What Is Bankruptcy? The Basics

Something I’ve wanted to do for a while is to write a series of posts educating the layperson about the fundamental concepts surrounding bankruptcy, debt, personal finance, and related issues. The law in these areas can be complicated, and most people, if they’re lucky, have never had to deal with it. In these troubling economic times, however, it’s more important than ever that people understand the legal framework dealing with consumer debt and know their rights and responsibilities. To kick off this series, which I’m calling SDL 101, I thought I’d address the topic at the center of my practice:

What Is Bankruptcy?

Bankruptcy is a legal process through which debtors who cannot meet their obligations are allowed to seek a “fresh start,” subject to a myriad of regulations designed to prevent abuse. Far from being a new concept, the roots of bankruptcy can be found as far back as the Book of Deuteronomy, in which God required the Israelites to forgive all debts owed to one another every seven years. In societies without a concept of bankruptcy, the penalties for not paying one’s debts were (and in some cases still are) often quite severe, including debtor’s prison and even slavery, sometimes affecting multiple generations. Perhaps mindful of the debtor’s prisons of mother England, the Founding Fathers wrote bankruptcy protection into the U.S. Constitution: Article I, Section 8 gives Congress the power to enact “uniform laws on the subject of bankruptcies throughout the United States.”

The bankruptcy process is designed to provide the debtor with protection from collection attempts and an opportunity to “start over from scratch,” while still providing creditors with partial or full repayment of debts if possible. When a debtor (an individual or a business) enters bankruptcy, the court appoints a trustee to account for and assess the debtor’s assets and debts, and determines what assets the debtor is entitled to declare as exempt from collection. The debtor’s non-exempt assets, if any, are then sold, and the proceeds go to pay the creditors according to formulas in the law. In some kinds of bankruptcy, the creditors are also entitled to a portion of the debtor’s earnings for a set period of time after the bankruptcy filing. When a debtor successfully completes the bankruptcy process, all dischargeable debts are canceled and the debtor is declared free and clear of any further obligations to repay the discharged debts.

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. One recent example is Napster, the notorious file-sharing service that declared Chapter 7 bankruptcy in 2002. The Napster name and logo were purchased at the bankruptcy auction by an unrelated company, which operates under them to this day.)

    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. (I’ll talk about exemptions in depth in a future installment). 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.

This is obviously a very cursory and incomplete examination of a very complex topic, and I hope to go into further detail about many of the things discussed above as this series progresses. For now,  you can learn more by consulting some of the following resources: