What is Chapter 7?

Chapter 7 refers to the section of U.S. bankruptcy law under which companies and individuals liquidate their assets in order to repay their debts.

How Does Chapter 7 Work?

Individuals, partnerships, or corporations can file bankruptcy under Chapter 7.

To file Chapter 7, the debtor files a petition with the local bankruptcy court (in some cases, creditors can force a debtor into Chapter 7 by filing the petition themselves). The debtor must provide the court with financial and tax information, as well as a list of creditors and outstanding debts. In most cases, the court also requires proof that the individual has obtained credit counseling. Filing the Chapter 7 petition automatically stops most collection actions against the debtor, including lawsuits, garnishments, and phone calls.

The U.S. trustee (or the court itself, in some states) then appoints an impartial trustee to handle the case and liquidate the debtor's assets. If all the debtor's assets are exempt or subject to liens, there may not be any assets to liquidate and hence no money to distribute to creditors. If there are assets to liquidate, however, the creditors usually file a written claim so that they can receive some of the proceeds. The trustee handles the liquidation and determines which creditors are paid first.

Ultimately, a judge decides whether to discharge an individual's debt. The judge can deny the discharge if the debtor failed to keep adequate records, failed to explain the loss of any assets, committed a crime, disobeyed court orders, or did not seek credit counseling. Alimony, child support, and student loans generally cannot be discharged in a Chapter 7 case, nor can most judgments against the debtor for criminal acts.

The procedure for filing Chapter 7 bankruptcy is very similar for businesses. Public companies must also file a form 8-K with the SEC to notify shareholders of the bankruptcy proceedings.

Most companies do not file Chapter 7 until they've been unsuccessful with a Chapter 11 filing, which lets them attempt to restructure the company and restore the ability to service debt. In Chapter 7, a company ceases operations and the appointed trustee liquidates the company's assets in order to repay its debts.

Lenders whose debt is backed by collateral are generally repaid first (via the receipt of the collateral), followed by the unsecured lenders and then the shareholders. In many cases, unsecured bondholders receive only pennies on the dollar. Shareholders almost never receive anything, but if they do, the trustee gives them an opportunity to claim their share.

Why Does Chapter 7 Matter?

Chapter 7 is usually the last resort for individuals and businesses. For individuals, the goal of Chapter 7 is to get a fresh start by removing debts. However, bankruptcy virtually ruins a person's credit for several years, making it very difficult and expensive to borrow money in the future.

The law works to prevent people from filing Chapter 7 merely to avoid repaying a debt. This is why not all individuals qualify for Chapter 7, especially those with high monthly income or those primarily saddled with consumer debts (i.e., credit card debt). If the individual does not qualify for Chapter 7, the case usually becomes a Chapter 13 filing, where the individual must still repay the debt, albeit under a payment plan.

Businesses don't get a fresh start under Chapter 7, and unlike Chapter 11, Chapter 7 does not offer a chance at rehabilitation. Under Chapter 7, businesses usually close for good and sell their assets. In the end, if a company's stock or bonds are deemed worthless by the bankruptcy court, investors might be able to deduct their losses on their tax returns.