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Types of Bankruptcy

2. What are the types of business bankruptcy?

The primary classifications for bankruptcy are as follows:

•    Liquidation – Liquidation bankruptcy is the process by which the assets of an individual or business are liquidated or sold in an effort to generate funds to pay creditors. Any debts owed to creditors after the liquidation of assets and payment to creditors is discharged.

⁃    Note: “Discharge” of a debt means that the debt is erased and cannot be collected through legal means in the future. For individual debtors, some assets may be exempt from inclusion in the bankruptcy process.

⁃    Example: ABC Corp is suffering declining sales. The company debts exceed its assets and it cannot service all of its debts from its revenues. ABC Corp decides to file for liquidation bankruptcy, which involves selling off all of its assets and transferring the funds generated to creditors.

•    Reorganization – A reorganization bankruptcy is a process by which the individual or business establish a plan to pay all secured debts and as much of its unsecured debts as possible during a set period of time (usual 5 years). The terms of the plan, including how much is paid to each creditor are based upon a number of factors, such as the amount of recurring, disposable income of the debtor. The unpaid portion of any unsecured debts are erased after the end of the payment plan period. The business may continue operations throughout this process.

⁃    Note: Creditors are paid based upon their “priority” and the status of their claims as secured or unsecured. Classes of investors receive a pro-rata share of available assets based upon the funds available and size of their claims. Secured creditors must be paid in full or a plan of reorganization fails.

⁃    Example: ABC Corp files for reorganization bankruptcy. All debt collections against the company halt. ABC must now come up with a plan to pay off its debts with income from future operations. It must use all disposable income to pay debts for the plan period. Secured debtors must be paid in full before unsecured debtors receive any funds.

•    Voluntary vs Involuntary – The bankruptcy process begins either with a debtor filing a voluntary petition or creditors of the debtor filing an involuntary petition. A debtor who qualifies under the law and wishes to do so may file a voluntary bankruptcy petition. In other situations, a creditor (or creditors) of a business debtor who meets the statutory requirements may force the debtor into involuntary bankruptcy. The process for initiating an involuntary bankruptcy is discussed separately.

While the process for liquidation bankruptcy is similar for individuals and businesses, reorganization bankruptcy for each is distinct. Throughout this chapter, we focus on business bankruptcy; however, many of the concepts applicable to business bankruptcy apply equally to individuals.

•    Discussion: Why do you think the law allows for both liquidation and reorganization bankruptcy? Are the objectives of each of these types of bankruptcy different? How do you feel about the ability to voluntary elect bankruptcy or to be forced into bankruptcy by a debtor?

•    Practice Question: ABC Corp is in financial trouble. It is considering filing for bankruptcy protection. Can you explain the two bankruptcy options available to ABC Corp and the general characteristics of each?

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