep certain assets deemed necessary to lead a normal life: clothing, household goods and furnishings, motor vehicles, and retirement funds are all examples of categories of assets that can be declared exempt up to a certain dollar value. In some cases, exemptions allow filers to avoid foreclosure on their homes. In many cases (so-called “no-asset” cases), the debtor does not have any non-exempt property at all, so the creditors receive nothing.
A chapter 11 bankruptcy involves reorganization, rather than liquidation. Chapter 11 is primarily used by businesses, although some high-income or high-asset individuals may be required to file under chapter 11 in rare cases. Chapter 11 allows businesses to continue operating during and after the bankruptcy process, although not all chapter 11 filers choose to remain in business. Whereas in a chapter 7 bankruptcy the trustee takes control of the debtor’s assets directly and liquidates them, a chapter 11 filer is allowed to develop its own plan for reorganization and partial or full repayment of creditors, subject to the approval of the trustee. Chapter 11 plans usually involve a portion of earnings going directly to creditors for a period of time after the filing, as determined by the details of the plan.
A chapter 13 bankruptcy is available to individuals only. Chapter 13 involves reorganization, like chapter 11: rather than undergo asset liquidation, the debtor proposes a plan to fully or partially repay his or her creditors over time, subject to the approval of the bankruptcy trustee. Whereas chapter 7 bankruptcies take place immediately, chapter 13 bankruptcies last for either 3 or 5 years, depending on the financial status of the filer, and typically require the debtor to pay a portion of his or her earnings to the court for disbursement to creditors throughout the term of the bankruptcy. As with the other forms of bankruptcy, individual chapter 13 filers are entitled to claim certain exemptions.

The other forms of bankruptcy are rare. Chapter 9 governs debt restructuring by municipalities. When Orange County, California declared bankruptcy in 1994, it filed under Chapter 9. Chapter 12 is a reorganization chapter that is available only to family farms and commercial fishermen. Chapter 15 was added to the bankruptcy code in 2005 and addresses international bankruptcies.