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 basic choices: Chapter 7 bankruptcy or Chapter 11 bankruptcy. Both are also available to individuals. Here is how these two types of bankruptcy work and how they differ.
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 and restructures 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 reorganization 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 is first in line to be paid off. Loans issued by banks or other financial institutions 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, including corporations, partnerships, joint ventures, and limited liability companies (LLCs).
Unlike Chapter 7, Chapter 11 gives a company the 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 debtor will remain in business 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 a number of temporary changes to bankruptcy laws designed to make the process more available to businesses and individuals economically disadvantaged by the COVID-19 pandemic. These include raising the Chapter 11 subchapter V debt limit to $7,500,000 and excluding federal emergency relief payments due to COVID-19 from current monthly income in Chapter 7. The changes apply to bankruptcies filed after the CARES Act was enacted and 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, then it will file for Chapter 7 and liquidate.
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Known as “liquidation” bankruptcy
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Assets are sold off by a trustee to pay debts
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When all assets are sold, the remaining debt generally is forgiven
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Used by both businesses and individuals
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Known as “reorganization” bankruptcy
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Debts are restructured by a trustee, and the business continues
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Remaining debts must be paid back through future earnings
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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.
While bankruptcy may be unavoidable in many instances (a severe recession in the case of a business; job loss or high medical bills for an individual), one key to preventing it is borrowing judiciously. For a business, that could mean not using debt to expand too rapidly. For an individual, it might mean paying off their credit card balances every month and not buying a larger home or costlier car than they can safely afford.
Before filing for bankruptcy, and depending on their own internal legal resources, businesses may want to consult with an outside attorney who specializes in bankruptcy law and discuss any alternatives that are available to them.
Individuals are required by law to take an approved credit-counseling course before they file. Individuals also have other resources available to them, such as a reputable debt relief company, which can help them negotiate with their creditors. Investopedia publishes an annual list of the best debt relief companies.
Can You File for Chapter 7 Online?
You can download the Chapter 7 bankruptcy forms online, but you cannot file bankruptcy online. Bankruptcy forms should be delivered in person to the local bankruptcy court, and only attorneys are allowed to file the forms online.
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, whereas 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.