All the Difficult Chapters of Bankruptcy Explained
Defining “Bankruptcy”
The term “bankruptcy” comes from the Italian banca rotta. Granted, everything with an Italian name sounds like either the name of an important painter or an elaborate pasta dish, but along with their other contributions to western civilization, the Italians were the original bankers (at least in the modern sense of the word).
Banca, as you probably already guessed, is the root of our modern term “bank.” The term actually means “bench” or “table.” While today those are two very different things, if you think about it, they’re really both just flat surfaces on legs. Money lenders set up their tables and did business over these “banks,” and over time… there you go.
Rotta is a term meaning “broken” (not to be confused with “rotted” – which comes from a totally different root). Literally translated, then, banca rotta means something like “broken bench,” or – in context – “broken bank.” Your personal bank is broken; you can’t pay your debts.
Pretty depressing, right?
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Rotta can also be translated as “rupture,” however. Granted, in some ways, this sounds way worse. Broken is bad enough, but ruptured? Eeewwww! But this same root is the basis for modern words like “interruption” and “route.” An interruption is different than something being entirely broken. Interruptions don’t last forever. And a route? Even if a route is partly established by someone blowing away obstacles (think of the sort of demolition that sometimes has to be done to lay tracks or build highways), the goal of a route is to get you somewhere. Maybe somewhere better.
Bankruptcy can mean your bank is broken. It can mean your finances are corrupted and that life has seriously ruptured. Or it can mean a structured interruption to all of that, and a system designed to establish a route out of where you are and towards a different future.
Which one actually applies is entirely up to you.
What Is Bankruptcy?
Bankruptcy is a legal mechanism that allows individuals or businesses who can no longer pay their debts to satisfy as many creditors as possible. It then eliminates many of the remaining obligations in order to allow that individual or business to move forward.
It’s a civilized alternative to simply demonizing or condemning individuals for falling short, getting sick, or running into insurmountable obstacles.
Does it sometimes mean people who screw up are “let off the hook”? You could frame it that way. I’d prefer to describe it as allowing individuals or companies in debt to make things as right as they can, learn a few painful lessons, then get back to contributing to society as best they can.
Modern bankruptcy is still a difficult process. It’s not supposed to be pain-free. It’s a way forward, however – not punishment for “failing.” Like divorce, quitting a job, or ending a relationship, we want to do what we can to avoid it. Sometimes, however, the best way past a problem is to go through it.
Personal Bankruptcy Options
If you’re an individual considering whether or not to file bankruptcy, there are two primary bankruptcy chapters you should know. The laws which govern the various bankruptcy chapters are made at the national level. The rules, in other words, are federal. State laws can impact details, however – either adding additional protections for individuals filing bankruptcy or determining the debt or income thresholds for an individual to file or the amount of personal property protected during the process.
The most common form of personal bankruptcy is Chapter 7. Roughly two out of every three personal bankruptcies filed in the U.S. are for Chapter 7 bankruptcy. This is sometimes referred to as “straight bankruptcy” (which is a fairly accurate description) or “liquidation bankruptcy” (which is not). Let’s take a look at why.
1. Chapter 7 Personal Bankruptcy
The idea of Chapter 7 bankruptcy is that the court determines a minimal amount of personal property you’re allowed to keep and everything else you own is sold off to pay down your debts. Whatever’s left that you can’t pay is “forgiven,” or wiped clean so you can reboot and try again.
In practice, of course, it’s not quite that simple. In over 90% of Chapter 7 bankruptcies, the individual choosing to file bankruptcy lacks sufficient property for the court to require any sort of selling-off. These are called “no asset” cases. Some of this is due to the many other options available before considering bankruptcy. Bill consolidation loans, low-interest personal loans, or other options for paying down credit card debt, medical bills, student loans, etc., mean Americans in the 21st century have options.
There are alternatives to filing bankruptcy that may offer better choices in many cases – including the option of using accumulated property or other assets to pay down debt or as security for restructuring that debt into something more manageable.
The larger reason, though, that only a low percentage of Americans filing Chapter 7 bankruptcy (or utilizing any of the major bankruptcy chapters) end up losing personal property are legally designated “exemptions.” Exemptions are protected sorts of property you don’t have to lose when filing bankruptcy. In most cases, for example, your home is exempt from the proceedings. At least one vehicle is typically exempt as well. Your clothes, personal electronics, kitchen appliances, etc., are usually safe as well. Most middle-class Americans simply don’t have the sorts of surplus property covered by most bankruptcy chapters.
Keep in mind that exempting something from being sold off to pay your creditors isn’t the same as saying you get to keep it even if you’re not finished paying for it. If you still owe on your “exempt” home or vehicle, you’ll need to make a plan for continuing those payments. They may be deferred during bankruptcy proceedings, but they don’t magically go away.
Everything Must Go (Except For This Or That Or The Other Thing)
Even if you have property not specifically exempted by either state or federal law, you may be able to hang on to it while you continue making your payments. You do this by “reaffirming the debt.” Reaffirming the debt essentially removes an item you’re still paying on from the mix and lets you super-pinky-promise you’ll continue making those payments on the original terms, despite whatever else is going on in your financial world. There’s paperwork and a few basic requirements to be met, but this provision is utilized regularly and works for many Americans.
What’s not impacted?
There are also several types of debt not impacted by Chapter 7 bankruptcy or most other bankruptcy chapters.
If you’re paying court-ordered alimony or child support, that obligation does not change because of bankruptcy.
Your student loans aren’t generally altered by bankruptcy proceedings.
And it probably goes without saying that bankruptcy won’t get you off the hook for paying your taxes. The courts will try to protect your other creditors as well, if possible. Why should businesses and their owners be punished for trusting you?
That said, please remember that bankruptcy laws are not written to punish you, but to shield you from complete destitution. You want to do right by your creditors whenever possible, but the number one goal is that you’re still functioning and taking care of those you love a year later, and five years later, and twenty years later. It’s not supposed to be easy, necessarily, but it is supposed to be possible for those who need it.
Advantages To Chapter 7 Bankruptcy
When you file Chapter 7, the courts step in and begin directing the rest of the process. You may be appointed a trustee who oversees the selling of any assets and otherwise makes sure the steps are followed. (Be prepared for this to feel far more humbling than it may sound when you initiate your bankruptcy.)
On the other hand, creditors are prohibited from further efforts to collect. You should receive no more phone calls or letters, and they can’t initiate wage garnishments or take other actions against you or your assets. If you’re contacted by a creditor during the process, refer them to your attorney. Don’t negotiate or explain or apologize.
The end game of Chapter 7 bankruptcy is that whatever unsecured debts you have left are wiped clean. (Unsecured debts are those not tied to specific collateral – credit cards, most personal loans, etc.) Chapter 7 bankruptcy stays on your credit report for 10 years afterwards. That matters, and it’s worth considering if you’re weighing the pros and cons of this or any of the common bankruptcy chapters. Keep in mind, though, that being unable to pay your debts doesn’t do much for your credit, either.
The entire process takes 4 – 6 months. At that point, you move forward with a fresh start. It should go without saying that you should make it a top priority to avoid sliding back into financial arrears. People build strong credit histories and work their way into strong credit scores after bankruptcy. You can, too.
2. Chapter 13 Personal Bankruptcy
Just over a third of personal bankruptcies in the United States are Chapter 13 bankruptcies. Where the goal of Chapter 7 bankruptcy is to forgive or eliminate your existing debt, the primary goal of Chapter 13 is to assist you in restructuring your debt.
Filing Chapter 13 bankruptcy allows you to throw up a hand and yell “HANG ON ONE MOMENT!” You’re not looking to sell off assets or wipe out debt (at least not most of it). Instead, the court assists you in holding off creditors while you submit a new plan for paying off your existing secured debt in full and some or all of your unsecured debt – all in a period of 3 – 5 years.
If the court approves your plan, you’re appointed a trustee and protected from collections and harassment during the repayment period. On the other hand, the court-appointed trustee micromanages your personal budget and verifies every dollar you spend to make sure you’re fulfilling your end of the deal.
Any debt remaining after the 3 – 5 year period is wiped out by Chapter 13 bankruptcy. That makes it similar to Chapter 7; it’s the focus that is primarily different. Chapter 7 assumes you can’t possibly pay the majority of your existing debts. Chapter 13 assumes you can pay enough that it’s worth giving you a little time and structure to do what you can. If your income is above a certain level, you may not qualify for Chapter 7. Or, if a majority of your debt comes from obligations not forgivable under Chapter 7, Chapter 13 bankruptcy may allow you to get right with your house payment, child support, etc., more easily than other bankruptcy chapters.
The part where you’re able to restructure your debt is pretty cool. The thing where you have to account for every cup of coffee and get challenged on whether or not you really needed those shoes kinda sucks. A little humility is sometimes the price of getting your financial world back under control, however.
As with Chapter 7, filing Chapter 13 temporarily stops creditors from calling or writing to you. They’re also prohibited from initiation of new actions against you – wage garnishments, repossessions, etc. Chapter 13 bankruptcy stays on your credit report for 7 years.
Small Business Bankruptcies
Bankruptcy law doesn’t distinguish between a small business or a big business. I’m assuming for our purposes, however, that if you’re reading this right now, you’re probably not a Fortune 500 corporation with your own legal department on levels 11 – 14 of your New York and Tokyo offices. I mean, if that’s you, we’re happy to have you. There’s good stuff here and all kinds of cool resources. It’s just that you suit-and-tie types usually don’t come slumming with us normal folks. We might be able to rustle up a few cans of soda and store-bought cookies left over from yesterday’s training, but we don’t have a sushi bar set up or anything, so…
Yeah, that’s what I thought.
Whatever the size of your business, be aware that far bigger companies than yours have gone through bankruptcy. Size is no guarantee of solvency. Sometimes, it makes it much harder to adapt and remain profitable when times change. For the moment, however, we’re going to assume we’re talking about sole proprietorships or relatively small, family-run operations. Most of the general rules are the same – it’s just the scale that’s different.
- 1. Chapter 7 Bankruptcy for Small Businesses
Chapter 7 for your business works very much the same as it does for individuals. If the numbers say there’s simply no realistic way forward and you can’t pay existing obligations, this might be the best option. If your business has assets, a court-appointed trustee will oversee liquidation and creditors will be paid based on a priority system largely determined by the court. Unlike your home or personal vehicle, there are no exemptions – from the building (if you own it) to the computers to the extra box of paperclips in the back storage closet, it all goes.
Once the liquidation process has paid as much as possible to your creditors, your remaining debt is erased. It’s rare for there to be protected debts for business the same way there are for individuals. (Your small business probably isn’t responsible for child support or student loans, etc.) - 1. Chapter 13 Bankruptcy for Small Businesses
Technically, Chapter 13 bankruptcy is strictly for individuals. If you’re a sole proprietorship, however, you are your business – at least in terms of economics and obligations. Chapter 13 often provides protections for your personal assets (most notably, your home) beyond those typical of Chapter 7 bankruptcy.
The goal of Chapter 13 for entrepreneurs or other individually owned and run businesses is the same as it is for individuals filing as, well… individuals. It’s primarily a restructuring tool allowing the business to catch its breath and rework its existing debts into a more manageable format. While it can involve some debt elimination, the hope is that with court intervention, you can pay most of your creditors most of what you owe and save your business.
On the one hand, part of capitalism is that businesses rise and fall, survive or don’t, based on supply and demand and their own respective merits. On the other, small business success is good for the economy, locally and nationally. If the intervention of a neutral third party (like the bankruptcy court system) can allow creditors to recoup most or all of what they’re owed AND help another small business keep producing, that’s a win all ‘round. - 1. Chapter 11 Bankruptcy for Small Businesses
Chapter 11 is Chapter 13 specifically designed for businesses bigger or more complicated than sole proprietorships. It allows businesses encountering severe difficulty (say, from an unexpected pandemic suddenly sweeping the nation) to go fetal position for a bit and defend themselves from creditors while they adjust, rework, restructure, or whatever they need to do to survive.
The success or failure of an individual American business may not seem like a big deal to anyone other than the owner(s), but both history and economics tell us it’s not that simple. Even a medium sized company can have anywhere from a handful of employees to several dozen. Most of them have families, meaning hundreds of people might be immediately impacted. A dozen families suddenly unemployed means fewer people going to the movies, buying groceries, ordering pizza, and shopping for back-to-school clothes. Now those businesses are in trouble, and the chain reaction continues.
Not every business can or should last forever. Ideally, however, responsible companies which have simply hit a rough stretch are able to reorganize and adjust, then come back strong with everyone benefitting. If not, Chapter 11 can at least buy enough time to cushion the fall for those involved.
Other Types of Bankruptcies
We won’t spend much time on the remaining bankruptcy chapters. They’re rather specialized and so unusual as to almost always require specialized representation:
Chapter 12 bankruptcy is primarily for family farms and some fishing operations. It’s similar to Chapter 13 in terms of focusing on the reorganization of debt and repayment over 3 – 5 years, but because of the seasonal nature of the businesses involved, payments are structured more creatively.
Chapter 15 is designed for individuals dealing with debt and/or assets in more than one country. Rather than juggle completely different processes while untangling who has a claim on what, Chapter 15 streamlines the process a bit while taking every claim into account.
Chapter 9 is for city or local governments which find themselves insolvent and unable to navigate their way clear. While rare, they allow municipalities to restructure and work out compromises much like Chapter 13 does for individuals or Chapter 11 does for businesses.
What If I’m Considering Filing Bankruptcy?
If you’re confronting severe debt and considering bankruptcy, consider a few things before you make your final decision.
First, is debt consolidation or some other, less extreme form of reworking your finances an option? If so, we might be able to help with that. You may not have to file bankruptcy in order to find your way through your current circumstances.
Second, should you hire a bankruptcy attorney? Bankruptcies can be a messy business, and depending on your situation, it might be worth getting professional guidance. My colleague Kevin has written an excellent piece on this exact topic which can help you consider the pros and cons for yourself.
Third, can you do it yourself online? Technically, yes – you can file bankruptcy online and manage the process yourself. Generally, however, you only want to take this approach if (a) you’re very comfortable with legal stuff and math and paperwork, and (b) your situation is straightforward and unlikely to take any tricky turns. That first part is largely subjective, and the second almost impossible to predict. So… your call.
Conclusion
Don’t wait until you have no other options. Take a few slow, deep breaths, and focus on the present and the future. Learn from any mistakes you may have made in the past, but don’t get stuck there. It’s called the past because it’s passed.
Educate yourself, then make the best call you can, and don’t look back. If that’s bankruptcy, we’ll be here when you’re ready to start rebuilding your credit and looking for financial advice moving forward.
If you’d rather discuss consolidation options or finding other ways to take more effective control of your personal or small business finances, we’re pretty good at that stuff as well. We can help you by connecting you to a suitable lender in no time. You just need to fill out some basic information in the form below:
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