bankruptcy

What It Is

Bankruptcy is a legal process under which a borrower protects and/or liquidates assets in order to repay debts.

How It Works

In general, there are three "types" of bankruptcy, each named after a section of U.S. bankruptcy law. In most cases, a debtor files a petition with the local bankruptcy court. Public companies must also file a form 8-K with the Securities and Exchange Commission (SEC) to notify shareholders of the bankruptcy proceedings. The debtor must provide the court with financial and tax information, as well as a list of creditors and outstanding debts. For individuals, courts may also require proof that the person has obtained credit counseling. Filing the bankruptcy petition often automatically stops most collection actions against the debtor, including lawsuits, garnishments and phone calls. Alimony, child support and student loans generally cannot be discharged in any kind of bankruptcy, nor can most judgments against the debtor for criminal acts.

Once the court receives the petition, it usually appoints an impartial trustee who meets with the creditors and works with the debtor to develop a repayment plan. The court often has to approve the plan before the trustee can proceed. The debtor then makes payments to the trustee, who distributes the money to creditors.

Chapter 11
In general, Chapter 11 is for businesses, not individuals. This does not mean it's off limits to individuals, but it does mean that filing Chapter 7 or Chapter 13 is often easier and more favorable for individuals. Most often, individuals who operate sole proprietorships, partnerships or other businesses that are closely intertwined with their personal assets are the best candidates for Chapter 11.

Ultimately, under Chapter 11, a judge decides whether to discharge an individual's debt. The judge can deny the discharge if the debtor failed to keep adequate records, failed to explain the loss of any assets, committed a crime, disobeyed court orders or did not seek credit counseling.

For businesses, the U.S. Trustee (the bankruptcy division of the Justice Department) will appoint one or more committees to represent a company's creditors and shareholders. The committees negotiate with the company to try to get as much of their money back as they can, and this process can take months. The creditors, shareholders and the bankruptcy court must approve the reorganization plan (in some cases, the shareholders vote on the plan), but the court can often overrule everyone and approve the plan anyway. The SEC also reviews the plan to make sure the disclosure is adequate and obeys the law.

Chapter 11 allows existing management to continue running the business (this is referred to as "debtor in possession"), but the bankruptcy court must approve major decisions, such as the sale of a division. During bankruptcy, the company usually will not have to make interest, principal or dividend payments on any of its securities.

The seniority of lenders becomes very important in Chapter 11. Lenders whose debt is backed by collateral are generally repaid first, followed by the unsecured lenders, and finally the shareholders. The reorganization plan may also allow companies to pay lenders with stock (which may be worth substantially less).

Chapter 7
Individuals, partnerships or corporations can file bankruptcy under Chapter 7. Most companies do not file Chapter 7 until they've been unsuccessful with a Chapter 11 filing, which lets them attempt to restructure the company and restore the ability to service debt. In Chapter 7, a company ceases operations and the appointed trustee liquidates the company's assets in order to repay its debts.

Ultimately, for individuals, a judge decides whether to discharge debt. The judge can deny the discharge if the debtor failed to keep adequate records, failed to adequately explain the loss of any assets, committed a crime, disobeyed court orders or did not seek credit counseling.

The law works to prevent people from filing Chapter 7 merely to avoid repaying a debt. This is why not all individuals qualify for Chapter 7, especially those with high monthly incomes or those primarily saddled with consumer debts (i.e., credit card debt). If the individual does not qualify for Chapter 7, the case usually becomes a Chapter 13 case, where the individual must still repay the debt, albeit under a payment plan.

Although the liquidation proceeds go first toward administrative and legal expenses, the seniority of a company's lenders is again very important in Chapter 7. Lenders whose debt is backed by collateral are generally repaid first (via the receipt of the collateral), followed by the unsecured lenders and then the shareholders. In many cases, unsecured bondholders receive only pennies on the dollar. Shareholders almost never receive anything, but if they do, the trustee gives them an opportunity to claim their share.

Chapter 13
Chapter 13, also called a wage-earner's plan, lets individuals attempt to restructure their finances in order to repay their debts. Individuals, the self-employed and those operating unincorporated businesses can file bankruptcy under Chapter 13. Corporations and partnerships cannot.

Chapter 13 is a viable option for people with regular incomes -- it allows debtors to propose installment plans to repay some or all of their debt over three to five years. Alimony, child support and student loans generally cannot be discharged in a Chapter 13 case, nor can most judgments against the debtor for criminal acts. If the debtor wants to keep his house or other assets that serve as collateral to a particular creditor, then the repayment plan needs to specifically address how that creditor will be paid in full within the five years allowed by the Chapter 13 laws. During this time, the debtor cannot take on any new debt without the trustee's permission.

Not all individuals are eligible for Chapter 13; those who have more than a certain amount of debt don't qualify and must file Chapter 11 or Chapter 7. But debtors often choose Chapter 13 over Chapter 11 or Chapter 7 because it helps them avoid foreclosure on their homes by allowing them to catch up on delinquent mortgage payments, and it helps them avoid direct contact with their creditors. A person can emerge from Chapter 13 (that is, be "discharged") if all of the debt is repaid and has completed a financial-management course. After discharge, the debtor's creditors can no longer pursue the debtor for payments or try to collect the discharged obligations.

Why It Matters

Bankruptcy is usually a last resort for individuals and businesses. For individuals, the goal is to get a fresh start by removing debts. However, bankruptcy virtually ruins a person's credit for several years, making it very difficult and expensive to borrow money.

Bankruptcy can be complex and expensive. Creditors involved with a bankrupt borrower bear unusually high risk, and their debts are likely to become worth pennies on the dollar (if that).

Exchanges usually delist companies that stay in bankruptcy beyond a certain time. This is not to say that their shares won't trade again; the listing may simply be moved to the over-the-counter (OTC) market or the Pink Sheets, where the ticker will end with the letter Q (to denote bankruptcy). If a company is able to emerge from bankruptcy, the lenders often become the new owners of the company and the shares of the existing shareholders are usually canceled or at least substantially diluted. But miracles do happen, and companies do pull themselves out of bankruptcy. In these cases, investors can profit substantially. If reorganization proves unsuccessful, however, the company ceases all operations, sells its assets, uses the money to pay off any debt and shuts the doors for good. If a company's stock or bonds are deemed worthless by the bankruptcy court, investors might be able to deduct their losses on their tax returns.

Source: Investing Answers