Bankruptcy law in the United States provides several chapters under which individuals and businesses can file for bankruptcy relief. Each chapter serves different purposes and has specific criteria, debt discharge rules, and protections for debtors.

A. Chapter 7 Bankruptcy (11 U.S.C. Chapter 7):

Chapter 7 bankruptcy, often referred to as “liquidation bankruptcy,” is designed for individuals or businesses with limited or no means to repay their debts. In Chapter 7, a trustee is appointed to collect and sell the debtor’s non-exempt assets to repay creditors. The remaining eligible debts are then discharged, relieving the debtor from personal liability for those debts. Chapter 7 is typically a quicker process compared to other chapters.

Automatic stay: The automatic stay goes into effect as soon as a Chapter 7 bankruptcy petition is filed. The stay stops most collection actions against the debtor, including wage garnishments, foreclosure proceedings, and debt collection lawsuits. It provides immediate relief and protection to the debtor.

Debt Discharge: One of the primary benefits of Chapter 7 bankruptcy is the potential discharge of debts. Discharge releases debtors from personal liability for certain debts, meaning they are no longer legally obligated to repay them. This discharge is typically granted for unsecured debts, such as credit card debt, medical bills, personal loans, business debts, and certain tax debts. While the discharge applies to the personal obligation to pay secured debts, such as mortgages or car loans, the lien remains. If the debtor wants to keep the collateral, the debtor must continue to pay the debt. Some debts, such as child support, alimony, court-ordered fines or penalties, certain tax debts, student loans (unless undue hardship can be proven), and debts arising from fraud or intentional misconduct, are generally non-dischargeable.

If a business files a Chapter 7 Bankruptcy, it cannot receive a discharge of debts. The individual owners may need to file personal bankruptcy as well if they have personal liability for the business debts. Other special considerations need to be addressed because once a business files for bankruptcy, its books will be open to scrutiny and the trustee may seek to recoup certain payments.

B. Chapter 13 Bankruptcy (11 U.S.C. Chapter 13):

Chapter 13 bankruptcy, often known as “reorganization bankruptcy” or “wage earner’s plan,” is designed for individuals with a regular income who want to reorganize their debts and create a repayment plan. It allows debtors to retain their assets while making regular payments to creditors over a specified period, typically three to five years. The repayment plan, which is based on the debtor’s income, expenses, certain assets, and certain liabilities, involves the debtor making regular payments to a bankruptcy trustee, who distributes the funds to creditors based on the plan and claims filed by creditors. A business is not eligible to file Chapter 13 bankruptcy. Additionally, there are debt limitations for filing under Chapter 13.

Automatic Stay: Similar to Chapter 7 bankruptcy, Chapter 13 also triggers an automatic stay that halts all collection activities by creditors upon filing the bankruptcy petition. The automatic stay halts foreclosure, repossession, wage garnishment, and other collection actions, including collection calls. Unlike Chapter 7, Chapter 13 affords protection to co-debtors on consumer debts, the so-called “co-debtor stay.”

Debt Discharge: At the end of the repayment period, any remaining eligible unsecured debts are discharged. This can include credit card debt, medical bills, personal loans, and other unsecured obligations, as long as the debtor has completed the repayment plan. However, certain debts, including student loans (in most circumstances), child support, and some tax debts, are generally non-dischargeable.

C. Chapter 11 and Subchapter V are two different chapters under the United States Bankruptcy Code that govern business bankruptcies. While both chapters provide a means for businesses to reorganize their debts and continue operations, they have some important differences.

i. Chapter 11 Bankruptcy (11 U.S.C. Chapter 11):

Chapter 11 is a broader and more complex bankruptcy chapter available to businesses of all sizes, including large corporations. While Chapter 11 bankruptcy is primarily used by businesses, it is also available for individuals with substantial debts and complex financial situations. It provides a reorganization process, allowing the debtor to develop a plan to restructure their finances and repay creditors while continuing their business operations under the supervision of the bankruptcy court. Alternatively, businesses can use Chapter 11 to liquidate their assets and dissolve the business if reorganization is not feasible.

The debtor has the exclusive right to propose a plan of reorganization within the first 120 days after filing for Chapter 11. The plan can modify the rights of secured and unsecured creditors, reject or assume contracts, sell assets, and create new financing arrangements. If reorganization is not feasible, the plan can provide for liquidating assets and dissolving the business. Chapter 11 also allows for the appointment of an official committee of unsecured creditors to represent their interests during the bankruptcy proceedings. Generally, the debtor remains in control of the process (the debtor-in-possession or “DIP”), but in some cases, the court may appoint a trustee to oversee the process.

In Chapter 11, the debtor’s assets may be used to satisfy creditor claims, and the value of the assets plays a significant role in the distribution to creditors. The debtor can seek debtor-in-possession financing, which allows them to obtain new loans to fund operations during the bankruptcy process. The repayment plan may involve reducing the debt principal, extending payment terms, or other arrangements that the debtor negotiates with its creditors. Chapter 11 plans typically involve complex negotiations among the debtor, creditors, and other interested parties.

Automatic stay: Similar to other bankruptcy chapters, the automatic stay comes into effect upon filing for Chapter 11 bankruptcy. It protects the debtor from collection actions and provides breathing room to negotiate a feasible repayment plan.

Debt discharge: Chapter 11 does not involve a straightforward debt discharge like Chapter 7. Instead, it focuses on creating a repayment plan that addresses the debtor’s financial obligations while protecting their assets and operations. Creditors typically receive a percentage of the owed amount over time. Business debts incurred by the debtor can be discharged, including loans, lines of credit, trade payables, and other liabilities related to the business. Personal guarantees made by the debtor for business debts may also be discharged. Non-business debts, such as personal credit card debt, medical bills, and other personal obligations, may be discharged, but they are typically not the primary focus of Chapter 11 bankruptcies.

ii. Subchapter V (11 U.S.C. Subchapter V):

Subchapter V is a relatively new addition to the bankruptcy code introduced by the Small Business Reorganization Act (SBRA) in 2019. It is a streamlined version of Chapter 11 bankruptcy specifically tailored for small business debtors with total secured and unsecured debts of less than $7.5 million. The primary goal of Subchapter V is to simplify the reorganization process, reduce costs, and expedite the resolution of small business bankruptcies.

Under Subchapter V, the debtor proposes a plan of reorganization, which must be accepted by the creditors. The plan typically spans three to five years. The debtor retains ownership and control of the business during the reorganization process. The plan can modify the rights of secured and unsecured creditors, reduce debts, extend repayment terms, and provide for the curing of arrears.

One significant feature of Subchapter V is the ability to modify certain secured debts, even if the creditor objects to the modification. In Subchapter V, the debtor’s disposable income is typically used to repay creditors rather than the value of the debtor’s assets. The Small Business Administration (SBA) may be involved in the process, providing assistance and oversight. The plan confirmation process is streamlined, and there is no requirement for a separate creditors’ committee.

Automatic stay: The automatic stay protections in Subchapter V are similar to those in Chapter 11. Upon filing, the automatic stay prevents creditors from pursuing collection actions against the debtor, allowing the business to continue operations while the reorganization plan is being formulated.

Debt discharge: Like Chapter 11, Subchapter V does not have a traditional debt discharge. Instead, it focuses on restructuring debts and developing a repayment plan that allows the small business to continue operating. Under Subchapter V, the debtor proposes a repayment plan to restructure its debts and continue operating the business. The plan is subject to approval by the bankruptcy court. Once the debtor successfully completes the plan, it can obtain a discharge of certain debts, similar to Chapter 11.

Like Chapter 11, the business debts of the debtor can be discharged, including loans, lines of credit, trade payables, and other liabilities incurred in the ordinary course of business. If the debtor has provided a personal guarantee for the business debts, those guarantees can also be discharged. Non-business debts, such as personal credit card debt, medical bills, and other personal obligations, may also be discharged if they meet the requirements for discharge under bankruptcy law.

iii. Essential vendors

During a Chapter 11 bankruptcy, the debtor company typically continues to operate and manage its affairs as a “debtor in possession” (DIP). The DIP may need to obtain goods, services, or supplies from certain vendors or providers to sustain its operations. An essential vendor or provider is one whose goods or services are necessary to maintain the debtor’s business operations and enable them to reorganize and emerge from bankruptcy. In some cases, the bankrupt company may have pre-existing contracts or relationships with these essential vendors or providers. However, it’s also possible for the debtor to seek new arrangements or renegotiate existing contracts to ensure continued supply or service.

The bankruptcy court overseeing the Chapter 11 case may grant special protections to essential vendors or providers to encourage them to continue doing business with the debtor. These protections can include allowing the debtor to pay for post-bankruptcy goods or services ahead of other unsecured creditors or granting them administrative expense priority, which means they get paid before other claims in the bankruptcy. The inclusion of essential vendors or providers in the Chapter 11 reorganization plan is crucial to maintaining the debtor’s business operations and maximizing the chances of a successful restructuring.

D. A note on the Automatic Stay

The Automatic Stay protects the Debtor, whether an individual or a business entity, by shielding them from collection actions, lawsuits, foreclosure, repossession, or other creditor actions while the bankruptcy case is pending. It provides equal protection to all creditors, preventing any one creditor from gaining an unfair advantage by pursuing individual collection efforts. Additionally, it safeguards the debtor’s property from being seized or sold by creditors, allowing the debtor to retain control and use of their assets during the bankruptcy process.

It’s important to note that while the automatic stay offers immediate protection, creditors may seek relief from the stay under certain circumstances, such as if they can demonstrate that their rights are being significantly harmed by the stay.

Although bankruptcy is a federal law, it interacts with state laws and is subject to the interpretation of the courts. Bankruptcy laws and procedures can vary by jurisdiction, and specific rules may apply. Consult with a bankruptcy attorney familiar with the laws in your particular jurisdiction for guidance tailored to your specific situation.

Do you have questions about this article or want more information on bankruptcy issues in general? Please contact Mitchell Goldstein (mgoldstein@setlifflaw.com) at (804) 377-1269, or Steve Setliff (ssetliff@setlifflaw.com) at (804) 377-1261.