Bankruptcy Foundations: Chapter 13 vs Chapter 11
When you founded your business and started asking big questions about how to help your business succeed, chances are you didn’t ask about how to file for Chapter 11 or Chapter 13 bankruptcy.
After all, no young business wants to think about the prospect of failure.
But sometimes, when the going gets rough, it’s helpful to know what your options are. That’s where Chapter 11 and Chapter 13 bankruptcy come into play. What are they, and how are they different? Here’s everything your business needs to know before you file.
What is Chapter 11 Bankruptcy?
Chapter 11 bankruptcy, named for U.S. bankruptcy code 11, is a type of bankruptcy involving a reorganization of a business’s assets, debts, and affairs. It’s often called the “reorganization bankruptcy” for that reason.
This particular kind of bankruptcy is intended for businesses who want to stay open but need a bit more time to pay their bills. This will allow them to keep cash flowing in so that they can pay off their debts. It’s also one of the most complex types of bankruptcy.
How Does Chapter 11 Work?
A Chapter 11 bankruptcy case begins with the filing of a petition in bankruptcy court. Most Chapter 11 filings are voluntary, but there are some cases where creditors will band together to file an involuntary Chapter 11 petition.
Aside from the petition, debtors must also file:
- Schedules of assets and liabilities
- Schedule of current income and expenditures
- A statement of financial affairs
- Schedule of executory contracts and unexpired leases
Upon voluntary petition for relief under Chapter 11, the debtor (you) assumes the role of “debtor in possession”, which means that you keep control of your assets while they are reorganized as part of Chapter 11 bankruptcy.
You will remain in this role until your plan of reorganization is approved, your case is converted to Chapter 7 or dismissed, or a Chapter 11 trustee is appointed (this only happens in a small number of cases).
Once you are made a debtor in possession, you can continue operating your business as usual. However, the bankruptcy court now has control over major decisions, such as the sale of assets, secured financing arrangements, etc.
The key point in a Chapter 11 bankruptcy is the Chapter 11 plan. It is essentially a contract between you and your creditors as to how you will operate and pay your debts in the future. Most plans allow for at least some downsizing to free up assets and pay off debts.
Who Can File Chapter 11?
Any business or individual can file for Chapter 11 bankruptcy. In fact, several businesses you may recognize have filed for Chapter 11 bankruptcy, including:
- General Motors
- Six Flags
- Marvel Entertainment
- Ally Bank
Keep in mind, however, that it’s not just big corporations who can file Chapter 11. Businesses of any size can file, even individuals. In fact, individuals are the most common filers of Chapter 11 bankruptcy, usually because their debts exceed the limits allowed under Chapter 13 bankruptcy.
What is Chapter 13 Bankruptcy?
This brings us to Chapter 13 bankruptcy, which is the closest thing to a soft landing you can find in the federal bankruptcy code.
Often called a wage earner’s plan, it also calls for a reorganization of the debtor’s finances under the approval of bankruptcy courts. It gets its name because it allows individuals with enough income to repay all or part of their debts as an alternative to liquidation.
As such, this is the bankruptcy option for those whose issue lies in immediate demands for payment, not a lack of income. Many businesses and business owners elect for Chapter 13 because it can allow them to keep their homes as long as they can continue to pay the mortgage.
How Does Chapter 13 Work?
Chapter 13 has many features in common with Chapter 11 bankruptcy, with a few key distinctions.
As in Chapter 11, a debtor will submit a petition for Chapter 13 bankruptcy in bankruptcy court, including a reorganization plan that does two things:
- Protects assets against foreclosure and/or liquidation
- Requests forgiveness of other debts
Like Chapter 11, Chapter 13 bankruptcy does not liquidate all of your assets in order to pay off your debts. It also allows you to reschedule secured debts (other than mortgages) and extend them over the life of the Chapter 13 plan, which may lower your payments.
However, unlike a Chapter 11 bankruptcy, Chapter 13 bankruptcies include a trustee. You make payments to the trustee each month for 36 to 60 months, and the trustee will distribute those payments among your creditors.
Who Can File Chapter 13?
Chapter 13 bankruptcies have a few more restrictions than Chapter 11.
Any individual, even if you’re self-employed, is eligible for Chapter 13 bankruptcy as long as:
- Your unsecured debts are less than $394,725
- Your secured debts are less than $1,184,200
You cannot file Chapter 13 bankruptcy if, at any point during the last 180 days, a prior bankruptcy petition was dismissed due to willful failure to appear in court, willful failure to comply with all bankruptcy orders, or your case was dismissed after creditors sought relief to recover property held in liens.
In addition, you cannot become a Chapter 13 debtor if you received credit counseling from an approved credit counseling agency within the last 180 days, either in an individual or group briefing, though there are some exceptions for emergency situations.
You’ll also have to prove that you have sufficient income available to make the monthly payments. Your income should cover both your monthly household requirements and the proposed payments under the reorganization plan.
Chapter 11 vs. Chapter 13 Bankruptcy
If the word bankruptcy conjures an image of a businessman stripped of everything he has and tossed to the curb, Chapter 11 and Chapter 13 bankruptcy show that it isn’t necessarily the case. Both types of bankruptcy focus on the reorganization of finances to free up liquidity, rather than removal of debt.
This does mean that you’ll be able to hold onto your business, even when going through bankruptcy court. However, Chapter 11 and Chapter 13 bankruptcies also come with their own set of risks, particularly Chapter 11 bankruptcy.
Risks and Expenditures
The idea of keeping your business alive and in your own two hands during the bankruptcy process is appealing to many business owners. Chapter 11 is particularly appealing for high debt/high asset debtors because it does not carry the debt limits attached to Chapter 13 bankruptcy.
However, Chapter 11 bankruptcy is more expensive and the legal proceedings are far more complex. It starts with the fees–Chapter 11 bankruptcy requires a $1,167 case filing fee and a $550 miscellaneous administrative fee. While Chapter 13 requires a $235 case filing fee and a $75 miscellaneous administrative fee.
In addition, Chapter 11 debtors must pay regular administrative fees to the U.S. trustee to offset the cost of their participation in the case.
There’s also a high level of risk with Chapter 11 bankruptcies. Most of them fail — only 10% to 15% of Chapter 11 reorganizations actually work. And if the reorganization doesn’t work, it can result in the liquidation of most or all of your assets.
Even if you would prefer Chapter 13 bankruptcy to Chapter 11 bankruptcy, you may not qualify for Chapter 13 bankruptcy.
While the greatest barrier to Chapter 11 bankruptcy is cost, your eligibility for Chapter 13 bankruptcy is limited by your debts. Again, if your unsecured debt is greater than $394,725 and your secured debt is greater than $1,184,200, you cannot file for Chapter 13 bankruptcy.
Chapter 13 is also quirky for businesses, in that businesses cannot actually file for Chapter 13 bankruptcy. Even sole proprietorships cannot file under Chapter 13, and stockbrokers and commodity brokers cannot file Chapter 13 bankruptcy either, even if their debts are personal.
What they have in common is the reorganization plan and agreed-upon repayment plan. Both Chapter 11 and Chapter 13 bankruptcy require a reorganization plan, though the process of getting it approved and the length of the repayment period are different.
Chapter 11 takes longer to approve because the legal process is more complex. However, as long as a debtor meets the requirements, there is no limit on the duration of a Chapter 11 plan, though most plans are between three to five years.
Chapter 13 is approved faster, but there is a limited commitment period of three to five years. During this period, the debtor must relinquish all or almost all of their disposable income to the trustee to be distributed to their creditors.
Keeping Your Business Healthy
Chapter 11 and Chapter 13 bankruptcies do offer options to help struggling businesses pull through tough times. The better option is to avoid bankruptcy in the first place. That requires a thorough understanding of how to use your finances, and that’s where we can help.
Make sure to check out our blog for more great tips on how to leverage your finances, like these seven ways to use a small business line of credit.