Bankruptcy Definition

Bankruptcy law provides for the development of a plan that allows a debtor, who is unable to pay his creditors, to resolve his debts through the division of his assets among his creditors.The philosophy behind the law is to allow the debtor to make a fresh start, not to be punished for inability to pay debts. Bankruptcy law allows certain debtors to be discharged of the financial obligations they have accumulated, after their assets are distributed, even if their debts have not been paid in full. Some bankruptcy proceedings allow a debtor to stay in business and use business income to pay his or her debts.

Bankruptcy law is federal statutory law contained in Title 11 of the United States Code. Congress passed the Bankruptcy Code under its Constitutional grant of authority to "establish. . . uniform laws on the subject of Bankruptcy throughout the United States." See U.S. Constitution Article I, Section 8. States may not regulate bankruptcy though they may pass laws that govern other aspects of the debtor-creditor relationship. A number of sections of Title 11 incorporate the debtor-creditor law of the individual states.

Bankruptcy proceedings are conducted in the United States Bankruptcy Courts. These courts are a branch of the District Courts of The United States. The United States Trustees were established by Congress to handle many of the supervisory and administrative duties of bankruptcy proceedings. Proceedings in bankruptcy courts are governed by the Bankruptcy Rules which were promulgated by the Supreme Court under the authority of Congress.

A bankruptcy proceeding can either be entered into voluntarily by a debtor or initiated by creditors. After a bankruptcy proceeding is filed, creditors generally may not seek to collect their debts outside of the proceeding. The debtor is not allowed to transfer property that has been declared part of the estate subject to proceedings. Furthermore, certain pre-proceeding transfers of property, secured interests, and liens may be delayed or invalidated. Various provisions of the Bankruptcy Code also establish the priority of creditors' interests.

There are two basic types of Bankruptcy proceedings. A filing under Chapter 7 is called liquidation. It is the most common type of bankruptcy proceeding. Liquidation involves the appointment of a trustee who collects the non-exempt property of the debtor, sells it and distributes the proceeds to the creditors. Not dischargeable in bankruptcy are alimony and child support, taxes, and fraudulent transactions. Filing a bankruptcy petition automatically suspends all existing legal actions and is often used to forestall foreclosure or imposition of judgment. After 45 or more days a creditor with a debt secured by real or personal property can petition the court to have the "automatic stay" of legal rights removed and a foreclosure to proceed. When the court formally declares a party as a bankrupt, a party cannot file for bankruptcy again for nine years.

Chapter 11 bankruptcy allows a business to reorganize and refinance to be able to prevent final insolvency. Often there is no trustee, but a "debtor in possession," and considerable time to present a plan of reorganization. The final plan often requires creditors to take only a small percentage of the debts owed them or to take payment over a long period of time. Chapter 13 is similar to Chapter 11, but is for individuals to work out payment schedules.

Under Bankruptcy Rules Rule 7001, an adversary proceeding may be filed in a debtor's bankruptcy action for certain specific reasons. An adversary proceeding may be filed to recover money or property of a debtor, for the sale of a debtor's property by a co-owner, to object or revoke a discharge, to revoke the confirmation of a reorganization plan, to determine the dischargeability of a debt, to obtain an injunction or other equitable relief, and for other matters.

Creditors also may initiate adversary proceedings to determine the validity or priority of a lien, to determine the validity of a debt, to obtain an injunction, or to subordinate a claim of another creditor. The debtor in possession may institute an adversary proceeding to recover money or property for the estate. A creditors' committee may be authorized by the bankruptcy court to pursue certain actions which the debtor has failed to pursue.

The bankruptcy rules consist of nine distinct parts with Part VII governing adversary proceedings and Part VIII governing appeals. The court that will hear an appeal and the appropriate standard of review depends on which court issued the order or judgment that is appealed. Appeals of final judgments, orders, and decrees of the bankruptcy court are taken to the district court or the bankruptcy appellate panel established by the district court.14 Final decisions, orders, and decrees of the district court, as well as appellate decisions rendered under 28 USC 158(a) are heard by the court of appeals

Additional Definitions


Bankruptcy is a legal proceeding, guided by federal law, designed to address situations where a debtor—either an individual or a business—has accumulated obligations so great that he or she is unable to pay them off. Bankruptcy law does not require filers to be financially insolvent at the time of the filing. Rather, it applies a criterion in which approval is granted if the filer is "unable to pay debts as they come due." Once a company is granted bankruptcy protection, it can terminate contractual obligations with workers and clients, avoid litigation claims, and explore possible avenues for reorganization.

Bankruptcy laws are designed to distribute the debtor's assets as equitably as possible among his or her creditors. Most of the time, with some exceptions, bankruptcy also frees the debtor from further liability. Bankruptcy proceedings may be initiated either by the debtor—a voluntary process—or may be forced by creditors.

According to the Administrative Office of the U.S. Courts, in Fiscal Year 2005, 1.637 million bankruptcies were filed in federal courts, up from 1.277 million in FY 2000. Of these 32,406 were business bankruptcies (down from 36,910 in FY 2000). Bankruptcy statistics are dominated by personal filings; these have been increasing sharply in recent years due in large part to rapidly increasing levels of personal indebtedness.

This phenomenon has been responsible for a major overhaul of bankruptcy law in 2005. The legislation, known as The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) was signed into law on April 20, 2005 and became effective October 17 of the same year. The law was designed, in part, to eliminate the practice of serial bankruptcy filings by individuals to escape carelessly accumulated debt.

Types of bankruptcy are named after chapters of the bankruptcy code. Individuals may file under the provisions of Chapter 7 or Chapter 13.


Under Chapter 7 bankruptcy law, all of the debtor's assets—including any unincorporated businesses that he or she may own—are fully liquidated. Assets deemed necessary to support the debtor and his/her dependents, such as a residence, may be exempted. This "liquidation bankruptcy" is the most common filing for business failures, accounting for about 75 percent of all business bankruptcy filings.

The federal bankruptcy court develops a full listing of the debtor's assets and liabilities. The court identifies assets deemed to be exempted, such as a family home, and then divides remaining assets among the various creditors; a trustee is appointed to oversee distribution of proceeds. Unpaid taxes receive top priority; secured creditors are usually considered next. After all assets are liquidated and distributed, the debtor is freed of all further obligations. John Pearce II and Samuel DiLullo note the pluses and minuses of this procedure in Business Horizons as follows: "This type of filing is critically important to sole proprietors or partnerships, whose owners are personally liable for all business debts not covered by the sale of the assets unless they can secure a Chapter 7 bankruptcy allowing them to cancel any debt in excess of exempt assets. Although they will be left with little personal property, the liquidated debtor is discharged from paying the remaining debt." The debts thus discharged exclude certain items which the debtor is required to pay despite the Chapter 7 filing. These include child support, alimony, recent income taxes, and student loans guaranteed by government.

The recently passed BAPCPA limits the ability of a debtor to file under Chapter 7. The debtor can only file for "liquidation bankruptcy" if his or her median income is below the state median income; if it is higher, and the person can afford to pay out $100 monthly to liquidate debt, he or she may only file under Chapter 13. The new law also mandates credit counseling ahead of filing in a government-approved program.


An individual or business filing under Chapter 13 turns over his or her finances to the bankruptcy court and is then obliged to make payments at the court's direction. Whereas Chapter 7 is characterized by full discharge of debt, Chapter 13 results in a repayment plan. Debtors prefer Chapter 7 because it usually allows them to hold on to their equity but, after a brief time, all obligations except such as listed above (child support, alimony, etc.) are eliminated. Courts prefer filings under Chapter 13 if the individual has any ability to satisfy the debt over time, and BAPCPA now codifies this leaning of the courts by defining a "threshold"—the state median income and an ability to pay $100 a month toward the indebtedness.

Provisions of BAPCPA have made Chapter 13 filings more burdensome for filers. Under the old dispensation, Chapter 13 filers enjoyed more protection against legal actions by litigants intending to recover funds or to impose new costs. Filers were protected against evictions; under BAPCPA they no longer are. They may lose their driver's licenses. They must continue to respond to divorce and child-support actions. BAPCPA has also moved family members with financial claims (e.g., for child support, alimony) to the first rank of recipients, ahead of secured creditors. Like Chapter 7 filers, Chapter 13 filers are also required to participate in mandatory financial management education.


In a bulletin titled Corporate Bankruptcy, the U.S. Securities and Exchange Commission summarizes why corporations file for bankruptcy under Chapter 11: "Most publicly-held companies will file under Chapter 11 rather than Chapter 7 because they can still run their business and control the bankruptcy process. Chapter 11 provides a process for rehabilitating the company's faltering business. Sometimes the company successfully works out a plan to return to profitability; sometimes, in the end, it liquidates. Under a Chapter 11 reorganization, a company usually keeps doing business and its stock and bonds may continue to trade in our securities markets."

Companies generally turn to Chapter 11 protection after they are no longer able to pay their creditors. Once a company has filed under Chapter 11, its creditors are notified that they cannot press suits for repayment (although secured creditors may ask the court for a "hardship" exemption from the general debt freeze that is imposed). Creditors are, however, permitted to appear before the court to discuss their claims and provide data on the debtor's ability to reorganize. In addition, unsecured creditors may appoint representatives to negotiate a settlement with the debtor company. Finally, creditors who feel that the debtor company's financial straits are due to mismanagement or fraud may ask the court to appoint an examiner to look into such possibilities.

Once a company asks for Chapter 11 protection, it provides the court, lenders, and creditors with a wide range of financial information on its operations for analysis even as it continues with its day-to-day operations; during this period, major business expenditures must be approved by the court. The business will also prepare a reorganization plan, which, according to CPA Journal contributor Nancy Baldiga, "details the amount and timing of all creditor payments, the means for effectuating such payments (such as the sale of assets, refinancing, or compromise of disputed claims), and the essential legal and business structure of the debtor as it emerges from Chapter 11 protection." Another important component of this plan is the disclosure statement, which presents projected business fortunes, proposed financial settlements with creditors and equity holders, and estimates of the liquidation value of the company. "The information included in the disclosure statement is critical to a creditor's evaluation of the reorganization plans offered for acceptance, as compared to possible other plans or even liquidation," wrote Baldiga.

The reorganization plan, if approved by the court and a majority of creditors, becomes the blueprint for the company's future. Principal factors considered in determining the feasibility of reorganization proposals include:

  • Status of the company's capital structure
  • Availability of financing and credit
  • Potential earnings of the company after reorganization
  • Ability to make creditor payments
  • Management stability
  • General economic conditions in the industry
  • General economic conditions in geographic regions of operation

BAPCPA has also introduced a number of changes governing Chapter 11 filings related to leases, payments made immediately prior to the bankruptcy filing, improved ability of creditors to reclaim products, caps on wage claims applicable to the pre-filing period, and other matters.


Small businesses facing a bankrupt client have few options to protect themselves. If the debtor is engaged in questionable or fraudulent business activities, the small business may use legal actions beyond simply waiting patiently for a bankruptcy court to act. In situations where the debtor has incurred debt only a short time before filing before bankruptcy, creditors can sometimes obtain judgments that put added pressure on the debtor to make good on that liability. In addition, noted the Entrepreneur Magazine Small Business Advisor, "the law provides for a '60-day preference' rule. This rule is designed to prevent debtors from paying off their friends right before they file bankruptcy while leaving others stiffed. The 60-day rule allows the court to set aside any payments made up to 60 days before the actual filing of bankruptcy. Creditors who have been paid must return the money to the bankruptcy court for it to be placed in the pot. Business owners should keep in close contact with their ongoing customers so that they will have a good enough relationship to know far in advance to avoid being caught up in this rule." Indeed, small business owners in particular should always be watching for clients/customers who show signs of being in financial distress. If such indications become present, the owner needs to determine the depth of that distress and whether his or her small business can withstand the likely financial repercussions if that client/customer declares bankruptcy. If a bankruptcy declaration would be a significant blow, then the business owner should weigh various alternatives to protect his/her business, such as cutting back on business dealings with the endangered company or tightening up credit arrangements with the firm.

Finally, advisors typically counsel small business creditors to file confirmations of debt with the court even if it seems highly unlikely that they will ever be compensated. This filing allows creditors to write off bad debts on their taxes.


A company that runs into serious financial difficulties has alternatives to bankruptcy. It can liquidate the business on its own and make payments to its creditors. "Such action may be achieved efficiently if [the business's] creditors … are few … and the assets … can readily be converted to cash," wrote Pearce and DiLullo. "If the number of creditors is large and the assets are numerous and difficult or time-consuming to sell (such as real estate), the protection, structure, and authority of the court may be needed."

Another option is for the company to place liquidation of assets in the hands of a trustee who subsequently pays creditors. The principal advantage of this avenue, say Pearce and DiLullo, is that the assets are thus protected from individual creditors who might otherwise file liens on the assets. "Composition agreements," meanwhile, can be used in situations where creditors agree to receive proportional (pro rata) payments of their claims in return for freeing the debtor company from the remainder of its debts.

These alternative strategies may enable some business owners to avoid the stigma of bankruptcy. But Pearce and DiLullo note that pursuing these options involves considerable risk: "astute creditors will recognize such actions as precursors to bankruptcy and may modify their relationships with [the company], which could precipitate a bankruptcy filing. If creditors believe that continuing in business will result in reduced assets, they may force a bankruptcy in order to stop operations and preserve the existing assets to pay outstanding debts."

SEE ALSO Business Failure/Dissolution


Administrative Office of the U.S. Courts. "Number of Bankruptcy Cases Filed in Federal Courts." Press Release, 24 August 2005.

Baldiga, Nancy R. "Practice Opportunities in Chapter 11." CPA Journal. May 1998.

"Checklist of Key Changes." FindLaw. Available from January 2006.

Pearce II, John A., and Samuel A. DiLullo. "When a Strategic Plan Includes Bankruptcy." Business Horizons. September/October 1998.

U.S. Securities and Exchange Commission. "Corporate Bankruptcy." Available from 8 December 2005.

                                Hillstrom, Northern Lights

                                updated by Magee, ECDI

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