DEFINITION: Bankruptcy is a legal process by means of which a bankruptcy court determines that an individual or business shall be legally declared incapable of meeting its outstanding debts in a timely manner.

For a bankrupt individual, the process provides relief from creditors and allows a fresh start. Certain categories of the debtor’s property are legally protected from liquidation in bankruptcy proceedings.

For bankrupt companies, the bankruptcy process may lead either to reorganization or to cessation of business operations.

For the individual or company’s creditors, the bankruptcy process usually provides some payment of outstanding claims, albeit at a discounted rate.

The question of who gets paid how much constitutes the main work of the bankruptcy court and will depend on the competing claims of all creditors, as well as the bankrupt individual or company’s financial condition.

The bankruptcy process is usually initiated at the request of the debtor, although sometimes it begins with a petition by one or more of creditors.

ETYMOLOGY: “Bankrupt” enters English during the sixteenth century. It is derived from Middle French banqueroute, which is derived from Old Italian bancarotta, a construction from banca (bank) and rotta (broken).

Banca (literally, bench) is of Germanic origin, and is akin to Old English benc, with the same meaning.

Rotta is derived from the past participle ruptus of the Latin verb rumpere (to break).

USAGE: Before the widespread adoption of bankruptcy laws, the failure to repay one’s debts was a crime and insolvent debtors were sentenced to debtor’s prisons.

The bankruptcy process was introduced into the legal system in England and elsewhere, not only to alleviate the harsh treatment of individual debtors, but also as a perceived benefit to society at large.

The idea was that bankruptcy’s social effects would be twofold:

  • It would benefit creditors, who received at least partial restitution of what is owed to them; and
  • It would allow debtors to continue contributing to the economy (which they could not do from inside prison walls).

In the US today, all bankruptcy cases are processed through the federal court system. Either a federal judge or a “trustee” appointed by the US Trustee Program—operating within the Department of Justice—presides over the court. The trustee, if any, represents the debtor’s interests during the bankruptcy proceedings.

If the bankruptcy process proceeds to a successful conclusion—that is, with the agreement of both the debtor and the creditors—the debtor is granted relief from his legal obligation to repay his debts.

In the US, bankruptcy filings are classified according to which of three chapters of the US Bankruptcy Code is applicable.

The majority of filings fall under one of the following three chapters:

  • Chapter 7 involves the liquidation of the debtor’s assets (with certain exceptions).
  • Chapter 11 focuses on reorganizations for both companies and individuals.
  • Chapter 13 facilitates debt repayment by means of structured payment plans.

Chapter 7 Bankruptcy

Most individuals who file for bankruptcy do so under Chapter 7, which allows them to be discharged from all unsecured debts, such as credit card balances and medical bills.

Individuals filing under Chapter 7 must liquidate non-exempt personal property to repay as much of their unsecured debt as possible. However, much of an individual debtor’s personal property is exempt from this liquidation requirement, including his primary residence, automobile, clothing, household goods, and tools of trade, up to a specific dollar value.

Chapter 11 Bankruptcy

Chapter 11 bankruptcy is commonly utilized by businesses aiming to reorganize and continue their operations.

By filing for bankruptcy under Chapter 11, a company will be able to come up with strategies for enhancing profitability, reducing expenses, and exploring new avenues for generating revenue.

Under Chapter 11, shareholders in possession of preferred stock will receive a high priority with respect to distribution of payments from the debtor’s estate, while shareholders possessing common stock will receive the last priority for such distributions.

Chapter 13 Bankruptcy

Individuals who earn too much money to qualify for bankruptcy protection under Chapter 7 bankruptcy have the option of doing so under Chapter 13.

Individuals and companies with stable incomes who file under Chapter 13 will be allowed to negotiate a practicable and structured debt repayment plan, sometimes referred to as a “wage earner’s plan.”

Chapter 13 repayment plans are typically structured in installments over a period of three to five years.

If the debtor fulfills his obligations to creditors under his repayment plan, the court will permit him to keep all of his property, including non-exempt assets.

Other Bankruptcy Filings

Aside from the commonly known bankruptcy proceedings like Chapters 7, 11, and 13, several other kinds of bankruptcy cases exist, as well:

  • Chapter 9 bankruptcy provides assistance for financially struggling municipalities, including counties, cities, towns, and school districts. Chapter 9 is analogous to Chapter 13, in that under this chapter municipalities avoid asset liquidation and negotiate a repayment plan with creditors.
  • Chapter 10 bankruptcy, which provided for reorganization for companies, was discontinued in 1978 and has in effect been replaced by the Chapter 11 provisions (see above).
  • Chapter 12 provides bankruptcy relief for family farms and fisheries. Under this chapter, they are allowed to maintain their businesses while working out a plan to repay their debts.
  • Chapter 15, the authorizing law for which was passed in 2005, provides bankruptcy protection for companies with international operations. It is especially designed to deal with assets held abroad and with foreign creditors.

Discharge of Debts under Bankruptcy

When a bankruptcy proceeding is successfully concluded, the debtor’s debts specified in the court order are discharged and the debtor is no longer legally bound to pay them. Moreover, the creditors listed in the order are prohibited from trying to collect the debts owed to them.

Not all debts are eligible for discharge via bankruptcy. Non-dischargeable debts include tax claims and other debts owed to the government, child support and alimony payments, liability for personal injury, and any debts not listed by the debtor.

Secured creditors, however, retain the right to enforce valid liens on property owned by the debtor.

Advantages and Disadvantages of Bankruptcy

Bankruptcy offers relief from the legal obligation to repay one’s debts. Additionally, it will likely safeguard one’s home or business, depending on which chapter one files under.

On the downside, bankruptcy will almost certainly have a negative impact on one’s credit rating, thus making it more difficult to obtain bank loans, credit cards, home mortgages, and even to rent an apartment.

A Chapter 7 filing will remain on your credit report for ten years, while a Chapter 13 will be there for seven years.