Bankruptcy is a legally declared inability or impairment of ability of an individual or organizations to pay their creditors. Creditors may file a bankruptcy petition against a debtor (”involuntary bankruptcy”) in an effort to recoup a portion of what they are owed. In the majority of cases, however, bankruptcy is initiated by the debtor (a “voluntary bankruptcy” that is filed by the bankrupt individual or organization).
The primary purpose of bankruptcy is: (1) to give an honest debtor a “fresh start” in life by relieving the debtor of most debts, and (2) to repay creditors in an orderly manner to the extent that the debtor has the means available for payment. Bankruptcy allows debtors to be discharged from the legal obligation to pay most debts by submitting their non-exempt assets, if any, to the jurisdiction of the bankruptcy court for eventual distribution among their creditors. A bankruptcy case is initiated by the filing of a petition, which contains the Debtor’s financial information. A married couple may file a joint petition. Though in a technical sense the filing of a joint petition initiates two separate bankruptcy cases (and estates), the cases and estates are usually consolidated and treated as one.
There are two common forms of bankruptcy: liquidation and reorganization. In the United States the law provides for one liquidation chapter (chapter 7); all other chapters are for reorganization (chapter 9- municipalities, chapter 11- businesses or individuals, chapter 12- family farmers, chapter 13- individual “wage earners”.) Upon the filing of the bankruptcy petition, the Debtor’s assets constitute the bankruptcy “estate”. With the notable exception of a case under chapter 11, a Trustee is appointed to oversee the Debtor’s estate, to evaluate claims and perform other functions. In certain instances a Trustee can be appointed to a chapter 11 case.
In a liquidation bankruptcy, the Debtor’s nonexempt (ie, legally unprotected) assets are sold off to satisfy creditor claims. This is referred to as “administering” the Debtor’s estate. The Creditors with timely filed and valid claims participate in a pro rata distribution of the proceeds obtained through the liquidation. The distribution is based on a system of priorities, in which certain classes of claimants are given priority over others. A liquidation case in which no liquidation occurs, and thus no assets are administered for the benefit of creditors, is generally referred to as a “no asset” case.
A reorganization bankruptcy is a bankruptcy in which a debtor reorganizes/restructures assets and debts. Individuals may initiate a reorganization bankruptcy in order to retain assets and pay creditor claims out of the individual’s income. However, reorganization bankruptcies can involve an “orderly liquidation” of some or all of the Debtor’s assets. A reorganization bankruptcy usually allows the Debtor to carry on while satisfying creditor claims (in whole or part).
Businesses may enter a reorganization bankruptcy in order to survive insolvency due to creditor claims exceeding the ability of the business to satisfy them. The basic process involves a business reducing each creditor’s claims to allow partial payment in order for the business to carry on with its daily commercial activity.
During the pendency of a bankruptcy preceding the debtor is protected from most non-bankruptcy legal action by creditors through a legally imposed stay. Creditors cannot pursue most types of lawsuits, garnish wages, or attempt to compel payment.
