Bankruptcy basics

COVID-19 put the economy in a chill so deep that even the Saipan sun could not thaw it. Businesses shuttered. People sheltered in place. And the flow of money froze.

The resulting hibernation ravaged businesses and employees alike—devastation that will continue to mount for many even as the lockdown slowly lifts. As a consequence, experts predict an explosion of bankruptcies, both personal and corporate, this year. And, indeed, we’ve seen the first wave with prominent retailers like J. Crew, Neiman Marcus, and J.C. Penney already filing for bankruptcy.

Because bankruptcy is on the rise, let’s look at what it is, how it works, and who can benefit from it.

At its simplest, bankruptcy is a legal process for people and businesses that can’t pay their debts. The goal of the process is to give debtors a fresh financial start while also treating creditors in a fair manner.

The most common trigger for bankruptcy is medical debt, which is the primary reason for about 60% of all personal bankruptcies, according to a Harvard University study. Other common reasons include job loss, divorce/separation, poor use of credit, and unexpected expenses from surprise events like a typhoon or pandemic.

Why do we allow bankruptcies? Because it’s good for the economy. We want people to innovate and take risks. But few people will start a business if they will be personally and permanently liable for the debts these ventures create. And the same for people who are saddled with debt. If you are a student with $150,000 in student-loan debt, will you start a business with unpredictable revenue or take a job with an established company that provides a reliable salary?

The model case is Henry Ford. Today he’s known as the man who created Ford Motor Co., one of the great companies of the 20th century. But Ford filed for bankruptcy twice before creating the Ford Motor Co. Without the bankruptcy system, the third time would not have been the charm for Ford or the millions of people who benefitted from his company.

Thus far, we’ve discussed bankruptcy as if it’s just one thing, but there are actually several forms of bankruptcy. The most common three are Chapter 7, Chapter 11, and Chapter 13 with individuals primarily using Chapters 7 and 13 and businesses largely employing Chapters 7 and 11.

The most common form of bankruptcy is Chapter 7, also known as liquidation. It works well for people with few assets (items of value like cash, land, stocks, and so on) who primarily have unsecured debt (such as credit cards and medical bills).

Under this approach, a debtor files for bankruptcy. The court then issues an automatic stay that stops most debt-collection attempts. No more phone calls. No more wage garnishment. Even lawsuits pause. Thereafter, a court-appointed trustee will sell the debtor’s non-exempt assets to pay off their creditors (the people they owe money to). Following this process, the court will normally erase any unsecured debts that remain.

While the Chapter 7 process may require a debtor to sell some of their stuff, it won’t force them to sell everything. Certain assets are exempt.

Likewise, although Chapter 7 clears away most unsecured debts, it won’t erase every debt. For example, it won’t wipe out taxes, student loans, and other forms of secured debt.

The second most common type of bankruptcy is Chapter 13, also known as reorganization, which allows a person to catch up on their debt while keeping their stuff. It often works well for people who can pay some, but not all, of their debt.

Under this approach, a debtor files for bankruptcy. An automatic stay is issued. And then the debtor develops a court-approved payment plan to pay back all of their secured debt and a portion of their unsecured debt. At the end of the payment plan, which normally lasts three-to-five years, any remaining unsecured debt will disappear.

That leaves us with our third type of bankruptcy: Chapter 11 bankruptcy, which is a more complicated version of Chapter 13. It’s popular with large businesses because it allows them to keep operating while paying off their debt. Indeed, if done right, customers may have no idea they are doing business with a company in the middle of a bankruptcy.

Under this approach, the debtor will file for bankruptcy. An automatic stay will be issued. And then the debtor will create a plan to pay their debt while operating the business (known as a reorganization plan). The debtor will then submit the plan for approval with both the court and their creditors. If everyone agrees, the reorganization plan will be implemented. If not, the debtor will go through the Chapter 7 process.

But a word of caution: While bankruptcy may sound like a wizardly way to wish away debt, there’s nothing magical about the experience. And it leaves scars on your credit report for years to come. So, before taking the plunge, do your homework and speak with an experienced attorney.

This column is for informational purposes only and is not intended to be taken as legal advice. For your specific case, consult a lawyer.