Types of Bankruptcy: What You Need to Know

For individuals and businesses facing financial hardships, United States bankruptcy laws are designed to offer relief from overwhelming debt. Bankruptcy rules and procedures are governed by federal law: The U.S. Bankruptcy Code.

But what are the various types of bankruptcy? And how should creditors respond when informed about a debtor’s bankruptcy filing?

Bankruptcy Basics

Bankruptcy is the process whereby a person legally declares himself or his business unable to pay outstanding debts. Depending upon the type of bankruptcy filed, the debtor’s financial obligations will either be virtually wiped clean (“liquidation”), or a repayment plan will be proposed and approved (“reorganization”).

When businesses declare bankruptcy, the business will either close or continue to operate with reduced payments to creditors.

“It’s critical that every company have an in-house process for handling bankruptcy notices as they are received. By establishing what to do with a Notice of Bankruptcy and how to handle it properly, your company can avoid missed deadlines and potential fines if the automatic stay is violated.”
– Ryan Frisbie, Legal Manager, BARR Credit Serviceswhite text used

Bankruptcy Chapters

There are actually six different types of bankruptcy under the U.S. Bankruptcy Code:

Chapter 7 Liquidation for individuals and businesses
Chapter 9 Reorganization for municipalities
Chapter 11 Reorganization for corporations, partnerships or LLC’s (and individuals in rare instances)
Chapter 12 Reorganization for family farmers and fishermen
Chapter 13 Reorganization for individuals and sole proprietorships
Chapter 15 Cross-Border Insolvency for foreign companies with U.S. debts

Chapter 7 and Chapter 13 proceedings are by far the most common for both individuals and businesses. For example, according to the Administrative Office of the U.S. Courts, in 2017:

486,542 individuals and businesses filed for Chapter 7
296,599 individuals and businesses filed for Chapter 13
5,966 businesses filed for Chapter 11

One thing all bankruptcy types have in common: Once the petition is filed, you are prohibited from attempting to collect the debt. This is called an “automatic stay.”

Chapter 7 Liquidation

Both individuals and businesses are eligible to file Chapter 7 liquidation.

Once a Chapter 7 bankruptcy petition is filed, a notice is immediately sent to all creditors listed in the petition. The notice will include information about the scheduled “341 Hearing,” also known as the “Meeting of Creditors”. The purpose of this hearing (which is before a trustee, not a judge) is to determine if the debtor owns any assets which can be liquidated and distributed to creditors.

If the case is deemed “No Asset,” unsecured creditors will not receive any payments. However, if the case is deemed to be an “Asset” bankruptcy, unsecured creditors may submit a Proof of Claim in order to be included in the distribution of assets. (If your account has been placed with BARR Credit Services for collection, we will gladly prepare and file a Proof of Claim on your behalf at no extra charge.)

What If the Debt Is Secured?

Chapter 7 debtors with secured debts have three options for treatment of those financial obligations:

They may surrender the secured property back to the creditor.
They may “reaffirm” the debt, whereby they retain the property and continue to make the necessary payments.
They may “redeem” the property by paying its fair market value in one lump sum.

Chapter 13 Reorganization

Individuals and sole proprietors of businesses are eligible to file for Chapter 13 reorganization.

As with the Chapter 7, all creditors in a Chapter 13 bankruptcy will receive a “Notice of Bankruptcy Case Filing” and 341 hearing. But unlike the Chapter 7, the purpose of the 341 hearing in a Chapter 13 is to determine if the debtor’s proposed repayment plan should be approved.

In addition to providing information about the 341 hearing, the Chapter 13 bankruptcy notice will also explain how to file a Proof of Claim and the deadline for filing. (If your account has been placed with BARR Credit Services for collection, we will gladly prepare and file a Proof of Claim on your behalf at no extra charge.)

“If you hope to make any recovery in a Chapter 13 case, you must first file a Proof of Claim with the bankruptcy court. Pay close attention to directions and deadlines set by the court to be sure your claim is received and accepted at the time of filing.”
– Ryan Frisbie, Legal Manager, BARR Credit Serviceswhite text used

As part of a Chapter 13 three-to-five-year repayment plan, the debtor must state the proposed amount to be paid to unsecured creditors. This amount will depend on the disposable income available, but it cannot be less than what the creditor would have received if the debtor had filed Chapter 7.

What If the Debt Is Secured?

Chapter 13 debtors with secured debts have three options for treatment of those financial obligations:

They may surrender the property back to the creditor, at which point the debt becomes unsecured, and is paid along with other unsecured debt through the Chapter 13 plan (usually at a large discount).
They may retain the property and continue to make payments “outside” of the Chapter 13 plan, just as before filing. This is only an option if there is no arrearage owed on the debt.
They may retain the property and make their payments through the Chapter 13 plan. This option is used when there is an arrearage owed on the debt which must be included in the total plan payment.

Once the Chapter 13 plan has been approved by the bankruptcy court, claims will be paid out based on priority. For instance, secured debts are paid first, then priority debts (such as taxes and domestic support obligations), and then general unsecured debts. Proofs of Claim must be filed prior to the scheduled deadline in order to be considered for payment.

Chapter 11 Reorganization

Chapter 11 reorganization is designed for businesses that want to keep operating but need time to restructure their finances in order to pay the bills. It allows for a reorganization plan to help keep the business active while paying all the creditors over a period of time.

Chapter 11 bankruptcy is available to every business, whether organized as a corporation, partnership or sole proprietorship (and to individuals in some cases). However, because of its complexity, Chapter 11 is most prominently used by corporate entities.

Filing can be done voluntarily, or it can be forced on a business if three or more creditors file a petition with the bankruptcy court.

Once the Chapter 11 petition is filed, creditors are temporarily prohibited from attempting to collect the debt. The debtor-business then has four months to prepare a reorganization plan, though that can be extended to 18 months.

After that, creditors can propose reorganization plans. This is typically done through a “creditors’ committee,” which represents both secured and unsecured creditors.

The plan is basically a contract between the debtor-business and creditor that defines how the business will operate and pay its financial obligations. Most plans include some downsizing to reduce expenses and free up assets.

Once a debtor files the Chapter 11 reorganization plan, the creditors’ committee must approve it before it can be approved by the bankruptcy court. (If the creditors reject the Chapter 11 plan, the debtor can ask for a “cram down,” whereby the judge forces creditors to accept it.)

There is no time limit on completing the Chapter 11 repayment plan, but most take between six months and two years.

Proof of Claim

In a Chapter 11 case, it is not necessary to file a Proof of Claim if the creditor agrees with the amount the debtor has listed as due in the petition. However, if the creditor believes it is owed more money than indicated by the debtor (or if the debtor lists the claim as disputed, contingent or unliquidated), the creditor should file a Proof of Claim for the full amount owed.

Receivership

Whereas Chapter 7 and Chapter 13 bankruptcy involve the work of a court-appointed trustee, for Chapter 11 the bankruptcy court often appoints a receiver to audit the books, handle the selling of assets, and repay creditors a portion (or all) of their claims. The receiver is typically an attorney or specialist from outside the court system. A receiver is more directly involved in the management of assets than a bankruptcy trustee is.