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Chapter 7 is the simplest and most common chapter of the bankruptcy code that individuals and businesses use when filing for bankruptcy. In a chapter 7 bankruptcy, a bankrupt debtor’s assets are liquidated to pay off creditors, and any remaining eligible debts are discharged at the end of the proceeding. While chapter 7 bankruptcies can be relatively straightforward for the debtor, creditors seeking to receive payment on debts owed by the debtor may face several challenges in collecting what they are owed.

The amount a creditor is able to collect will depend on the type of debt they are owed, the assets the debtor owns, and the number of other creditors involved in the proceeding. Like other forms of bankruptcy, chapter 7 involves several deadlines and procedural requirements that can affect a creditor’s rights.

How Does Chapter 7 Work?

In a chapter 7 bankruptcy, a debtor’s non-exempt assets are sold and the proceeds used to pay creditors. Some assets are exempt from bankruptcy, meaning the debtor gets to keep them despite owing money to creditors. For example, debtors using the federal set of exemptions are allowed to keep up to $25,150 of home equity and $13,400 of household goods. Anything above these limits will be sold to cover their debts.

It’s important to note that only individual debtors, not business entities, are entitled to exemptions. If a business is liquidating in chapter 7, all of its assets are sold to cover its debts. However, if a business’s debts are personally guaranteed by its owner, it’s common for the owner to also file for bankruptcy to shield personal assets from liquidation.

A chapter 7 bankruptcy usually takes about six months from the filing of the bankruptcy petition to the sale of assets and the debtor’s discharge of remaining debts. At the beginning of the case, the bankruptcy court will mail notice of the proceeding to all of the debtor’s creditors. Creditors should carefully review this notice and send the court a proof of claim form. Without sending in a proof of claim, creditors are not entitled to receive any payment.

A debtor is required to file a schedule of all their debts and assets when they file for bankruptcy. If the information on the schedule differs from information the debtor gave the creditor in the past, the creditor has a chance to confront the debtor at a hearing. Spotting a discrepancy like this can lead to greater payouts in bankruptcy or even a denial of the debtor’s discharge for fraud.

Throughout the case, an automatic stay prevents any creditor from attempting to collect payment from the debtor outside of the bankruptcy proceeding. Once a creditor finds out about the bankruptcy, they must immediately stop any attempts to collect. There are limited exceptions to the stay; a lawyer can advise a creditor whether their claim fits into one of these exceptions.

Once the assets are sold, the proceeds are divided among the creditors. The amount each creditor receives depends on whether they are secured or unsecured and, if unsecured, whether they have priority.

Secured Creditors in Chapter 7

Usually, secured creditors are in a much better position than unsecured creditors in chapter 7. While unsecured creditors receive a portion of the sale of non-exempt assets, which may be very low or even nothing at all, secured creditors are entitled to the full value of the collateral that secures the debt.

The discharge of debt at the end of chapter 7 only affects personal debts, not liens on property. That means a secured creditor keeps the right to repossess the property. However, it also means that any debt over the value of the collateral is discharged at the end of bankruptcy.

In practice, this means that there’s often room to negotiate with the debtor to allow them to keep the collateral in exchange for paying the full value of the debt. For example, if a debtor still owes $10,000 on a car worth $7,000, the creditor could agree to let the debtor keep the car in exchange for eventual payment of the full $10,000. Such agreements are called reaffirmation.

If the debtor won’t agree to reaffirmation, the creditor is entitled to repossess the collateral once the bankruptcy is over and the automatic stay is lifted. Even if the debtor returns the collateral, the secured creditor still has an unsecured claim to any deficiency. In the example above, the creditor would get the $7,000 car back and have an unsecured claim for $3,000 that would entitle the creditor to some of the debtor’s assets sold in the chapter 7 proceeding.

Unsecured Creditors in Chapter 7

Most unsecured creditors are in a fairly precarious position in chapter 7 (or any bankruptcy), as it’s very possible that they will be unable to collect anything on the debt they are owed. Normally, unsecured creditors are entitled only to a portion of the liquidated assets equal to their share of the debt. For example, if a debtor owes $50,000 and the liquidation only produces $10,000, an unsecured creditor who was owed $10,000 would only receive $2,000.

However, two types of unsecured creditors fare better than most. First, some debts cannot be discharged in bankruptcy, such as alimony or child support payments. These creditors would still be entitled to payment even after the chapter 7 bankruptcy ended. Second, some unsecured debts, such as alimony or wages, are entitled to priority over other unsecured debts, meaning they get full payment before lower priority creditors receive anything.

Some debts, like child support or liability for intentional injuries, can’t be discharged in bankruptcy. Other debts might not be dischargeable if the debtor committed fraud in filing for bankruptcy, for example, by trying to hide some of their assets. A bankruptcy attorney can analyze a situation and determine the best strategy for proving a debt is nondischargeable or that it should be given priority over other debts.

As a practical matter, many chapter 7 bankruptcies do not provide any payment for unsecured creditors at all because all of the debtor’s assets are exempt. This makes finding exceptions to discharge especially important.