When a debtor becomes insolvent and the bankruptcy proceeding begins, the debtor will either liquidate its assets or reorganize its debts. The liquidation route is governed by Chapter 7 of the Bankruptcy Code.
In a liquidation, the assets of the debtor, usually a corporation, are sold in piecemeal or as a going concern “in order to satisfy the [d]ebtor[’s] creditors.” Under the Code, a trustee administers the liquidation by “marshalling all available property, reducing it to money, distributing it to creditors, and closing up the estate.” The sale of the debtor’s assets creates proceeds that are divided among interest holders in the debtor. The division of proceeds is made according to the hierarchy of the claimants’ rights.
By contrast, when an insolvent debtor is reorganized under Chapter 11, the debtor’s assets are not actually sold. Instead, the company is fictionally “sold” to existing creditors who pay for the company with their existing claims and interests. This transaction cancels the creditors' claims and interests, receiving in exchange claims against or interest in the new, reorganized entity.
Chapter 7 liquidation is the most common form of bankruptcy in the United states. The Code treats individual debtors differently from non-individuals, such as corporations, limited liabilities companies, and business partnerships. The statutory differences are explained below.
Non-individuals (Business Entities)
Business entities are eligible for Chapter 7 bankruptcy. Businesses generally file for chapter 7 liquidation when there is no possibility of achieving profitability under a chapter 11 reorganization. A chapter 7 bankruptcy terminates the company’s operations and takes the company completely out of business. A trustee assumes control of the entity to ensure that creditors benefit from the maximum value of the debtor’s assets.
The order in which creditors are paid depends on their status as creditors to the debtor. Indeed, the United States Supreme Court recently remarked that “[l]ower priority creditors cannot receive anything until higher priority creditors are paid in full.” Naturally, the creditor/investor who took the least amount of risk, usually a secured creditor, is paid first. A secured loan is a loan backed by collateral, meaning that if the debtor cannot repay the loan, the creditor is entitled to recover the collateral, or its cash value in lieu of the loan’s repayment. Because secured lenders know they will receive some amount of payment if the debtor declares bankruptcy, they take the least amount of risk.
Unsecured creditors have second claim to the debtor’s assets because they take greater risk than secured lenders. An unsecured creditor is a lender that does not take any security interest in the assets of the debtor, such as through collateral. Hence, when a debtor goes bankrupt, unsecured creditors may obtain only a pro rata distribution of the debtor’s assets and an amount in proportion to the size of their debt. And any recovery will come only after the secured creditors have recovered their interests.
Last in line are the company’s stockholders. They take the greatest amount of risk in the success or failure of a company. Thus, their recovery is limited by the preferential claims of secured and unsecured creditors. Stockholders cannot recover any assets if the secured and unsecured creditors’ claims are not fully repaid.
Unlike an individual debtor, a non-individual debtor does not achieve a discharge of its debts following liquidation; discharge of liability is only available to individual debtors. This statutory provision reflects Congress’s goal “to prevent businesses from evading liability by liquidating debtor corporations and resuming business free of debt.” In other words, corporate debt, unlike individual debt, “survives” liquidation proceedings and is “charged against the corporation when it resume[s] operations.”
As stated in the 1915 U.S. Supreme Court case of Williams v. U.S. Fidelity G. Co., a principal purpose of the bankruptcy act is to "relieve the honest debtor from the weight of oppressive indebtedness and permit him to start afresh free from” prior “misfortune.” Accordingly, chapter 7 “allows an individual who is overwhelmed by debt to obtain a ‘fresh start’” through a discharge of his or her debt by surrendering for distribution the debtor’s nonexempt property. The discharge releases an individual debtor from personal liability for most debts, preventing creditors from taking collection action against the debtor.
However, not all individuals may qualify for liquidation. To qualify, an individual must pass the “means test” established in § 707(b). The means test will shift consumer debtors into chapter 13 bankruptcy if they are able to “pay some or all of their debts in a chapter 13 plan” through their prospective income. In other words, the Code prefers an income-based repayment plan (as provided in chapter 13) when a debtor is able to repay his or her creditors through future income. The means test is essentially a screening mechanism, designed “to weed out chapter 7 debtors who are capable of funding a chapter 13 case.”
Further, a bankruptcy court may dismiss a chapter 7 case if the individual debtor’s debts are primarily consumer rather than business debts. This dismissal is discretionary and is based on whether the court finds that the granting of relief would be an abuse of chapter 7.
[Last updated in May of 2020 by the Wex Definitions Team]