Types of Bankruptcy
Are you familiar with the three most common types of bankruptcy?
Do you know the difference between voluntary and involuntary bankruptcy?
The most common “chapters” (or types) in bankruptcy are Chapters 7, 11, and 13. A simple explanation of each chapter follows:
Chapter 7, straight liquidation: In a chapter 7 bankruptcy, the debtor’s assets are divided into two categories:
- Exempt: A debtor’s exempt assets are protected in whole or in part from being taken to pay creditors. For example, exemptions protect formal retirement accounts, Social Security benefits, home equity, and some personal property. The rules of exemption are a bit tricky – exemption can be capped at different levels based on state law, and eligibility for an exemption may also depend on how long the debtor has owned the asset.
- Nonexempt: The debtor’s nonexempt assets are sold, or liquidated, and the cash proceeds are given to the bankruptcy trustee for distribution to creditors (the trustee being an individual appointed by the court to oversee that process).
Taxing authorities, former employees, and secured creditors get the lion’s share of the cash generated by the liquidation of the debtor’s assets. General unsecured creditors (creditors without liens) get very little, if anything. In bad economic times, most Chapter 7 bankruptcies are filed as no-asset cases, meaning that unsecured creditors get zilch.
Chapter 11, business reorganization: Sometimes a business that’s in financial trouble will want to try to stay in business, rather than go through liquidation under Chapter 7. The bankruptcy court allows the company to stay in business and to remain in possession and control of its assets, while implementing a plan to repay creditors based on the debtor’s assets and income.
A creditor’s committee is appointed to help the debtor determine what a reasonable repayment plan would be. After the repayment plan is drawn up by the debtor and the creditors’ committee, a proposal is made to creditors in writing. If you, as a creditor, have filed a proof of claim in a Chapter 11 bankruptcy, you’ll receive a proposed plan of arrangement, and you get to vote on it. If more than half of the unsecured creditors in number (more than half of the total number of creditors) and amount (creditors representing more than half of the total debt owed) approve the plan, it becomes binding on the debtor. As long as payments are made according to that plan, the debtor can remain in business.
Chapter 13, wage earner bankruptcy: This form of bankruptcy is similar to a Chapter 11 reorganization, but is limited to wage earners or nonbusiness entities. An ordinary individual or married couple with regular income, whose unsecured debt isn’t outrageous, can file Chapter 13 and enter into a repayment plan very similar to the plan described for Chapter 11.
The Chapter 13 debtor files a plan to repay a specified amount or percentage to unsecured creditors over a specified period of time, usually from three to five years, depending on the debtor’s monthly income.
Voluntary vs Involuntary Bankruptcy
Some bankruptcies are filed by creditors who gang up on the debtor when payments to those creditors are substantially delinquent. This is referred to as an “involuntary petition.” On the other hand, when the debtor files a petition for bankruptcy, that’s considered “voluntary.” Involuntary bankruptcy can occur under Chapters 7 and 11, but not under Chapter 13.
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