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Understanding Bankruptcy

Liquidation: Chapter 7

Broadly speaking, there are two different ways to go bankrupt: liquidation (Chapter 7) or reorganization (Chapter 11 or Chapter 13). In the next two sections, I will introduce you to these two variations and explain, briefly, how they apply to both individuals and companies. Let's start with a general overview of liquidation.

With a LIQUIDATION (Chapter 7) bankruptcy, the trustee sells the assets of the debtor, and then uses the money to pay back the creditors as much as possible. Once the creditors are paid, the debtor is given a discharge, which cancels the rest of the debt permanently.

Time frame for a Chapter 7 bankruptcy: After the bankruptcy paperwork is filed, if everything goes smoothly, the entire process takes about 3-4 months.

Although, the goal of the trustee is to pay back the creditors, it is rare for creditors to get back much of their money. In fact, with a Chapter 7 bankruptcy, a creditor that recovers even 25 cents on the dollar (a quarter of the money that is owed) is considered fortunate. Much of the time, creditors get nothing.

Chapter 7 liquidation can be used by both individuals and by companies. With an individual, the discharge gives the debtor a fresh start, enabling him to continue his or her life more comfortably. With companies it works differently: once the assets are liquidated and the proceeds are distributed, the company is dissolved permanently, at which time it ceases to exist.

If a company being liquidated has issued stock, its value goes to zero and the stockholders lose their money. At the same time, because the company is forced to close, the employees lose their jobs and their benefits. This loss can be particularly difficult for retired workers who depend upon pensions and health insurance which, up to now, had been provided by the company.

If the company going bankrupt is large, the trustee may be able to sell an entire division to another company. In such cases, many of the employees may be able to keep their jobs by working for the new company.

The general idea behind Chapter 7 bankruptcy is to liquidate everything in an attempt to pay all the debts. For the most part, this is the principle that guides the overall process. However, there are two significant exceptions I want to mention.

First, bankruptcy law recognizes that certain types of assets are so important they should not be taken away. Such assets are called "exempt property". For example, an individual debtor who file for Chapter 7 bankruptcy is, by law, allowed to keep his car, his clothing, and his pension.

Second, bankruptcy law also recognizes that some debts, called PRIORITY DEBTS are more important than others. During a Chapter 7 bankruptcy, priority debts must be paid back before any other debts. In other words, creditors who hold non-priority debts will not receive anything unless there is more than enough money to pay back all the priority debts in full.

When an individual files for Chapter 7, priority debts include taxes and other government debts, child support, alimony, student loans, and criminal restitution. When a company files for Chapter 7, priority debts include taxes and other government debts, salaries (subject to fixed limits), and contributions to employee benefit plans.

This is why Chapter 7 debtors often do not receive anything. Before regular debtors can be paid, even partially, the government and all the other priority debtors must by paid in full.

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