What Is Bankruptcy?

Definition & Examples of Bankruptcy

Bankruptcy is a legal process designed to help individuals and companies get a financial fresh start by discarding or making arrangements to repay unmanageable debt. It can also be a way for companies to end business and liquidate assets in an orderly way.

There are times when the mountain of debt becomes too difficult to climb. Bankruptcy offers a way out of this situation while still considering the creditors seeking to collect debts. While a bankruptcy will stay on your credit report for a long time, sometimes it is the best option for starting over financially.

What Is Bankruptcy?

When an individual, couple, or business feels like they are no longer able to repay all of their debts, they may seek to file for bankruptcy. Although there are several different types of bankruptcy and different qualifying factors for each, the end goal is the same: to be discharged from debts and get a financial fresh start.

A discharge is an order from the bankruptcy court permanently prohibiting any creditor from attempting to collect the discharged debt from the debtor. It's also known as a bankruptcy injunction. The discharge only occurs after the debtor has met all the terms of the bankruptcy agreement and payment plan or the court has ruled otherwise. Those terms will vary depending on the bankruptcy chapter.

Types of Bankruptcy

There are six types of bankruptcy, known as chapters:

  • Chapter 7 liquidation is by far the most common bankruptcy chapter for individuals. It calls for the sale of a debtor's nonexempt property. The proceeds are then distributed to their creditors. Chapter 7 liquidation is appropriate for individuals who do not have a regular income and cannot or do not wish to use Chapter 13's payment plan system.
  • Chapter 13 bankruptcy is the second most common chapter for individuals. It permits a debtor who is making a regular income to repay at least a portion of debt over a period of three to five years. 
  • Chapter 11 is used by businesses to reorganize complex debt structures. 
  • Chapter 9 is used by municipalities and other political subdivisions such as utility, hospital, airport, or school districts.
  • Chapter 12 is for family farmers and family fisherman.
  • Chapter 15 is filed by foreign debtors who usually are companies with bankruptcy or receivership actions pending in other countries.

Bankruptcy can have long-term financial and legal consequences. If you're thinking about filing for bankruptcy, then it's wise to consult a lawyer who specializes in this area. If you can't afford a lawyer, check with the American Bar Association to find out if you qualify for free legal help.

How Bankruptcy Works

If a debtor files for bankruptcy, they must be in good standing with the courts and have had credit counseling from an approved agency within the last 180 days. They will also have to go through a debtor education course before their debts are finally discharged. Beyond these requirements, each bankruptcy chapter will have its own specific qualifying factors, fees, and required paperwork.

A few other consistencies across the different chapters include the overarching bankruptcy system, the use of trustees, and the end goal of discharge.

The Bankruptcy System

The bankruptcy system is operated by the U.S. Bankruptcy Courts as outlined in the U.S. Bankruptcy Code. The bankruptcy courts are subunits of the federal district court system. As a result, there is a bankruptcy court in each federal district of the U.S. However, depending upon the population of a district, there may be multiple courthouses in different cities. Bankruptcy courts are supervised by bankruptcy judges that are appointed by federal judicial committees.

Bankruptcy Trustees

In the vast majority of bankruptcy cases, a trustee is automatically appointed when the case is filed. The trustee administers the bankruptcy case by reviewing the documentation of the debtor.

In a Chapter 7 case, the trustee will attempt to sell any nonexempt property to pay creditors. In other cases, the trustee will oversee the payment plan and coordinate payments to creditors. The trustee also has the obligation to watch vigilantly for fraudulent conduct and failure of the debtor to disclose information. They owe a fiduciary duty to the creditors and must collect as many assets as possible to pay them. 

Protections and Discharge

Once a debtor is approved for bankruptcy, they are typically protected from creditors seeking as long as the debtor sticks to the terms of the bankruptcy agreement. Once all terms are met, any remaining debts that were included in the bankruptcy filing will be discharged.

Although the discharge is permanent, it is not all-inclusive. Some debts are not dischargeable. For example, most tax debts, child support, and spousal support cannot be discharged.

Depending on the type, bankruptcy will stay on your credit report for seven to 10 years. This can have a prolonged impact on your ability to open new credit cards or take out other loans.

Chapter 7 Bankruptcy vs. Chapter 11

Chapter 7 bankruptcy, also known as liquidation, is what most people think of when it comes to bankruptcy. It involves selling assets and using the proceeds to pay debts. For a business, however, selling assets often results in ceasing operations. Unless a business owner plans to shut down, Chapter 11 is often the better choice for businesses that can continue to generate income to pay off their debts.

Chapter 7 Bankruptcy Chapter 11 Bankruptcy
Liquidate nonexempt assets to pay debts Retain assets, pay debts from income
Discharged within 4 to 6 months Can take several years
No reduction of loan balances Reorganize debts in order to pay them off on payment plan
No monthly payments Higher fees

Bankruptcy Fraud

As bankruptcy is a federal system codified by Congress into the United States Bankruptcy Code, bankruptcy fraud falls under the domain of the federal government. Specifically, bankruptcy fraud, which includes false oaths, failure to disclose debts or assets, and other fraudulent conduct, is a federal crime. Committing bankruptcy fraud can lead to you losing your discharge. You may also end up in jail for up to five years, paying up to a $250,000 fine, or both.

Although the federal government keeps a watchful eye out for bankruptcy fraud, any creditor of a bankruptcy debtor can file a complaint against the debtor. The complaint may seek to deny the debtor a discharge for bankruptcy fraud. In addition, the complaint may seek a judgment by the bankruptcy court that the debt owed to the creditor is non-dischargeable in bankruptcy. A debt may be non-dischargeable under the bankruptcy laws or because the credit was obtained by fraudulent means. Bankruptcy is certainly not a safe haven for the unscrupulous debtor.

Key Takeaways

  • Bankruptcy helps an individual, family, or business discharge its debts either through liquidation or a payment plan.
  • There are six different types of bankruptcy, each designed for different circumstances and with different qualifying factors.
  • The bankruptcy process can take anywhere from a few months to several years.
  • Debtors approved for bankruptcy are typically protected from creditors as long as they meet the terms of the bankruptcy agreement.