Chapter 7 vs. Chapter 11: An Overview
Companies that find themselves in a dire financial situation where bankruptcy is their best—or only—option have two main choices in the U.S.: Chapter 7 bankruptcy or Chapter 11 bankruptcy. Both are also available to individuals.
Under a Chapter 7 bankruptcy, the business closes its doors and its assets are sold off to pay its creditors. In a Chapter 11 bankruptcy, the company may continue to operate under court supervision.
Key Takeaways
- Chapter 7 and Chapter 11 are two common forms of bankruptcy.
- In a Chapter 7 bankruptcy, the assets of a business are liquidated to pay its creditors, with secured debts taking precedence over unsecured debts.
- In a Chapter 11 bankruptcy, the company continues to operate under the supervision of a court-appointed trustee, with the goal of emerging from bankruptcy as a viable business.
Chapter 7
Chapter 7 bankruptcy is sometimes called liquidation bankruptcy. Businesses going through this type of bankruptcy are past the stage of recovery and must sell off assets to pay their creditors. The process works much the same for individuals.
The bankruptcy court will appoint a trustee to ensure that creditors are paid off in the right order, following the rules of “absolute priority.”
Secured debt takes precedence over unsecured debt in bankruptcy, and the holders of secured debts are first in line to be paid off. Loans that are secured by a specific asset, such as a building or a piece of expensive machinery, are examples of secured debt.
Whatever assets and cash remain after all the secured creditors have been paid are pooled together and distributed to creditors with unsecured debt. Those would include bondholders and shareholders with preferred stock.
To qualify for Chapter 7 bankruptcy, the debtor can be a corporation, a small business, or an individual.
Individuals are also eligible for another form of bankruptcy, Chapter 13, in which the debtor agrees to repay at least a portion of their debts over a three- to five-year period under court supervision.
Chapter 11
Chapter 11 bankruptcy is also known as “reorganization” or “rehabilitation” bankruptcy. It is the most complex form of bankruptcy and generally the most expensive. For that reason, it’s most often used by businesses rather than individuals. The business may be corporations, partnerships, joint ventures, or limited liability companies (LLCs).
Unlike Chapter 7, Chapter 11 gives a company an opportunity to reorganize its debt and try to reemerge as a healthy business.
A Chapter 11 case starts with the filing of a petition in a bankruptcy court. The petition may be a voluntary one, filed by the debtor, or an involuntary one, filed by creditors who want their money.
During Chapter 11 bankruptcy, the business will keep operating while taking initiatives to stabilize its finances, such as cutting expenses, selling off assets, and attempting to renegotiate its debts with creditors—all under the court’s supervision.
The Small Business Reorganization Act of 2019, which went into effect on Feb. 19, 2020, added a new subchapter V to Chapter 11 designed to make bankruptcy easier and faster for small businesses, which the U.S. Department of Justice defined as “entities with less than about $2.7 million in debts that also meet other criteria.” The act “imposes shorter deadlines for completing the bankruptcy process, allows for greater flexibility in negotiating restructuring plans with creditors, and provides for a private trustee who will work with the small business debtor and its creditors,” the Justice Department says.
Note
The Coronavirus Aid, Relief, and Economic Security (CARES) Act, signed into law on March 27, 2020, made temporary changes to bankruptcy laws designed to make the process more available to businesses and individuals economically disadvantaged by the COVID-19 pandemic. These changes ended, for the most part, in March 2021.
Chapter 7 vs. Chapter 11: Key Differences
Like Chapter 7, Chapter 11 requires the appointment of a trustee. However, rather than selling off all assets to pay back creditors, the trustee supervises the assets of the debtor and allows the business to continue.
It’s important to note that debt is not absolved in Chapter 11. The restructuring only changes the terms of the debt, and the company must continue to pay it back through future earnings.
If a company is successful in Chapter 11, then typically it will be expected to continue operating in an efficient manner with its newly structured debt. If it is not successful, it will file for Chapter 7 and liquidate.
Chapter 7
Known as “liquidation” bankruptcy
Assets are sold off by a trustee to pay debts
When all assets are sold, the remaining debt generally is forgiven
Used by both businesses and individuals
Chapter 11
Known as “reorganization” bankruptcy
Debts are restructured by a trustee, and the business continues
Remaining debts must be paid back through future earnings
Used primarily by businesses
How to Prevent Bankruptcy
Bankruptcy is generally a last resort for businesses and individuals alike. Chapter 7 will, in effect, put a business out of business, while Chapter 11 may make lenders wary of dealing with the company after it emerges from bankruptcy. A Chapter 7 bankruptcy will remain on an individual’s credit report for 10 years, and a Chapter 13 for seven.
Bankruptcy can be unavoidable. A business can go under during a severe recession. An individual can suffer a job loss or crushing medical expenses.
Still, many bankruptcies could have been avoided. One key, for both businesses and individuals, is to borrow judiciously. For a business, that could mean not expanding too rapidly. For an individual, it might mean not buying a larger home or a costlier car.
Before filing for bankruptcy, a business owner should consult with an outside attorney who specializes in bankruptcy law and discuss the alternatives.
Individuals are required by law to take an approved credit counseling course before they file. They may also have other resources available, such as a reputable debt relief company that can help them negotiate with their creditors. Investopedia publishes an annual list of the best debt relief companies.
Can You File for Bankruptcy Without an Attorney?
Individuals can file for bankruptcy under Chapter 7 or Chapter 13 without an attorney, according to the website of the U.S. federal courts system. This is called "filing pro se."
However, the site strongly recommends seeking the help of a qualified attorney "because bankruptcy has long-term financial and legal outcomes" and misunderstandings or mistakes can have serious results.
Who Can File Chapter 11?
Chapter 11 bankruptcies can be filed by any individual, business, partnership, joint venture, or limited liability company, with no specific debt-level limits and no required income.
What's the Difference Between Chapter 11 and Chapter 13?
Both Chapter 11 and Chapter 13 allow for the discharging of debts but have different costs, eligibility, and time to completion, making them two different types of bankruptcies.
- Chapter 11 can be done by almost any individual or business, with no specific debt-level limits and no required income.
- Chapter 13 is suitable for individuals with stable incomes, and this type of bankruptcy sets specific debt limits.
The Bottom Line
Chapter 7 and Chapter 11 are two common options for businesses to declare bankruptcy.
Chapter 7 is considered a liquidation bankruptcy: it doesn't require a repayment plan but the business has to sell some assets to pay creditors.
Chapter 11 is considered a reorganization bankruptcy that allows businesses to maintain their operations while creating a plan to repay creditors.
