For as long as there have been people, there have been debtors and creditors. (Debtors are people who owe money and creditors are people to whom the money is owed.) Moreover, as long as there have been debtors and creditors, there have been debtors who have not been able to pay their debts. Throughout history, however, there has been very little in the way of organized bankruptcy proceedings to straighten out the mess left when debts go unpaid and the lender wants his money back or at least something in return for the lost funds.
Obviously, there is a balancing of interests that needs to be done in considering what to do about unpaid debts.
On the one hand, there is the lender's interest. The government and the courts are committed to keeping the lenders as satisfied as possible and thus willing to continue to lend funds. Any economy that operates on the basis of the extending of credit requires a system that protects the lenders. The role of government in such a situation is to provide laws that protect the lenders from bad debts and to ensure that they keep placing funds in the marketplace.
On the other hand, there are the debtors. One problem for debtors is that they need some sort of legal system that protects them from creditors who are trying to impose harsh terms with their loans or who use unsavory collection practices. Debtors also have the problem that there are times when they are simply unable to pay back the loans that they have borrowed. In such a case, should that individual debtor be financially crippled for life as he struggles vainly to pay back large debts that are constantly increasing due to high interest rates, or does he deserve a fresh start at some point?
Given this situation, it is clear that any economy requires some sort of governmental scheme for regulating the lending, payment, and collection of funds. The Bankruptcy Code (Title 11 of the United States Code) is a complex set of federal regulations that govern what happens when a debtor simply cannot pay back his or her debts. The Code tries to assure that debtors can get a fresh start, while still protecting the interests of the creditor to as great an extent as possible.
There are several different types of bankruptcy. In this summary, we will just briefly discuss the three most popular types. The types of bankruptcy are named for the chapters in the Bankruptcy Code in which the rules for the type of bankruptcy are laid out.
Chapter 7 filings, for businesses and individuals, are also known as “liquidation filings”. As that name implies, Chapter 7 is for companies whose sole intent is to enter the bankruptcy process to pay off their creditors to whatever extent they are able to and then to dissolve the firm at the completion of the process. It is also for individuals who are in far too big a debt “hole” to ever climb out of and are simply interested in giving up their assets and getting a fresh start.
Chapter 7 is mostly concerned with how to divide up the company that is going bankrupt of the assets of the individual creditor. The Code also protects certain assets from collection. For example, an individual may be allowed to keep his or her living quarters, materials necessary to make a living, and certain other personal assets, even in a Chapter 7 liquidation bankruptcy.
Chapter 11 filings are known as “reorganization” filings. Chapter 11 is generally used by businesses, not individuals. When a company files for Chapter 11 bankruptcy protection, it is indicating that, while it recognizes its dire financial condition, it feels that it still has valuable assets and a viable business plan, and thus it intends to keep the business in operation at the completion of the proceeding.
In a Chapter 11 proceeding, the debtor company and the creditors arrange a reorganization of the company’s debts so that the company can stay in business while paying, over the course of time, as much of the debts that it owes as is possible under the circumstances.
Chapter 13 of the Code is only for individual persons who are filing for bankruptcy but who do not want to give up their assets. Instead, they want to rearrange their debts so that they can be paid off, in part or in full, over the course of a period of time. As with the Chapter 11 proceeding, the debtor and the creditors negotiate to the point where the debtor can pay off some or all of his or her debts over time, while allowing the debtor to keep his or her assets. To qualify for a Chapter 13 proceeding, the individual debtor must be a steady wage earner, so that the plans to pay back the debts are realistic.
The main point of the bankruptcy proceeding is to get a “discharge”. After the assets of the debtor have been given to the creditors in a Chapter 7 proceeding or after the plans called for in a Chapter 11 or 13 proceeding have been accomplished, the bankruptcy court will grant a discharge. This means that all of the outstanding debts of the debtor are eliminated. Even if, the day after the discharge, the debtor hits the lottery and wins $25 million, the debtor will not be responsible to pay back any of the discharged debts.
However, if it turns out that the debtor lied or took another fraudulent action during the bankruptcy process, a court may revoke the discharge and reinstate the debts that were discharged. In addition, federal law provides severe criminal penalties for bankruptcy fraud.