Understanding the Difference Between Chapter 11 & Chapter 7 Bankruptcy
E.J. Simonsen | Nov 22, 2021
If your business is overwhelmed with debt and struggling to maintain operations, you may be starting to consider bankruptcy. It's not an easy choice for anyone, which is why it's so important to have all of the facts before you make a final decision. If your business is considering bankruptcy, know your options.
Here's everything you need to know about two common types of business bankruptcy: Chapter 11 and Chapter 7. In this article, we'll discuss their differences, as well as the pros and cons of each business bankruptcy type, so you can better understand what your options are, and which may be right for your business.
Business Bankruptcy: Understanding the Differences Between Chapter 11 & Chapter 7 Bankruptcy
While both Chapter 11 and Chapter 7 bankruptcies offer protection from creditors, lawsuits, and harassment — their primary function is to resolve outstanding business debts — their methods, intent, and outcomes are very different. The greatest difference between Chapter 11 and Chapter 7 bankruptcy is what happens to the business and its owner after the bankruptcy process is complete.
In a Chapter 11 bankruptcy, also known as a "reorganization" bankruptcy, the overarching goal is to save the business. The business continues to operate under the business owner’s control — not the court's. A reorganization plan is developed to help the business restructure, pay back, and eliminate outstanding debts. The expected outcome of a Chapter 11 bankruptcy is a reinvigorated business that is back on track and profitable.
In a Chapter 7 bankruptcy, also known as a "liquidation" bankruptcy, the overarching goal is to liquidate assets and close the business. A trustee is appointed to manage the liquidation process, and when complete, the business's debts are either paid off or written off by any creditor with an outstanding business. Once liquidated, the business must close its doors.
Before we dive into the full explanation of the differences between Chapter 11 and Chapter 7 bankruptcy, take a look at the chart below to get a better understanding of the key differences between the two.
Chapter 11 vs Chapter 7 Bankruptcy: Key Differences
Chapter 11 Business Bankruptcy
Chapter 7 Business Bankruptcy
Known as the reorganization bankruptcy.
Known as the liquidation bankruptcy.
Focuses on developing a plan to restructure business debts, save the business, and make it profitable.
Focuses on selling assets off to repay business debts before closing the business.
All debts are put into the restructuring plan to eliminate, reduce, or pay back over time at low interest through future disposable income.
When all assets are sold, any remaining debt is generally uncollectable, as to the business.
The business continues operating through and following the Chapter 11 bankruptcy process.
When Chapter 7 business bankruptcy is complete, the business must close its doors.
Still, have questions about the differences between the two types of bankruptcies? Let's dig a little deeper.
Understanding Chapter 11 Business Bankruptcy
For businesses looking for bankruptcy protection, but hoping to keep their doors open, a Chapter 11 bankruptcy may be the best option. As mentioned, Chapter 11 business bankruptcy is designed to help businesses restructure debts while keeping business assets and income untouched. While Chapter 11 bankruptcy does allow businesses to remain operational, it can be a complex process. For in-depth information on how Chapter 11 bankruptcy works for businesses, check out our post What is Chapter 11 Bankruptcy?.
What are the Pros and Cons of Chapter 11 bankruptcy compared to Chapter 7 bankruptcy?
Let's take a look at the pros and cons of Chapter 11 bankruptcy, so you can get a better sense of whether Chapter 11 or Chapter 7 might be better suited to your situation.
The Pros of Chapter 11 Business Bankruptcy:
- Your business stays open. For many business owners, the ability to save their business, and remain operational through bankruptcy is the biggest advantage of Chapter 11.
- Business owners retain control. Unlike Chapter 7 bankruptcy, in Chapter 11 bankruptcy business owners retain control of their business. While a trustee is assigned, they have no control over the business. They monitor progress, make recommendations, and assist you and your attorney as needed.
- Your business gets a break from creditors. Tired of harassing phone calls from aggressive creditors? Chapter 11 puts an automatic stay in place to halt all collection activity, so you and your business bankruptcy attorney can focus on creating a plan for reorganization.
- Your business can renegotiate most debts. When you partner with an experienced business bankruptcy attorney, Chapter 11 allows you to renegotiate, reduce, and even eliminate thousands or millions of dollars worth of debts, including government guaranteed debt. Moreover, the right reorganization plan can resolve personal guarantee issues.
The Cons of Chapter 11 Business Bankruptcy:
- Chapter 11 bankruptcy can be complex. The more complex the business or overall situation the more complex and longer the process. Some businesses will need six or seven months to complete their reorganization. It's a lengthy, extensive, and complex process which means your business is expending a great deal more time and money than it might with a more straightforward bankruptcy process like Chapter 7.
- The business must show how it will become profitability. The goal of a Chapter 11 bankruptcy is restoring a business back to profitable operations. This means that your business's 3-5 year financial projections must show it being a profitable operation, once outstanding debts are eliminated, reduced, or reorganized. While this is a positive, it can be a challenging endeavor for a business in dire financial straits, before its debts are considered.
What About Subchapter 5 Chapter 11 Bankruptcy?
If your business is considering Chapter 11 but is concerned about facing the extraordinary costs associated with it, Subchapter 5 is a specific type of Chapter 11 bankruptcy that was developed for small businesses with under $7.5 million in debt. Subchapter 5 works to make it easier and more affordable for small businesses to restructure, wipe out, or reorganize debt, helping to save small business owners from having to file personal bankruptcy.
Subchapter 5 is a streamlined version of Chapter 11 business bankruptcy that aims to reduce the associated fees and time associated with a larger business bankruptcy process. The goal of a Subchapter 5 bankruptcy is the same as a Chapter 11 bankruptcy, the process is just a bit less involved to accommodate the generally less complex assets and debt associated with a smaller business.
Now that we've taken a closer look at Chapter 11 bankruptcy, let's compare what we know to Chapter 7 Bankruptcy.
Understanding Chapter 7 Business Bankruptcy
When it comes to understanding Chapter 7 bankruptcy, it's important to remember that there are two types: Chapter 7 personal bankruptcy and Chapter 7 business bankruptcy.
A Chapter 7 business bankruptcy turns the business over to a trustee who will liquidate the business in an orderly fashion. Under a Chapter 7 business bankruptcy, the business must stop operating. The court will liquidate all assets to pay off as many existing debts as possible, with priority going to secured debt over unsecured debt.
When liquidation is complete, the business won't owe any remaining debts. In the event that a creditor isn't fully paid, most will choose to write off that debt, rather than trying to collect from a business that no longer exists. While business owners would receive any finances left over after creditors are paid, the reality is that most Chapter 7 business bankruptcies have debt exceeding the business assets, which means there is almost always nothing left for the owners following liquidation.
Once complete, the business must officially close its doors, by filing the required documents as required by state and federal law, to limit current or future liability for the business owners.
What are the Pros and Cons of Chapter 7 Business Bankruptcy When Compared to Chapter 11?
Just like Chapter 11, Chapter 7 business bankruptcy isn't right for every business. Here's a look at the pros and cons to help you get a better idea of what to expect from a Chapter 7 business bankruptcy.
The Pros of Chapter 7 Business Bankruptcy
- Chapter 7 offers transparency to all creditors by orderly resolving business debt. When the Chapter 7 bankruptcy process is complete, creditors are assured that no assets are remaining, and the owners did not divert monies to themselves at creditors’ expense. With no assets, the business is effectively collection-proof. Business owners are out from under the harrowing and expensive experience of defending a business that's underwater and can move on with their lives.
- Chapter 7 is much less complex than Chapter 11. In a Chapter 7 bankruptcy, business owners essentially turn over the business to a bankruptcy trustee. From there, the trustee makes all liquidation decisions, working to resolve as much outstanding debt as quickly as possible. This makes the process much faster than Chapter 11, where the business owner and their attorney must work together to develop a reorganization plan.
- Chapter 7 business bankruptcy can minimize personal damages. In situations where a small business is in financial trouble, it's possible for business owners to become personally and financially involved. As long as business owners do not have personal liability for a business's debts, and they took precautions which prevent creditors from piercing the corporate veil, or alleging fraud, alter ego, etc., they are effectively off the hook following the Chapter 7 bankruptcy.
The Cons of Chapter 7 Business Bankruptcy
- Chapter 7 bankruptcy shutters your business. The biggest difference between Chapter 11 and Chapter 7 is that with a Chapter 7 bankruptcy, the business closes. This means it's only an option for businesses with no viable financial future.
- Business owners do not retain control. Unlike a Chapter 11 bankruptcy, in a Chapter 7 bankruptcy, business owners relinquish all control of the business to the bankruptcy trustee. The trustee then makes all liquidation decisions, and owners forfeit any further control. Including the sale of tangible and intangible assets such as brand, name, phone numbers, web domains, and trade secrets (blueprints, code, recipes, etc.).
- Chapter 7 business bankruptcy does not erase personal liability. While filing Chapter 7 can prevent business owners from becoming financially entangled, if you or another business owner are already personally liable for business debts, Chapter 7 does not erase that liability. You may still have to file either a personal Chapter 7 bankruptcy or negotiate a settlement with creditors for any outstanding debts.
Chapter 11 vs Chapter 7 Business Bankruptcy: What's the Best Choice for My Business?
Making the decision to file for bankruptcy isn't an easy one. No business owner starts a company with bankruptcy in mind. But, if your business is struggling to operate, bankruptcy can offer the support your business needs to pay off outstanding debts and move on.
In general, a Chapter 11 or a Subchapter 5 bankruptcy is best for the businesses that could still become profitable given the right reorganization plan. Chapter 7 business bankruptcy is best for businesses that see no viable financial future and are looking for some way to erase crippling debt. That said, every business is different, and there are a wealth of business debt relief options available to you.
To get a better sense of what options your business might have, get in touch with The Lane Law Firm today. Our business bankruptcy attorneys have seen it all and would be happy to offer their recommendations for your business's unique situation. Contact the Lane Law Firm today.