Although both Chapter 7 and Chapter 11 bankruptcies provide means of financial relief under the U.S. Bankruptcy Code, they are vastly different in the purpose they serve. They are applied in different circumstances. One path allows a business to close and liquidate assets. The other provides breathing room to reorganize and rebuild.

Knowing which path to take when a company (or individual) is overwhelmed with debt is important because there is a big difference between the implications on assets, future earnings, and legal obligations. Exploring the differences between Chapter 7 and Chapter 11 will help you understand the legal processes and fundamental differences in their underlying philosophies, one of discharge and the other of rehabilitation.

Choosing Between Liquidation (Chapter 7) and Reorganization (Chapter 11)

When a business is overwhelmed by debt, bankruptcy offers two primary paths:

  • Liquidation

  • Reorganization

These core concepts, embodied by Chapter 7 and Chapter 11 of the U.S. Bankruptcy Code, represent fundamentally different philosophies regarding a distressed entity's future. The choice between the two depends on whether the goal is to shut permanently or to reopen with a new financial beginning.

Chapter 7 (Liquidation)

The final option for a business or an individual is usually Chapter 7, also called liquidation. It offers a methodical and lasting shutdown of operations. This commences with a company or individual declaring bankruptcy, after which it has to stop its operations. Then a court trustee is appointed to step in.

The trustee primarily takes control of the debtor's non-exempt assets, sells them off, and distributes the money to the creditors per a statutory order of preference. This orderly procedure guarantees the fair sharing of available assets.

The primary goal of Chapter 7 bankruptcy is to offer a last, orderly means to liquidate an unviable business. It enables the fair division of assets left over among creditors and relieves the debtor of qualified debts.

It is a relatively straightforward process and, in most cases, quicker and simpler than other alternative bankruptcy options. Most Chapter 7 cases are concluded in three to six months, emphasizing the disposition of assets. It can be availed to individuals, partnerships, and corporations looking for a definite way out of their debts and closure.

Chapter 11 (Reorganization)

Chapter 11 bankruptcy, which is commonly known as a new beginning, aims to provide financially distressed businesses or individuals with an opportunity to reorganize and revive. It is a sharp contrast to other types of bankruptcy because the main aim is not the liquidation but the long-term sustainability of a viable business.

In Chapter 11, the company's existing management usually remains in charge as a "debtor-in-possession". Debtor-in-possession refers to a debtor who retains possession of their property during a bankruptcy proceeding, as though they were a trustee. Rather than sell assets, the business involves its creditors in negotiating a reorganization plan. The plan shows how the company can reorganize itself financially and in its operations to make it profitable again. This aims to enable the firm to remain operational as it settles its debts gradually.

When the court accepts this plan, the company can reorganize its debts and finances to repay creditors and remain in business. This plan helps the company come out of bankruptcy as a profitable going concern to save jobs and economic activity. Corporations and partnerships usually use this kind of bankruptcy. Nonetheless, high-net-worth individuals can also file if their debts are beyond the scope of other bankruptcy chapters.

Chapter 11 bankruptcy is complex and time-consuming compared to other bankruptcies, as it usually takes six months to two years. This is because creating and implementing a viable reorganization plan entails.

How Chapter 7 Bankruptcy Works for Individuals and Businesses

Chapter 7 bankruptcy provides individual and business owners a clear route to eliminating debt by selling non-exempt assets. Although it is often viewed as a last resort, this process offers a legal framework for a new financial beginning. Let us look at its mechanics, especially regarding the exemption of assets and the discharge of debts in case you contemplate doing so.

The Chapter 7 Process

The process under Chapter 7 starts by filing a bankruptcy petition in the court. The courts then issue an automatic stay. The stay is an injunction that immediately stops most collection efforts against the debtor. This means that the creditors cannot call, sue, garnish wages, or repossess property without court approval. This provides immediate relief from collection activities.

Soon after, the courts appoint a Chapter 7 trustee. The main task of this trustee is to:

  • Take legal possession of all the debtor's non-exempt assets

  • Examine financial records

  • Find property(s) that can be sold to pay the creditors

The functions of the trustee are wide-ranging. They collect and convert the estate's property to money and pay the proceeds to the creditors in a legally determined order of priority. Once assets are sold, the money goes to the creditors in a special order set by the Bankruptcy Code, where a fair and equitable payment is made based on the debt type.

Property Exemptions in Chapter 7

One of the significant issues that individual filers and sole proprietors considering Chapter 7 should consider is what happens to their property. More importantly, not all debtors' assets are auctioned off to the creditors. There are exemptions in the bankruptcy law, which enable the debtor to keep some necessary assets. The exact exemptions to be used depend on whether the debtor will use the:

  • Federal bankruptcy exemptions or

  • The laws in the state where they live

Whereas certain states mandate the application of state exemptions, in others, debtors can use either the federal or state exemption scheme, whichever is more protective. California is an "opt-out" state. This means filers must use one of the two available state-specific exemption systems rather than federal ones.

Federal law, 11 U.S.C. § 522(d), and similar state law, exempts property from property taxes, including:

  • A homestead exemption on a primary residence up to $31,575

  • A cap on the value of a motor vehicle at $5,025

  • Household goods and furnishings of up to $800 per item, with a total aggregate value of up to $16,850

  • Clothing

  • Jewelry of up to $2,125

  • Tools of the trade not exceeding $3,175

  • Retirement accounts like 401(k)s and IRAs — The retirement accounts are fully exempt. As for the IRAs, the cap is at $1,711,975 per person.

  • Some governmental benefits, like Social Security and unemployment, are typically excluded.

These exemptions guarantee that debtors are left with essential needs to get their lives back after bankruptcy.

Dischargeable and Non-dischargeable Debts

Discharge of debts is one of the most significant advantages of Chapter 7, as this legally absolves the debtor of personal liability for some debts. Typical unsecured debts often discharged in a Chapter 7 are:

  • Credit card debt

  • Medical bills

  • Personal loans

  • Deficiency balances on repossessed vehicles

This discharge gives debtors a clean slate and prevents them from being burdened with these past financial debts.

Not every debt can be discharged, though. Some obligations are considered non-dischargeable and will outlive the bankruptcy procedure, so the debtor still has to pay them. Examples of non-dischargeable debts include:

  • Recent tax debts, generally those incurred within three years of filing)

  • Most student loans, which are very difficult to discharge except on grounds of undue hardship

  • Child support obligations

  • Alimony

  • Debts incurred through fraud, embezzlement, or willful and malicious injury

This difference should be understood as it enables debtors to plan their future finances when the bankruptcy ends and set their expectations.

Is It Possible That My Whole Discharge is Denied?

One of the greatest fears of bankruptcy filers is the possibility of having their entire discharge denied. Therefore, the whole process may be fruitless. Although uncommon, a court may refuse to discharge a debtor for specific reasons that signal a lack of good faith or cooperation. This establishes a great deal of trust and authority, which makes it clear that bankruptcy is not a get-out-of-jail-free card. A discharge may be denied due to:

  • Concealing assets from the trustee or the court

  • Destruction or hiding of financial records

  • Bankruptcy fraud, that is, by giving false information on the petition or schedules

  • Willful disobedience of court orders

An example of grounds that the court may refuse to discharge is when a debtor transfers property shortly before filing so that it is not included in the bankruptcy estate, or simply does not attend the meeting of creditors. These actions undermine the integrity of the bankruptcy system. Thus, it is best to be honest and comply with the Chapter 7 system.

Understanding The Reorganization Process Under Chapter 11

Chapter 11 bankruptcy is an intricate but strong system of reorganizing a business's finances and, in certain situations, an individual's finances to enable them to proceed with operations. Chapter 11, however, unlike Chapter 7, which is liquidating, offers a rehabilitation structure under which debtors can formulate a feasible plan to repay their creditors over time, and still retain their business. This complex procedure involves several major players and crucial steps towards a successful financial turnaround.

Can You Still Run Your Business During Bankruptcy?

One of the most basic and attractive features of Chapter 11 is that of the debtor-in-possession (DIP). In most of Chapter 11 proceedings, the management of the business that has been in place continues to direct business operations. This means that the same people managing the company before the declaration of bankruptcy continue operations while retaining legal control as debtor-in-possession, not as a trustee. The DIP operates the business, disposes of property, sells or leases property, and incurs new debt, generally under the court's control.

What Role Do Creditors Play in Reorganization Bankruptcy?

As long as the debtor is in possession, there is a great counterbalancing power, the creditors' committee. Typically, the U.S. Trustee selects a committee of the biggest unsecured creditors. This committee is crucial in upholding the interests of all unsecured creditors in the Chapter 11 process. It is mandated with the duty of:

  • Investigating the debtor's financial position

  • Overseeing the debtor's activities

  • Negotiating with the debtor concerning the conditions of the reorganization plan

Active committee involvement means that the plan solves the creditors' concerns and gives them a reasonable value for their claims.

The Reorganization Plan and Disclosure Statement in Chapter 11

A Reorganization Plan and Disclosure Statement are at the heart of a Chapter 11 case. The reorganization plan is more or less the blueprint of the debtor for future profitability and financial stability. It outlines:

  • The debtor’s plans to reorganize its debts

  • The treatment of the different classes of creditors,

  • How the business will continue to be run

This document spells out new payment arrangements, possible debt write-offs, asset disposals, or other strategic adjustments the business will need to survive and thrive.

The debtor is required to file a Disclosure Statement before creditors can vote on this plan. This important document gives the creditors sufficient information on the debtor's financial position, the proposed plan, and the liquidation analysis (what the creditors would get in case the business is liquidated under Chapter 7). The disclosure statement's role is to ensure that the creditors have enough information to decide whether to accept or reject the reorganization plan. The court must approve the disclosure statement before it can be distributed to creditors.

What Does It Mean to Emerge from Chapter 11 Bankruptcy?

The final objective of a Chapter 11 case is what is referred to as the confirmation of the reorganization plan by the bankruptcy court. To be confirmed, a plan must satisfy several legal requirements, such as:

  • Becoming feasible — The debtor must show that they can implement the plan and make the proposed payments fair and equitable to all creditor classes

  • The creditors vote on the plan, and should the required approvals be made, the court has a confirmation hearing.

On confirmation by the court, the debtor legally binds itself with all the creditors to the plan. This is a turning point because it reflects a successful completion of the reorganization process.

To emerge from Chapter 11 is to state that the business has been able to come out of bankruptcy, its plan is confirmed, and the company can now operate under the conditions of its plan without most of the pre-bankruptcy debts.

Although the journey to emergence is challenging, it offers a strong chance for a struggling business to restore financial wellness and stay in business, often resulting in a leaner and more competitive company.

Key Questions to Guide Your Bankruptcy Decision

When a business is in a dire financial situation, the choice to file bankruptcy, or more precisely, whether to seek Chapter 7 liquidation or Chapter 11 reorganization, is enormous. The decision is based on a critical, sincere evaluation of the state of business, its prospects, and the owner's goals.

It is a crucial strategic inflection point that must be considered with many critical questions. Let us look at each.

Is the Business Viable in Principle?

This question cuts to the core of the bankruptcy decision. Is your business a sound and profitable business that is simply being choked by an unsustainable load of historical debt? Or is the basic business model faulty, making it unable to earn enough to meet even the operating expenses?

Chapter 7 liquidation may be the most feasible and sensible course of action if the business model is faulty, or the market environment has permanently crippled its profitability, and the business needs to be wound down in an orderly fashion. However, when the company has a good market, a faithful customer base, and a good product or service but is overwhelmed by its financial structure, Chapter 11 provides an opportunity to shed the unmanageable debt and emerge as a leaner and more viable business.

Can You Afford the Process?

Chapter 11 reorganization is infamously costly, with significant legal, accounting, and administrative fees. Depending on the complexities of the case, the expenses can efficiently run into tens of thousands and even hundreds of thousands of dollars.

Do you have access to sufficient capital to finance the Chapter 11 process, like ongoing operating costs and professional fees? This usually includes obtaining "debtor-in-possession (DIP) financing," whereby the business can borrow new money during bankruptcy, and in many cases with super-priority over pre-existing creditors. Chapter 11 can also be an unrealistic objective without a well-defined financial plan to support the restructuring initiatives, and a conversion to Chapter 7 or dismissal may be the result.

What is the Ultimate Goal?

Clarifying your objective is paramount. Is it more important to exit the business cleanly, reduce ongoing liabilities, and have a swift resolution, even if it means closing the doors permanently? In that case, Chapter 7, which is about liquidation and discharge of debts, will serve that purpose.

On the other hand, when you intend to rescue the company, keep people employed, retain business relationships, and perhaps create a profitable business again, the only choice left is to file Chapter 11. The chosen chapter should align with the strategic vision of the company and stakeholders.

What if There Are Personal Guarantees?

Personal guarantees on business debts are critical for LLC owners, corporations, or even sole proprietorships. Business bankruptcy (Chapter 7 or Chapter 11) often concerns business debts. Personal guarantees, however, mean that the business owner is personally responsible for those debts, irrespective of whether the business has filed for bankruptcy. When your business files Chapter 7, these personal guarantees will usually continue after the business goes bankrupt, and creditors can go after you. Although a person may file a personal Chapter 7 or Chapter 13 bankruptcy to discharge these personal guarantees, the processes are distinct. The reorganization plan in a Chapter 11 may cover the treatment of guaranteed obligations, and in some cases, allow the owner to settle his/her guarantee liability as part of the general plan. It is thus an essential step towards making the appropriate bankruptcy decision about your company to determine the degree of personal guarantees and how they may affect your finances.

Find a Bankruptcy Attorney Near Me

To make it through the complexities of Chapter 7 and Chapter 11 bankruptcy, you need to have a clear picture of the philosophies behind each of them and what they entail. Chapter 7 is the last resort where assets are sold to begin fresh, and Chapter 11 is a well-thought-out restructuring that aims to revive a failing but potentially viable business. The decision for which chapter to file depends on the overall health of your business, its financial ability to undertake the process, and its end goals: a clean exit or a new beginning.

The consequences of your financial condition and the future of your business are so profound that consulting a professional legal advisor is not only a good idea, but a necessity. Talk to San Diego Bankruptcy Attorneys today for the best guidance on proceeding with your unique case. Contact us at 619-488-6168.