How Bankruptcy Works

Enron filed for bankruptcy in the Northern District of Texas. See more corporation pictures.
Enron filed for bankruptcy in the Northern District of Texas. See more corporation pictures.
United States Bankruptcy Court

Bankruptcy is one of the most complex areas of law, incorporating elements of contract law, corporate law, tax law and real estate law. In recent years, several high-profile corporations like Enron, WorldCom and Adelphia have filed for bankruptcy. Although businesses only accounted for about 2 percent of all bankruptcy filings in the United States last year, commercial bankruptcies can have a big impact on the economy because there can be a lot of money at stake [ref].

In this article, we'll explain the different types of bankruptcy filings under United States law, figure out who pays what to whom, and describe the process of reorganizing a company and running it under bankruptcy.


All of the different kinds of corporate bankruptcy amount to the same problem -- a company has more debt than it can pay. In this situation, a company files for bankruptcy. This gives it legal protection from its creditors. The company can either get out from under the debt or work out a repayment plan and continue operating. A bankruptcy filing prevents creditors from trying to collect on debts outside the process of the bankruptcy filing itself.

What circumstances lead a company to file for bankruptcy? Sometimes debt grows over time until the business owners realize they have no hope of paying it off. The 2002 bankruptcy of Kmart is an example of this. Competition from other discount store chains led to a steady decline in sales, and the company began missing payments to their suppliers [ref].

Companies sometimes face a sudden loss of revenue that prevents them from paying their suppliers. For example, a printing company might draw 30 percent of its revenue from a single publisher. If that publisher moved its contract to a different company, the printer would lose almost a third of its revenue. However, it would still have to pay employee wages, health care plans, taxes, suppliers and all of its other bills.

A sudden, massive financial loss can result in instant debt without the revenue to pay for it. This is often the result of some wrongdoing on the company's part. A lawsuit or government fines can cost a company millions or billions of dollars. Scandals can also cause stock prices to drop. WorldCom was already struggling in 2002 when an accounting scandal became public. The scandal severely damaged the company and forced them into bankruptcy.

Creditors can also force a company into bankruptcy. They might do this if they discover that the owners are selling off all of the company's assets and preparing to dismantle the company without paying their debts. A creditor might also force a bankruptcy if the company is already making large payments to a different creditor.

Next, we'll take a look at the different terms used in bankruptcy filings and see how bankruptcy filings generally work.

Bankruptcy: Terms and Types

The types of bankruptcy are named for their chapters in the United States Bankruptcy Code. Learn about the types of bankruptcy including Chapter 7 and Chapter 11.
The types of bankruptcy are named for their chapters in the United States Bankruptcy Code. Learn about the types of bankruptcy including Chapter 7 and Chapter 11.
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Bankruptcy Basics

Although bankruptcy is complicated and the exact steps can vary from state to state, each chapter of bankruptcy uses the same terminology and follows the same basic process.

Two main parties are involved in bankruptcy filings -- the debtor and the creditor. The debtor is the party who has debt, or owes money, to the creditor. A debtor can be a company or an individual. The creditor is an organization or company that claims the debtor owes property, service, or money. Most bankruptcy cases involve several creditors.


Debtors can have two different types of debt -- secured and unsecured. With secured debts, creditors have the legal right to something of yours if you fail to make the proper payments. Your mortgage, for example, is a secured debt. By loaning you the money to pay for your house, the bank gets a lien on it. If you stop making mortgage payments, the bank can foreclose and take possession of your house.

In business, secured debt can get very complicated. Various business loans may give creditors a lien against intangible aspects of the business, such as patents, trademarks or intellectual property. The creditor can still repossess property that has a lien against it, even if some portion of the debt has been discharged -- secured debt can't ever be fully discharged. The debtor can either make the payments and keep the item, or stop paying on the debt and have the item repossessed. Secured creditors are always paid first in a bankruptcy settlement.

Types of Bankruptcy

The four types of bankruptcy are named for their respective chapters in the United States Bankruptcy Code. The type of bankruptcy that you file depends on several factors, including whether or not you are an individual or part of a corporation.

Chapter 7 is what most people mean when they say, "I'm filing for bankruptcy." This is a liquidation bankruptcy, which means that the trustee sells off all non-exempt assets held by the debtor so that the debts can be repaid to the fullest extent possible. Individuals, corporations and partnerships are all eligible for Chapter 7 bankruptcies. The portion of the debt that can't be repaid through liquidation is discharged. Businesses generally try to avoid Chapter 7, because it is impossible to conduct business operations. Income generated after the bankruptcy filing is not a part of the bankruptcy -- the debtor can keep it.

Chapter 11 is the most complex bankruptcy filing and the one that most troubled businesses file (although some individuals may file it as well). In a Chapter 11 bankruptcy filing, the debtor continues to function, maintains ownership of all assets, and tries to work out a reorganization plan to pay off creditors.

In the past, a business had an almost unlimited amount of time to come up with their reorganization and payment plan. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 imposes a 120-day time limit. If the debtor has not submitted a plan within that period, creditors can submit their own plans.

Chapter 12 is specifically for farm owners. The debtor still owns and controls his assets and works out a repayment plan with the creditors. Chapter 13 is like Chapter 11, but for individuals. The debtor retains control and ownership of assets. He also works out a three to five-year repayment plan. Some portion of the debt may be discharged, depending on the income of the debtor. There are also limits on the amount of debt involved.

Lastly, here are a few key bankruptcy terms you'll want to familiarize yourself with:

  • Debt adjustment - The arrangements made for the repayment or satisfaction of debts in an amount or manner that differs from the original arrangements
  • Dischargeable debts - Debts that can be erased by going through bankruptcy
  • Nondischargeable debts - Debts that cannot be erased by filing for bankruptcy
  • Lien - A charge or encumbrance upon property for the satisfaction of a debt or other duty
  • Secured debt - A debt on which a creditor has a lien
  • Unsecured debt - A debt that is not tied to any item of property

Chapter 11 - Business Bankruptcy

Although some large companies have filed for bankruptcy in recent years, the overall number of corporate bankruptcies has declined.
Although some large companies have filed for bankruptcy in recent years, the overall number of corporate bankruptcies has declined.

Companies choose to file Chapter 11 because its long-term revenues will be higher than the liquidation value of the assets. This way, creditors can get more money back if they allow the debtor business to reorganize and work out a payment plan. The business becomes a debtor in possession, maintaining control and ownership of their assets and continuing their regular operations. At this point, there is usually no trustee.

A company that declares Chapter 11 must disclose all of its assets and make a list of all the debts that it is seeking protection from. This is the creditors' right to question the debtor, a fundamental part of bankruptcy law. In cases involving millions or billions of dollars, this step alone can be incredibly complex. The creditors also meet with the debtor.


If the bankruptcy court finds that there has been fraud or gross mismanagement on the part of the debtor, they can appoint a trustee, who will take over the operations of the debtor for the duration of the proceeding. The business continues to operate as normal, but the original owner is no longer in control. The trustee appointed to a specific bankruptcy may be different from the "U.S. Trustee." While federal bankruptcy courts are in charge of the proceedings, the Department of Justice also assigns a U.S. Trustee to each district. The U.S. Trustee serves as a watchdog over bankruptcy cases and may act as the trustee in a proceeding.

While under Chapter 11, a company can only make the usual sales and purchases that are part of its standard business operations. For example, it can't buy out another company, sell off a division of the company, or sell a major piece of equipment or property without approval from the court. It can't undergo a major expansion, either.

In all Chapter 11 proceedings, a creditors' committee represents the majority of the unsecured creditors, and negotiates the best possible payment options for them. Large-scale cases may have multiple creditors' committees, each representing different groups and factions of the creditors. Stockholders can also form a committee.

At this point, the debtor formulates a plan to reorganize its debts. This plan can be a simple as a payment plan. With larger bankruptcies, companies may take many steps to reorganize their debt. They might offer stock to some creditors. A retail business might have to close stores, lay off employees, or renegotiate union contracts. One of the major provisions of Chapter 11 allows a company to void many of its contracts, including union contracts, contracts with suppliers, and real estate leases.

The debtor can also "avoid" certain payments or purchases that happened in the period prior to the bankruptcy. The usual period is 90 days, but payments or gifts made to friends, family or company insiders have a one-year limit (or longer, depending on the state where the bankruptcy is filed). Some payments can be returned to the debtor and become subject to the terms of the reorganization plan. This keeps debtors from manipulating their assets and giving preference to certain creditors.

Once the debtor submits a reorganization plan, the creditors and the company's stockholders vote on it. Stockholders are generally very low in terms of priority, and even if they vote down the plan, the court can go ahead with it if the creditors approve. Once the court approves the plan, the Chapter 11 bankruptcy is certified and confirmed. Now the debtor must comply with the plan and make the proper payments to the creditors (or to the trustee, if one has been appointed).

It is important to note that during the period of reorganization, the company's stocks will be virtually worthless. If the company gets out of Chapter 11 and begins operating normally, those stocks can increase in value, but at first they will probably be worth much less than the initial purchase price. Bondholders can sometimes get a fraction of the bonds' face value as part of the reorganization.

If a debtor violates the terms of the plan, there are several potential consequences. A trustee may be appointed. If it appears that the company will not be able to operate profitably and follow through with repayment plans, the Chapter 11 will be converted into Chapter 7. This is a death sentence for the company.

No one ever goes to jail for being in debt. This is easy to overlook when many high profile corporate bankruptcies follow financial crimes committed by executives or accountants. Financial fraud can lead a company to bankruptcy, and the executives may be prosecuted, but bankruptcy itself is not a crime.

Personal Bankruptcy

Alternatives to Bankruptcy

Filing for personal bankruptcy is a serious decision, one that should be made after careful consideration and, if possible, with the advice of a lawyer. Entering into bankruptcy can help to alleviate your debts, but it will also affect your credit rating and your ability to borrow money in the future. So while it can be a good option for those who need it, personal bankruptcy should be a last resort after other alternatives have been exhausted. With that in mind, let's first consider a few alternatives to filing for bankruptcy.

The most basic alternative to filing for bankruptcy is to simply do nothing. If you owe money to creditors but have a small (or no) income, you may be considered judgment proof -- also called collection proof. Being judgment proof means that creditors would have nothing to take from you if they decided to sue you in court. Also, in some cases, creditors may decide to simply write off your debt rather than pursue repayment, and in seven years, that debt would be erased from your record. Still, keep in mind that if your financial condition does improve, you may no longer be considered judgment proof and creditors may approach you once again for repayment of debts.


A second possibility is to negotiate with creditors and to work out an individual payment plan. However, this process can be daunting, especially when dealing with creditors who are particularly aggressive or intimidating.

Instead of personally negotiating with creditors, you can contact a debt management agency for help. These agencies are nonprofit entities, and a listing of them can be found on the United States Trustee's Web site. Working with an agency means that no bankruptcy will appear on your record. But there is a drawback to working with a debt management agency: you won't have the protections provided by Chapter 7 or 13. Namely, agencies often require debts to be paid in full, and they can cancel your plan if you fall behind on payments. Another common concern related to debt management agencies is that they are heavily funded by creditors, a situation which may produce a conflict of interest for the agency.

Individual Filing

You're now aware of some of the alternatives to filing for bankruptcy. But you might still be thinking about filing, so let's consider the various possibilities for personal bankruptcy. We'll also look at the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 and how this "new" law affects individuals filing for bankruptcy.

Individuals are eligible to file for bankruptcy under Chapter 7, 11, 12 or 13. As discussed earlier, Chapter 11 usually applies to businesses, but it can apply to individuals with extremely large debts, such as someone whose debt exceeds the limits for filing under Chapter 13 (according to, secured debts must be less than $922,975 and unsecured debts less than $307,675).

A Chapter 7 filing means that the debtor has no hopes of paying off his or her debts and is looking for a fresh start. Now, as a result of the Bankruptcy Abuse Prevention and Consumer Prevention Act of 2005, the debtor must take a Means Test in order to qualify for protection under Chapter 7. If your current monthly income (which is actually your average monthly income for the six months prior to filing) is greater than the median income for a family of the same size in your state, you generally can't file for Chapter 7. Here's an example of how the Means Test works. In 2005, the estimated average yearly income for a four-person family in Georgia was $64,427. That translates to an estimated average monthly income of $5,368.92. So, if your average monthly income for the six months prior to filing for bankruptcy was greater than $5,368.92, you aren't eligible to file for Chapter 7 and will probably have to file under Chapter 13 [ref].

After filing, the debtor is assigned a court-appointed trustee. The trustee will organize the sale of the debtor's assets. The debtor may be allowed to retain certain items, such as a house or part of the value of a car, based on exemption laws, which can differ drastically from state to state. Any non-exempt assets are sold by the trustee and used to pay off a portion of the filer's debts. Because the debtor cannot afford to pay off all of his or her creditors, some debts may be discharged and will not have to be repaid.

Both Chapter 12 and 13 are designed to help an individual with a regular income to restructure his or her debts. The main difference is that Chapter 12 is designed for farmers. These types of filing can be more favorable for the debtor than Chapter 7 because it allows the filer to retain most (or even all) of his or her assets and to form a plan to repay debts over a period of several years. Unlike someone who files for Chapter 7, a Chapter 13 debtor is not immediately discharged from his or her debts. Like Chapter 7 filers, the debtor is assigned a trustee, with whom the debtor must form a repayment plan. The court either approves the plan or orders changes. Once the plan goes into effect, the debtor has three to five years to repay his or her debts, and frequently the debtor only has to repay 30 to 50 cents on the dollar.

The "New" Bankruptcy Law

­The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, which took effect on October 17, 2005, was designed to curb fraud and also to aid individuals seeking debt relief. One important change demands that all debtors must now get credit counseling before filing for bankruptcy and additional budget management and debt counseling before debts can be discharged. The counseling agency must be approved by the United States Trustee's office.

Under the new law, some people who have high incomes will no longer be allowed to file under Chapter 7. Instead, they'll have to pay back at least some of their debts through Chapter 13. Those filing under Chapter 13 have to hand over an amount of their income dictated by the IRS. That amount is based on the current monthly income previously calculated. The use of the current monthly income method means that some debtors may be forced to give up more income than they have, and that some Chapter 13 plans may not work.


Lawyers must also now attest to the accuracy of the information passed to them by their clients. While this requirement may help ensure that debtors submit accurate information, it could also result in lawyers spending more time on cases and consequently, bigger legal bills.

For Chapter 7 filers, property is more vulnerable to being seized by creditors under the new law. Property is now valued at the amount it would cost to replace it rather than what it could be sold for at an emergency fire sale. Some property may be exempt from seizure, but those seeking protection under Chapter 7 must now have lived in a state for two years to be eligible for exemption. To use your new state's homestead exemption (which determines how much equity you can keep in your home), you must have lived in the state for 40 months. Exemptions often vary significantly from state to state, so it's important to examine the options available in your state (or in your old state if you recently moved) if you are considering filing for bankruptcy.

Origins of Bankruptcy

Initially, bankruptcy was an involuntary state -- people who were forced into bankruptcy were considered criminals, and could be thrown into debtor's prison or even executed. The word bankruptcy is said to stem from an Italian tradition of destroying the workbench of a tradesman who couldn't pay his debts. The Italian phrase for broken bench, banca rotta, is the origin of the word [ref].

In the 1800s, United States bankruptcy laws were limited and usually passed to help the country through difficult economic periods. The Bankruptcy Act of 1898 was the first modern bankruptcy law, and it was further refined during the Depression with the Bankruptcy Act of 1933, the Bankruptcy Act of 1934 and the Chandler Act of 1938. Individuals were given the power to have their debts discharged, and corporations were given the opportunity to reorganize and pay their debts while they were in bankruptcy.


With the exception of railroad companies, few bankruptcies were filed after World War II. The Bankruptcy Reform Act of 1978 was a landmark in United States bankruptcy legislation. This law created the chapters of bankruptcy that we have today and expanded the powers and rights of both consumer and corporate debtors to file bankruptcy. Filings increased in the following decades, leading to fears that the bankruptcy system was too lenient and wasteful. This also created a backlog in bankruptcy courts, leading to a push for "fast track" bankruptcies for small businesses and "prepackaged" bankruptcies to help streamline the process and ease the caseload. Reform laws were also passed to encourage more Chapter 13 filings instead of Chapter 7 filings [ref].

The bankruptcy reforms passed in 2005 are just the latest changes to these laws, as the pendulum swings from empowerment of debtors to the empowerment of creditors. Changes in the political landscape, the views of the public and the economic situation all affect future bankruptcy laws.

For lots more information about bankruptcy, check out the links that follow.

Lots More Information

Related HowStuffWorks Articles

More Great Links

  • Beltran, Luisa. "WorldCom files largest bankruptcy ever." CNN Online, July 19, 2002.
  • Business bankruptcy FAQ. LexisNexis.
  • Bankruptcy Information, FAQs, Chapter 7 & 13 Information. Bankruptcy Action.
  • Crawford, Krysten. "Ex-WorldCom CEO Ebbers guilty." CNN Online, March 15, 2005.
  • "Delphi files for bankruptcy." CNN Online. October 8, 2005.
  • "Kmart files chapter 11." CNN Online, January 22, 2002.
  • Leonard, Robin. "Bankruptcy: Is it the right solution to your debt problems?" Nolo, 2004. ISBN 0-87337-973-x.
  • Lisante, Joan E. "New Bankruptcy Law Tightens Rules, Adds Paperwork." Consumer Affairs, October 14, 2005.
  • The New Bankruptcy Law. NOLO, 2005. objectId/B0B66870-4C52-4303-919B10B9611D3EF9/213/161/ART
  • "An Overview of Corporate Bankruptcy." Investopedia, July 8, 2005.
  • "Reorganization under the bankruptcy code, chapter 11." Public Information Series of the Bankruptcy Judges Division. U.S. Courts, December 1998.
  • Summers, Mark S. "Bankruptcy Explained: A guide for businesses." John Wiley & Sons, 1989. 0-471-61982-5.
  • The United States Trustee Program. U.S. Dept of Justice.