What is bankruptcy protection?

When a person or company is unable to make payment to creditors to pay off their debts, they can file for bankruptcy protection under US bankruptcy laws. For an individual, bankruptcy protection may involve the discharge of most debts, along with the sale of some of their assets, or a structured plan to pay off debts that are owed. For a company, bankruptcy protection can provide full or partial relief from debt and contracts, assuming the company remains in operation, or the company can go out of business and sell its assets to pay off debt.

There are two types of bankruptcy protection commonly used by individuals: Chapter Seven and Chapter 13, where "chapter" refers to the chapter of the bankruptcy code that describes each. In Chapter Seven, also called "direct bankruptcy" or "liquidation", a trustee is appointed to control the individual's assets. The trustee then liquidates or sells the assets and then delivers the money to creditors to pay off debts, to the extent possible. However, the individual may keep some personal assets depending on the laws of the state in which they live.

Chapter 13, also called “wage-earner bankruptcy,” allows an individual to propose a plan to pay their debts without interest over a period of three to five years, although the individual's payment plan is subject to court approval. While in Chapter 13, an individual is protected from creditors collecting debts or confiscating assets to pay debts, and creditors must abide by the terms of the approved payment plan. Both types of personal bankruptcy make it very difficult for an individual to obtain credit for a period of seven to ten years after seeking bankruptcy protection.

Companies can also seek bankruptcy protection under Chapter Seven, but also under Chapter 11, which is a reorganization rather than a liquidation of assets. It can take months or years for a company to come out of this type of bankruptcy. As in Chapter 13, a company in Chapter 11 can propose a plan to pay off its debts within a certain period of time, after which it is up to creditors to come up with a plan. If the company has shares traded on a public stock exchange, the shares can no longer be publicly traded when bankruptcy protection is sought. In some cases, this causes the company's stock value to drop to zero.

For companies, and especially individuals considering bankruptcy, hiring a bankruptcy attorney is highly recommended, due to the complexity of bankruptcy laws, which also vary somewhat from state to state.