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What is Bankruptcy? Explaining The Chapters In Bankruptcy Code

Created on 26 Jul 2023

Wraps up in 9 Min

Read by 2.3k people

Updated on 31 Jul 2023

The doomsday for every company when all hope is lost, "bankruptcy" is quite well known in the business sector. Bankruptcy refers to a legal process undertaken in case an individual or business is not able to repay the debt they owe. Filing for bankruptcy provides relief to an individual or a business as well as allows them to reset things in order. Lehman Brothers and SVB financial group (parent company of Silicon Valley Bank) are a few examples of infamous companies filing for bankruptcy.

Bankruptcy is generally imposed by a court's order after the debtor files for it. Based on the debtor's claim, condition, and past financial records, the court decides whether bankruptcy can be declared. Choosing to bankrupt the organisation benefits the economy and the people related as well due to the possibility of receiving funds owed from liquidation or other methods.

When it comes to India, the Insolvency and Bankruptcy Code 2016 is the law for bankruptcy. Certain segments in India's bankruptcy law are inspired by the U.S. Bankruptcy Code. The primary goal of the U.S. bankruptcy code is to strike a balance between the concerns of debtors, who find themselves unable to fulfil their financial obligations, and creditors, who seek to reclaim the funds owed to them. Apart from this, some proceedings in bankruptcy may relieve the debtor from paying the debt owed.

The US Bankruptcy Code

The U.S. bankruptcy code also encompasses various chapters, each tailored to specific bankruptcy scenarios and types of debtors. Among the commonly utilized chapters are Chapter 7, Chapter 11, and Chapter 13.

Chapter 7 bankruptcy entails the sale of assets to repay creditors, granting individuals and businesses a new beginning. Chapter 11 bankruptcy primarily centres around reorganising and restructuring businesses, enabling them to continue operating while devising a repayment plan for creditors. Chapter 13 bankruptcy, on the other hand, is specifically designed for individuals with regular income, providing an extended timeframe to gradually repay their debts through a structured repayment plan.

These distinct chapters within the bankruptcy code address the diverse needs of debtors in various financial circumstances, aiming to offer relief, a fresh start, and a path toward financial stability. Let's go through the various chapters in the U.S. Bankruptcy Code in depth as well as figure out the similarities it contains with India's bankruptcy law.

Chapter 7 of the US Bankruptcy Code

Chapter 7 of the US bankruptcy code involves the liquidation of the corporation's assets. As per this chapter, the corporation's assets are sold to pay off the obligations or liabilities carried forward. Liquefaction of the assets is the last resort for the corporation. This step is usually taken after Chapter 11’s business restructuring and voluntary agreement, discussed below, bore no fruit.

How To File under Chapter 7 of the US Bankruptcy Code?

  • In Chapter 7, the debtors need to file a petition with the bankruptcy court. Information like assets and liabilities, financial statements, and executory contracts need to be submitted to the court. The debtor may be required to submit a repayment plan that was designed during the mandatory credit counselling.
  • Petitions filed in the Chapter 7 case can be voluntary or involuntary. Once the petition is accepted by the bankruptcy court, a trustee is appointed. A creditor’s committee is selected to aid the trustee in undertaking and managing activities.
  • The trustee will collect the claims from the committee of creditors to verify them. If the claims are verified as accurate, the trustee will accept them. The trustee is also required to arrange a meeting where the committee of creditors and trustee may ask questions from the debtor about their financial affairs. The debtor needs to provide answers as well as any documents requested by the trustee.
  • The trustee is also responsible for selling the assets of the debtor and distributing the proceeds to the creditors. The distribution of proceeds is to be done among six said classes of claims, preferentially from the senior class to the junior class. The next class is entertained once a class of claims is fully paid.
  • A debtor usually seeks discharge in a bankruptcy case. The discharge removes the legal obligation to pay certain debts from debtors. Payment for various kinds of debts, such as credit card debt, personal loans, and medical bills, can be exempted. But there are certain types of debts where the discharge request is not entertained. Debt due to student loans, child support, tax obligation, etc., are not to be considered under Chapter 7 discharge.

Debtors also need to understand that a discharge relieves them from the burden of certain financial responsibilities but not all. They are debts that need to be repaid.

Know how Symphony saved itself from the brink of bankruptcy here.

Chapter 11 of the US Bankruptcy Code

Chapter 11 of the US bankruptcy code gives the corporation a chance to reorganise its business operations to make the corporation profitable and prevent it from liquidating. Liquidation of a corporation simply means selling off its assets to receive proceeds that will help in paying off the liabilities.

Lehman Brothers' bankruptcy filing during the 2008 financial crisis was made under Chapter 11 of the U.S. bankruptcy code. Chapter 11 provides a framework for the reorganisation and restructuring of a business to help it emerge from financial distress.

How To File Under Chapter 11 of the US Bankruptcy Code?

A mandatory petition needs to be filed in the bankruptcy court providing details such as creditors, financial statements, etc.

  • A petition can be voluntary or involuntary. An involuntary petition is filed by creditors. The creditors will have to provide a document called “proof of claim” when the court sets the bar date.
  • Under the voluntary petition, the debtor or the corporate (within 10 days of filing) is required to provide vital information like the corporate’s legal name, legal address, and social security number. Apart from these, the debtor also needs to give information like the name and address of each creditor.
  • The debtor is required to request relief along with a provisional plan or an intention to provide a plan in the petition. Once the order of relief is granted to the debtor, the debtor takes on a new identity called “debtor in possession.” The debtor assumes certain rights and responsibilities, including managing the assets and affairs of the bankruptcy estate, subject to court oversight and approval. Any extraordinary action taken during the ordinary business operation needs the approval of the court.
  • Now that the identity of a debtor in possession is given to the corporate, an automatic stay is imposed. The automatic stay is like a moratorium period wherein legal proceedings, claim collection, and transfer of assets are kept on hold. Creditors cannot get proceeds from debtors for their claims during this period unless they prove the insignificance of the said assets in the business operations. But to protect the secured creditors from losing out fully, the debtors are required to make periodic payments for the collateral assets that they use.
  • The debtor is also given an exclusive right to file a reorganisation plan. The time given to bring such a plan in front of the corporate is 120 days. This period is known as an exclusivity period. It can be extended to a maximum of 18 months. A disclosure statement which includes the reorganisation plan and activities that the debtor will conduct has to be filed in the court within the exclusivity period. The court will judge the suitability and feasibility of the plan as per the bankruptcy code.
  • Once the approval to the statement is given, the plan must be mailed to creditors and equity shareholders. The approval of each class of creditors and equity shareholders is required. If at least one and half the number of a class and two-thirds of the dollar amount of claims give consent to the plan, the plan is approved.

The approved plan, when confirmed, will discharge the debtor from any debt before reorganisation implementation. But the debtor is required to make payments stated in the plan.
Finally, the court will continuously monitor the progress of the plan and its implementation. Discharge from debt is available only when the plan is confirmed.

Chapter 13 of the US Bankruptcy Code

Chapter 13 involves the construction of a repayment plan for an individual with a regular income. The repayment plan includes a periodic payment schedule to repay the debt owed to creditors. The time for payback is 3 to 5 years.

The repayment time is determined by comparing the debtor’s monthly income with the state median. If the debtor’s monthly income is less than the state median, the debtor is assumed to be riskier. This results in a plan of three years. On the other side, if the debtor’s monthly income is greater than the state median, the debtor is considered to be less risky. This leads to a plan of five years. The maximum period allowed as per the repayment plan is five years.

How To File Under Chapter 13 of the US Bankruptcy Code?

  • Similar to Chapter 7, the Chapter 13 case requires the individual debtor to file a petition in the bankruptcy court. Information like assets and liabilities, financial statements, and executory contracts need to be submitted to the court. A trustee is appointed to take the process ahead. The debtor is also required to provide the trustee with the details of the tax returns filed.
  • An automatic stay is enforced for cases filed under Chapter 13, where all legal proceedings are halted. The automatic stay gives the debtor enough time to repay his past dues.
  • The trustee in Chapter 13 is required to arrange a meeting where the committee of creditors and the trustee may ask questions from the debtor about his financial affairs. The debtor needs to provide answers as well as any documents requested by the trustee.
  • The bankruptcy court asks for a repayment plan along with the petition, which is to be submitted within 14 days of filing. The court examines the plan and its feasibility. Once it is proven feasible, the judge will approve the plan.
  • The debtor needs to pay a periodic payment to the trustee, who will distribute the amount to the creditors. The claims are reimbursed in a specific order that is a) priority claims, b) secured loans, and c) unsecured loans.
  • The debtor has to ensure that the payment is made on time and that any other debt can be borrowed without consulting with the trustee. The debtor has to restrict his/her lifestyle to make payments from their payroll.
  • Individual debtors who have filed a case under Chapter 13 of the bankruptcy code also seek discharge from debts. If the debts are not repaid in the repayment period, one can be granted a discharge on certain debts, such as credit card loans and medical bills. But certain debts like child support, alimony, tax obligations, and student loans will not be granted a discharge.
  • In case a situation that is not in the debtor’s control arises, which hampers the plan, then the debtor can ask the court for a “hardship discharge”. It is also applicable when creditors have received an amount equivalent to what they would have received in case of liquidation of assets.

Hence we saw that Chapter 7 focuses on liquidation, Chapter 11 emphasises business reorganisation and Chapter 13 provides a repayment plan for individuals with regular income. The appropriate chapter for a debtor depends on factors such as their financial situation, goals, and eligibility criteria. It's advisable to consult with a bankruptcy attorney to determine the most suitable chapter and navigate the bankruptcy process effectively.

The Bottom Line

In conclusion, individuals or businesses who have filed for bankruptcy can utilise the benefits provided by the U.S. bankruptcy code to gain relief and reset their business operations. The bankruptcy code also gives debtors various options, like restructuring business operations or liquidating business assets. Bankruptcy involves short-term consequences, such as credit damage and asset loss. Nevertheless, it acts as a last resort for the individual or business to regain financial stability over time. A debtor should know the intricacies that are there in the bankruptcy code.

Despite the potential adverse effects on credit and the risk of asset loss, bankruptcy presents individuals and businesses with a valuable chance to confront their financial challenges, reorganize their affairs, and strive toward a more promising financial horizon. It is better to seek guidance from experts and advisors to comprehend the impact of each alternative in the bankruptcy code and choose the most optimum option wisely. Overall, the bankruptcy code's aim is the welfare of the debtor as well as creditors. Hence, it acts as a support to recover from a dire state and gives a revival opportunity.

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Muskan Somani

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Muskan has completed her BBA with a specialisation in Finance from NMIMS, Mumbai. She is currently pursuing MBA with a Major in Finance and a Minor in Business Analytics from K.J. Somaiya Institute of Management, Mumbai. She loves dancing and exploring new cuisines, dogs, and anime.

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