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How Corporate Bankruptcy Works

Chapter 7 vs. Chapter 11

A business whose debt is greater than its assets has two options when filing for bankruptcy: Chapter 7 and Chapter 11. Companies file for bankruptcy in federal court, asking the court to freeze all of the business's outstanding debts, approve a plan to pay down those obligations and ultimately absolve its responsibility for some of the remaining money owed. The court then notifies creditors of the bankruptcy proceeding, orders them not try to collect the debt and tells them to get in line for payment by filing certain documents with the court [source: Justina].

Bankruptcies proceed under federal law and the different variations of the process are named for the chapter of the federal banking code under which they were enacted. For businesses, the choice depends on whether the company wants to continue operating or simply wants its creditors to call off the dogs so that the business can wind down in peace [source: SEC].

A business can seek Chapter 7 bankruptcy only if it immediately ceases all operations. Often referred to as "liquidation," this type of bankruptcy is a popular option for sole proprietors and small business owners. It allows them to get out without losing any of their personal money or assets, unless those assets were put up as collateral for a business debt like a loan or mortgage [sources: SEC, U.S. Courts].

Chapter 11 bankruptcy, on the other hand, is often referred to as "reorganization" because the process lets a business climb out of suffocating debt and tinker with its setup while continuing to operate. Although the company's management continues to run the show on a day-to-day basis, all significant business decisions have to be approved by a bankruptcy court. The business has to file a plan with the court, detailing how it will pay creditors and in what order. It can also restructure its finances and consolidate operations – getting out of burdensome contracts or scaling down production -- in an attempt to avoid future financial troubles [source: SEC].