Definition
Bankruptcy is a legal process where individuals or businesses declare their inability to repay their debts. It’s initiated by the debtor, who files a court petition detailing their income, debts, and assets. The court examines these details and may discharge the owed debts or create a plan for partial payment.
Key Takeaways
- Bankruptcy is a legal proceeding for people or businesses that are unable to repay their outstanding debts. The bankruptcy process begins with a petition filed by the debtor or on behalf of creditors.
- It provides the individual or company a chance for a fresh start, but bankruptcy records remain on a credit report, negatively impacting potential future loans, credit cards or employment opportunities for a period of 7 to 10 years.
- There are several types of bankruptcy under the U.S. Bankruptcy Code, most commonly Chapter 7 which involves liquidation of assets, and Chapter 11 or 13, often used by businesses, which involves debt reorganization and payment plans.
Importance
Bankruptcy is an essential term in finance as it pertains to the legal status of an individual or entity that cannot repay their outstanding debts to creditors.
It is important because it provides a structured way for these debts to be settled, either through the liquidation of assets or the formulation of a repayment plan.
Through bankruptcy, distressed debtors can have a fresh start, albeit with effects on their credit history.
Creditors, on the other hand, can recover a portion of what’s owed to them from the debtor’s distributed assets or future earnings, which they would not have received if the debtor had no avenue to sort out their financial problems.
Thus, bankruptcy acts as a crucial financial tool that brings balance, order, and fairness to the financial marketplace by resolving issues related to insolvency.
Explanation
Bankruptcy is a legal procedure that provides a fresh start for individuals or businesses that are unable to repay their debts. The essential purpose of bankruptcy is to allow the debtor to clear his financial slate while also offering creditors a chance for repayment.
It serves as a balancing mechanism that prevents debtors from plunging into endless debt cycles and provides a strategic way to manage insurmountable financial burdens. Bankruptcy offers the debtor the opportunity to discharge debts and work out a plan to repay creditors in an orderly and supervised manner.
In terms of its use, bankruptcy is often considered as a last resort when all other avenues for debt repayment are unavailable or insufficient. There are different types of bankruptcy, such as Chapter 7, which involves liquidation of assets to pay off debts, or Chapter 13, which allows individuals with a regular income to create a plan to repay all or part of their debts.
Businesses can also file for bankruptcy under Chapter 11, which involves a reorganization of a debtor’s business affairs and assets. This means that while bankruptcy can cause significant damage to your credit score, it provides a legal and structured way to handle unmanageable debt and work towards financial recovery.
Examples of Bankruptcy
Lehman Brothers Holdings Inc.: This is a classic case of bankruptcy from the 2008 financial crisis. It was the fourth-largest U.S. investment bank at the time. They declared bankruptcy due to a vast amount of bad investments in subprime mortgages and the bank’s own massive indebtedness. It was the largest bankruptcy filing in U.S. history with a staggering debt of $613 billion dollars.
General Motors: The automotive giant filed for bankruptcy in 2009 following a severe drop in sales during the global financial crisis. The U.S. government stepped in with a rescue package to help restructure the company and save jobs. Despite its financial distress, General Motors managed to exit bankruptcy within 40 days thanks to a $
5 billion bailout package.
Toys “R” Us: In 2017, one of the world’s largest toy store chains filed for bankruptcy after struggling to pay down nearly $5 billion in debt. The company’s inability to invest in online retail also contributed to its bankruptcy. Despite attempts to restructure and an initial plan to keep stores open, by 2018 the company announced it would sell or close all of its U.S. stores.
FAQs on Bankruptcy
What is Bankruptcy?
Bankruptcy is a legal procedure initiated by an individual or a business that cannot pay their debts and seeks the assistance of the court to get a fresh start. It allows individuals and businesses to eliminate all or part of their debt under the protection of the federal bankruptcy court.
What are the types of Bankruptcy?
There are several types of bankruptcy, the most common being Chapter 7, Chapter 11, and Chapter 13. Chapter 7 bankruptcy is a liquidation bankruptcy for individuals who have little to no income. Chapter 11 bankruptcy is for businesses that want to continue operating while repaying their debts, and Chapter 13 bankruptcy is for individuals who earn a regular income to develop a plan to repay all or part of their debts.
How does Bankruptcy affect my credit score?
Bankruptcy can have a severe impact on your credit score, which can remain on your credit report for seven to ten years. However, the impact of bankruptcy on your credit score diminishes over time, and you can start rebuilding your credit immediately after bankruptcy proceedings are complete.
What are the consequences of declaring Bankruptcy?
Declaring bankruptcy has serious consequences, including lowering your credit score, impacting your ability to obtain future credit, denial of jobs, and significant impact on insurances rates. However, it also provides a chance to start over financially, as most or all your debts are cleared.
When should I consider filing for Bankruptcy?
Bankruptcy should be considered as a last resort when you’ve exhausted all other debt relief options. If you’re unable to pay your debts, can’t negotiate with your creditors, or can’t formulate a repayment plan due to the size of your debts, then, and only then, bankruptcy should be considered.
Related Entrepreneurship Terms
- Insolvency
- Chapter 7
- Chapter 11
- Debt Discharge
- Liquidation
Sources for More Information
- U.S. Courts – An official website of the United States Government which offers comprehensive information about bankruptcy.
- Investopedia – A well-known resource for terms related to finance and investing, including bankruptcy.
- Federal Trade Commission Consumer Information – The FTC offers resources and advice on dealing with debts and filing for bankruptcy.
- NerdWallet – Provides in-depth articles about bankruptcy, its impacts, and how it works.
