Chapter 7 vs. Chapter 11: What’s the Difference?
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The United States (US) Bankruptcy Code, also known as Title 11 of the US Code, was enacted in 1978 and is the primary federal law that governs bankruptcy. It establishes procedures for individuals and businesses to file for bankruptcy, also outlining the rights of creditors and other stakeholders. This Code has a total of 15 Chapters, each addressing a different aspect of bankruptcy proceedings, and is designed to help debtors resolve insolvency issues. Two main chapters are important in deciding whether a business wants to try to stay afloat or simply sell off assets to pay the debts owed, Chapter 7 vs. Chapter 11. This article delves into the differences between each chapter and which process is a more viable option according to the circumstances of the bankruptcy.
Understanding Chapter 7 & Chapter 11 Bankruptcy
What is Chapter 7 Bankruptcy? (Liquidation Process)
Chapter 7 Bankruptcy, also known as “straight bankruptcy” or “liquidation bankruptcy”, is a legal process where an individual or business with significant debt sells non-exempt assets to pay creditors, with the remaining debt being discharged. Essentially, it provides the business a “fresh start” by eliminating most of their outstanding debts. It involves a court-appointed trustee who manages the liquidation process and distributes the proceeds to creditors while allowing the debtor to keep certain exempt assets based on state laws. It does not include restructuring plans or repayment plans. After the business ceases to exist certain debts (e.g., taxes, fraud-related claims) are non-dischargeable. It is generally the last resort due to its impact on credit scores and limitations on future borrowing.
What is Chapter 11 Bankruptcy? (Reorganization Process)
Chapter 11 Bankruptcy, or reorganization bankruptcy, is a legal process where a debtor can reorganize their debts and assets under court supervision. It allows them to continue operating while restructuring their finances and attempting to pay creditors over time. The debtor remains in control, known as debtor-in-possession, but must follow strict court supervision. The business proposes a repayment plan that must be approved by creditors and the court, This type of process is suitable for both small businesses and large corporations.
Chapter 7 vs. Chapter 11 – Key Differences
| Differential Point | Chapter 7 | Chapter 11 |
| Purpose | The primary goal is to sell off non-exempt assets to distribute the proceeds to creditors as much as possible. | The primary goal is to restructure the debts by renegotiating terms with creditors, selling assets, or adjusting operations. |
| Eligibility | Both individuals and businesses can be eligible, if they meet the income and debt requiremetns | Available to individuals with substantial debt and is commonly used by businesses looking to restructure their debts while continuing operations. |
| Process Duration | Typically takes a few months | Can last longer, ranging from several months to a couple of years |
| Control Over Business | The debtor has minimal control over the liquidation process, as the court-appointed trustee manages the sale of assets. | The debtor maintains control over day-to-day operations while working with the court and creditors to develop a reorganization plan. |
| Impact on Creditors | Creditors receive a smaller percentage of their total debt. | Depending on the plan, creditors may receive a larger portion of their debt. |
| Outcome | Liquidation of the debtor’s assets to pay off creditors and the business ceases its operations. | The business reorganizes its debts and emerges from bankruptcy as a viable entity. |
Impact of Chapter 7 & Chapter 11 on Creditors & Stakeholders
Creditors’ Rights & Repayment Priority:
Under Chapter 7, creditors may only receive a fraction of what they are owed, depending on the value of the liquidated assets. According to the provisions of this Chapter, secured creditors (e.g., banks with collateral) are paid first and unsecured creditors (e.g., suppliers, bondholders) receive residual amounts. On the other hand, in chapter 11 creditors negotiate new repayment terms, and some debts may be reduced, converted into equity, or rescheduled.
Suggested reading : Role of e-auctions in liquidating assets
Impact on Employees & Business Operations:
As the process in Chapter 7 vs. Chapter 11 leads to liquidation, most employees are likely to be laid off as the business ceases operations. Chapter 11 bankruptcy allows for reorganizations, potentially leading to reduced workforce through layoffs but with a higher chance of the company continuing operations and some employees retaining their jobs, albeit with possible changes to benefits and working conditions.
Choosing Between Chapter 7 & Chapter 11 – Factors to Consider
When deciding between Chapter 7 vs. Chapter 11bankruptcy, the key factors to consider are:
Financial Viability of the Business:
If the business has a little chance of recovery, then the business should choose Chapter 7 as liquidation is the best option to maximize creditor returns. Chapter 11 is better for businesses with the potential to restructure debt and continue operating, believing they can become profitable again.
Creditor Negotiation Willingness:
Chapter 7 vs. Chapter 11 bankruptcy may be easier to file if creditors are unlikely to support a reorganization plan, while Chapter 11 requires significant creditor cooperation to develop and approve a reorganization.
Time & Legal Complexity:
Chapter 7 vs. Chapter 11is a simpler process with lower legal fees, hence providing businesses with a quick exit. However, Chapter 11 involves more complex procedures, making the recovery process longer, as it requires detailed financial analysis and legal representation to manage the reorganization process.
Conclusion
A business has several factors to consider when applying the Bankruptcy Code. In a Chapter 7 Bankruptcy, a business is completely liquidated, meaning all assets are sold off to pay creditors, eventually leading to the business being shut down. This process is done under the control of a court-appointed trustee. Creditors receive only a portion of the proceeds from asset liquidation based on the priority of their claims. In contrast, in Chapter 11 Ibc , a company can reorganize its debts and continue operating while restructuring its finances to attempt to remain in business, under the management of the company itself, but with court supervision. Creditors may receive a combination of debt restructuring and potential equity stake in the reorganized company. A company that has very little value in its assets, and significant debt with no realistic path to repayment, may find Chapter 7 a suitable option, while a company that can restructure its debts and become financially viable again, wanting to maintain control over operations, and intends to continue operating as a business, will find Chapter 11 more viable.
