Bankruptcy

The fundamental policy tension in bankruptcy law is between two competing values: relief for the honest debtor who cannot pay and deserves a fresh start, and protection for creditors who extended credit in good faith and are entitled to recover as much as possible from the debtor's available assets. American bankruptcy law has historically struck a balance between these values that is somewhat more debtor-friendly than the legal systems of many other countries — providing a statutory right of discharge that eliminates most personal liability for individual debtors and a reorganisation mechanism that allows businesses to continue operating rather than being dismembered — while also imposing rigorous procedural requirements, means testing for individual debtors, and priority rules that protect secured and priority unsecured creditors before general unsecured creditors receive anything.

Constitutional and Statutory Foundation

The constitutional basis for federal bankruptcy law is the Bankruptcy Clause of Article I, Section 8, Clause 4, which empowers Congress to establish uniform laws on the subject of bankruptcies throughout the United States. The constitutional mandate of uniformity — the requirement that bankruptcy law apply consistently across all fifty states — is fundamental to the commercial functioning of the national economy. Without uniform bankruptcy law, creditors in different states would face dramatically different rights and protections depending on where a debtor happened to reside or operate, disrupting interstate credit markets and capital allocation.

The Bankruptcy Reform Act of 1978 enacted the modern Bankruptcy Code as Title 11 of the United States Code, replacing the prior Bankruptcy Act of 1898. The 1978 legislation substantially modernised the bankruptcy framework, creating the modern bankruptcy court system, expanding the automatic stay, creating the Chapter 11 reorganisation framework in its modern form, and establishing the priority scheme that remains largely in place today. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, known as BAPCPA, represented the most significant amendment to the Bankruptcy Code since 1978, tightening eligibility for Chapter 7 through the means test, expanding required credit counselling for individual debtors, and modifying numerous provisions across all chapters.

All bankruptcy cases are filed in the United States Bankruptcy Courts, each of which is a unit of the federal district court for its district. Bankruptcy judges are appointed by the court of appeals for fourteen-year terms rather than holding Article III life tenure, and the district courts, which have original and exclusive jurisdiction over cases under Title 11, in practice refer their bankruptcy cases to the bankruptcy judges of their districts. The United States Trustee Program, a division of the Department of Justice, oversees the administration of bankruptcy cases and appoints trustees in Chapter 7 and Chapter 13 proceedings.

Chapter 7 — Liquidation Bankruptcy

Chapter 7 of the Bankruptcy Code governs liquidation bankruptcy — the process by which a debtor's non-exempt assets are collected, sold, and distributed to creditors in satisfaction of their claims, with the debtor receiving a discharge of remaining eligible debts at the conclusion of the process. Chapter 7 is the most commonly used form of bankruptcy in the United States, accounting for approximately sixty percent of all bankruptcy filings annually, and is available to both individuals and business entities.

When an individual files a voluntary Chapter 7 petition, or when a creditor files an involuntary petition that results in an order for relief, the filing immediately creates the bankruptcy estate — a legal entity consisting of all of the debtor's legal and equitable interests in property at the time of filing. A trustee is appointed by the United States Trustee almost immediately upon filing, with broad authority to examine the debtor's finances, liquidate non-exempt assets, and distribute the proceeds to creditors in the priority order established by the Bankruptcy Code.

Certain property of individual debtors is exempt from the bankruptcy estate — that is, it cannot be seized and liquidated by the trustee. Exemptions include the homestead exemption protecting a specified amount of home equity, the motor vehicle exemption, the household goods exemption, the tools of trade exemption for instruments necessary to the debtor's livelihood, and various retirement account exemptions. The specific amounts and categories of exempt property are determined partly by federal law and partly by state law, with debtors in some states able to choose between federal exemptions and more generous or more restrictive state exemptions.

For individual debtors, the Chapter 7 discharge eliminates personal liability for most pre-bankruptcy debts — the discharge injunction permanently prohibits creditors from attempting to collect discharged debts. However, certain categories of debt are non-dischargeable in Chapter 7 under 11 U.S.C. Section 523 — they survive the bankruptcy and remain the personal obligation of the debtor. Non-dischargeable debts include most student loans unless the debtor can demonstrate undue hardship in an adversary proceeding, domestic support obligations including child support and alimony, income taxes that qualify for priority under Section 507(a)(8), generally those for which the return was last due within three years before the filing, debts arising from fraud or intentional misrepresentation, debts arising from willful and malicious injury to another person or their property, fines and restitution imposed by criminal courts, and debts arising from drunk driving causing death or personal injury.

For business entities — corporations, partnerships, and limited liability companies — Chapter 7 liquidation produces no discharge of the entity's debts. The trustee liquidates all business assets, distributes the proceeds to creditors in the statutory priority order, and closes the case. The business entity ceases to exist. Shareholders receive whatever remains after all creditor claims have been satisfied — which in most business bankruptcies is nothing, because the company's assets are insufficient to pay all creditors in full.

Chapter 7 Means Test for Individuals

The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 introduced the means test as a gatekeeping mechanism restricting access to Chapter 7 for individual debtors with primarily consumer debts whose income exceeds the median income of their state. An individual whose current monthly income — the average monthly income from all sources over the six months preceding the bankruptcy filing — is below the applicable state median income for a household of comparable size is presumptively eligible for Chapter 7. An individual above the state median must complete the more detailed means test calculation, subtracting specified allowed expenses from monthly income to determine whether their disposable income is sufficient to fund a meaningful Chapter 13 repayment plan — if it is, their Chapter 7 case may be dismissed or converted to Chapter 13 as an abuse of the Chapter 7 process.

Chapter 11 — Reorganisation Bankruptcy

Chapter 11 of the Bankruptcy Code is the reorganisation mechanism available primarily to businesses — though individual debtors with debts above Chapter 13's debt limits may also use Chapter 11 — that allows the debtor to remain operational while restructuring its debts under a court-confirmed plan of reorganisation. Chapter 11 is the bankruptcy chapter of greatest significance to securities industry professionals because it governs the restructuring of publicly traded companies, directly affecting the rights and recovery prospects of bondholders, other secured and unsecured creditors, and equity holders.

Upon filing a Chapter 11 petition, the debtor becomes the debtor-in-possession — a legal status that allows existing management to retain control of the business and continue operations, subject to specific restrictions and the oversight of the bankruptcy court. The debtor-in-possession steps into the shoes of a trustee and assumes fiduciary duties to the bankruptcy estate and its creditors. This self-administration is the defining characteristic of Chapter 11 and distinguishes it from Chapter 7, where a trustee appointed by the United States Trustee displaces management immediately. A Chapter 11 trustee may be appointed — displacing existing management — only upon a showing of cause such as fraud, dishonesty, incompetence, or gross mismanagement, or if appointment is in the interests of creditors.

The debtor-in-possession has the exclusive right to propose a plan of reorganisation during the first one hundred and twenty days after filing — the exclusivity period — extendable by the court for cause. If the debtor fails to file a plan within the exclusivity period or the court terminates exclusivity, creditors and other parties in interest may propose competing plans. The reorganisation plan sets out how the debtor proposes to treat each class of creditor claims — which debts will be paid in full, which will be reduced, which will be converted to equity, and over what timeframe payments will be made.

To be confirmed by the bankruptcy court, the reorganisation plan must satisfy a series of statutory requirements including feasibility — the court must find that confirmation is not likely to be followed by liquidation or the need for further financial reorganisation — and either acceptance of the plan by each impaired class or, if an impaired class votes against it, satisfaction of the fair and equitable requirement, which includes the absolute priority rule. Confirming a plan over the objection of a dissenting class in this way is called a cramdown.

Chapter 13 — Wage Earner Adjustment

Chapter 13 is the reorganisation mechanism available exclusively to individual debtors with regular income whose total debts fall below specific dollar thresholds. For cases filed between April 1, 2025 and March 31, 2028, a debtor must have no more than one million five hundred and eighty thousand one hundred and twenty-five dollars in secured debt and no more than five hundred and twenty-six thousand seven hundred dollars in unsecured debt to qualify for Chapter 13.

Under Chapter 13, the debtor proposes a repayment plan to be funded from future income over a period of three to five years — three years for debtors below the state median income and five years for debtors above it. The plan must pay all priority unsecured creditors in full, must provide secured creditors at least the value of their collateral, and must pay general unsecured creditors at least as much as they would receive in a Chapter 7 liquidation. After the debtor completes all required plan payments, the remaining eligible unsecured debts are discharged.

Chapter 13 provides important benefits not available in Chapter 7. Most significantly, Chapter 13 can stop foreclosure on a primary residence — the debtor can cure mortgage defaults through the plan over its three-to-five year term while making current mortgage payments. Chapter 13 also allows debtors to retain all their assets, including assets that would be non-exempt and therefore subject to liquidation in Chapter 7.

The Automatic Stay — 11 U.S.C. Section 362

One of the most powerful and immediately effective provisions of the Bankruptcy Code is the automatic stay, created by 11 U.S.C. Section 362, which takes effect instantaneously upon the filing of a bankruptcy petition — without any court order or notice to creditors — and immediately halts virtually all collection actions against the debtor and the debtor's property. The automatic stay stops all lawsuits and legal proceedings against the debtor, all efforts to collect pre-bankruptcy debts including telephone calls, letters, and wage garnishments, all foreclosure proceedings against real property of the debtor, all repossession of personal property, and all setoff of debts owed to the debtor.

The automatic stay serves the twin purposes of giving the debtor immediate breathing room to organise its affairs and assess its options without the disruptive pressure of simultaneous creditor collection actions, and of preserving the bankruptcy estate for orderly distribution to all creditors rather than allowing the most aggressive or best-positioned creditors to seize assets at the expense of others. The stay ensures that the orderly priority scheme established by the Bankruptcy Code governs creditor recoveries rather than the chaotic first-come-first-served dynamic of competing collection actions.

Certain actions are specifically exempted from the automatic stay, including criminal proceedings against the debtor, the collection of domestic support obligations such as child support and alimony, regulatory actions by governmental units, and the perfection of certain security interests under narrow circumstances. A secured creditor whose collateral is declining in value may seek relief from the automatic stay from the bankruptcy court, which may grant such relief by providing adequate protection of the creditor's interest or, if adequate protection cannot be provided, by lifting the stay and allowing the creditor to proceed against the collateral.

Priority of Claims — The Creditor Waterfall

The distribution of assets in a bankruptcy case follows a strict priority order established by the Bankruptcy Code, most comprehensively by 11 U.S.C. Section 507. This priority scheme determines which creditors are paid first and which receive distributions only after higher-priority creditors have been paid in full. In most bankruptcies, assets are insufficient to pay all creditors in full, making priority the most consequential factor determining each creditor's actual recovery.

Secured claims represent the highest category of recovery. A secured creditor — one whose claim is supported by a lien on specific property of the debtor, such as a mortgage lender secured by real property, an auto lender secured by a vehicle, or a bondholder secured by company assets under an indenture — has the right to recover against the specific collateral securing its claim, up to the value of that collateral. To the extent the value of the collateral equals or exceeds the amount of the debt, the secured creditor is fully secured and has a legally enforceable right to full payment from the collateral value. To the extent the collateral is insufficient to satisfy the full debt — a partially secured creditor — the excess is treated as an unsecured claim and participates in the general unsecured pool.

After secured claims are addressed, Section 507(a) establishes a priority ordering among unsecured claims, each category of which must be paid in full before the next category receives anything. First priority is domestic support obligations such as child support and alimony. Second priority is administrative expenses — the costs of administering the bankruptcy estate itself, including trustee fees, professional fees of attorneys and financial advisers retained by the estate, and the costs of goods and services provided to the debtor during the bankruptcy case. 

Third priority covers unsecured claims arising in the ordinary course of the debtor's business or financial affairs during the gap period in an involuntary bankruptcy — the period after the involuntary petition is filed but before the order for relief is entered. Fourth priority — the wage priority — covers unsecured claims of employees for wages, salaries, and commissions earned within one hundred and eighty days before the bankruptcy filing, subject to a per-employee cap that adjusts for inflation periodically, currently seventeen thousand one hundred and fifty dollars per employee. 

Fifth priority covers unsecured claims for contributions to employee benefit plans arising from services rendered within one hundred and eighty days before filing, subject to a cap of seventeen thousand one hundred and fifty dollars multiplied by the number of covered employees, less any amounts paid under the wage priority. 

Eighth priority covers unsecured claims of governmental units for taxes, including income taxes, employment taxes, excise taxes, and customs duties, subject to specific timing requirements that determine which tax periods qualify for priority.

After all priority claims have been paid in full, any remaining assets are distributed pro rata among general unsecured creditors — trade creditors, holders of unsecured bonds, former employees with claims exceeding priority limits, and all other creditors without secured or priority claims. If any assets remain after general unsecured creditors are paid in full — which occurs only in the rare case of a solvent debtor — those remaining assets are distributed to equity holders in order of their liquidation preference: holders of senior preferred stock first, then junior preferred stock, then common stockholders.

The Absolute Priority Rule

The absolute priority rule is the foundational principle of creditor priority in bankruptcy, requiring that no junior class of claims or interests receive any distribution from the bankruptcy estate unless and until every senior class has been paid in full. In a Chapter 11 reorganisation, the rule applies when the court is asked to confirm a plan over the objection of a dissenting impaired class — the cramdown under 11 U.S.C. Section 1129(b). If a class of unsecured creditors votes against the plan, the plan can be confirmed only if that class is paid in full or no junior class, including equity holders, receives or retains any property on account of its junior claim or interest. A plan that every impaired class accepts is not subject to the rule in the same way, because creditors may agree to take less than full payment or to let junior holders retain value.

For securities industry professionals, the absolute priority rule has direct practical significance for the relative recovery prospects of different securities in a distressed issuer's capital structure. Secured bondholders have priority claims on specific collateral and typically recover more in bankruptcy than unsecured creditors. Senior unsecured bondholders have priority over subordinated bondholders. All bondholders have priority over preferred stockholders. All stockholders are subordinated to all creditors. In most corporate bankruptcies, common stockholders receive nothing — the company's assets are insufficient to pay creditors in full, and the absolute priority rule prevents any value from flowing to equity until creditor claims are fully satisfied.

Impact of Bankruptcy on Bonds and Credit Risk

The relationship between bankruptcy risk and bond pricing is fundamental to fixed income analysis. As a company's financial condition deteriorates and the probability of default increases, its bonds trade at increasing discounts to par value reflecting both the probability that the company will file for bankruptcy and the expected recovery rate — the fraction of the bond's face value the investor expects to recover through the bankruptcy process. Investment grade bonds are those rated Baa3 or above by Moody's and BBB minus or above by S&P and Fitch, reflecting low assessed probability of default. High yield or speculative grade bonds — those below investment grade — carry higher yields compensating investors for higher default risk and lower expected recovery in the event of bankruptcy.

Recovery rates in corporate bankruptcies vary significantly by the position of the bond in the capital structure, the nature and quality of any collateral securing the bond, and general economic conditions at the time of default. Historically, senior secured bondholders have recovered the most, senior unsecured bondholders less, and subordinated bondholders the least, and average recoveries on defaulted corporate bonds have been well below face value for every class of debt. Actual recoveries in any individual case can differ widely from historical averages. Equity holders receive zero recovery in the majority of large corporate bankruptcies.

Broker-Dealer Bankruptcy and the Securities Investor Protection Act

When a broker-dealer becomes financially distressed and cannot meet its obligations to customers, the applicable legal framework is not solely the standard Bankruptcy Code but rather a specialised regime established by the Securities Investor Protection Act of 1970 — enacted after the collapse of dozens of broker-dealers in the late 1960s and early 1970s left thousands of investors without access to their cash and securities. The Securities Investor Protection Act created the Securities Investor Protection Corporation, a non-profit membership corporation funded by assessments on SIPC member broker-dealers, to oversee the orderly liquidation of failed broker-dealers and to compensate customers for losses of cash and securities held in their brokerage accounts up to specified limits.

When a SIPC member broker-dealer is in financial difficulty and customers appear to be at risk, SIPC may apply to a federal court for a protective decree authorising the appointment of a SIPC trustee to liquidate the broker-dealer. The institution of a SIPC proceeding brings any pending ordinary bankruptcy liquidation to a halt and supersedes it. The SIPC trustee is specifically authorised to transfer customer accounts and securities to other solvent broker-dealers, satisfying customer claims without requiring customers to wait for the full bankruptcy process to unfold.

SIPC protection covers each customer's account for up to five hundred thousand dollars in total claims, of which no more than two hundred and fifty thousand dollars may be for claims for cash — uninvested cash balances. Securities held in customer accounts are protected up to the full five hundred thousand dollar limit. SIPC protection does not cover investment losses from market movements, unsuitable recommendations, or broker fraud — it covers only the loss of securities and cash resulting from the financial failure of the broker-dealer itself. It does not apply to commodity futures contracts, foreign exchange contracts, or investment contracts not registered as securities.

The Securities Investor Protection Act substantially alters the rights of unsecured creditors in a broker-dealer bankruptcy by giving customers with unsecured claims priority over other general unsecured creditors in distributions of customer property — the pool of cash and securities held by the broker-dealer in its customer accounts. This customer priority is a departure from the standard Bankruptcy Code priority scheme and reflects Congress's specific policy judgment that retail investors deserve special protection in broker-dealer failures.

Famous Corporate Bankruptcies and Their Lessons

Several landmark corporate bankruptcies illustrate the functioning of the bankruptcy system and the practical application of its priority rules for investors.

The Enron Corporation bankruptcy filing of December 2, 2001 — at the time the largest corporate bankruptcy in United States history — resulted in the complete elimination of common equity value and left unsecured creditors recovering a fraction of their claims after years of complex litigation. Enron's stockholders received nothing. Employees who held Enron stock in retirement accounts lost their retirement savings. The Enron bankruptcy produced significant regulatory reform through the Sarbanes-Oxley Act of 2002.

The General Motors Corporation bankruptcy filing of June 1, 2009 — at its filing the largest industrial company bankruptcy in United States history — employed a Section 363 sale structure that allowed the United States Treasury to purchase substantially all of the operating assets of the old General Motors and transfer them to a new company free of most legacy liabilities, with the proceeds distributed to creditors. Secured creditors were paid in full. Unsecured creditors — including bondholders — received partial recovery through equity in the new company. Old GM equity holders received nothing. The GM bankruptcy resolved in approximately forty days, an extraordinarily rapid resolution for a company of its size.

The Lehman Brothers Holdings bankruptcy filing of September 15, 2008 — the largest bankruptcy filing in United States history measured by assets, with some six hundred and thirty-nine billion dollars in total assets — triggered immediate systemic consequences in global financial markets and remains the subject of ongoing litigation regarding claims and recoveries. Unsecured creditors of Lehman Brothers ultimately recovered more than forty cents on the dollar for senior and general unsecured claims against the holding company after years of proceedings.

Examination Relevance and Key Takeaways

Bankruptcy is tested on the SIE, Series 7, and Series 65 examinations in the context of corporate debt securities, credit risk, creditor priority, capital structure, and broker-dealer customer protection. Candidates must understand the three principal chapters of the Bankruptcy Code, the automatic stay, the priority of claims under 11 U.S.C. Section 507, the absolute priority rule, and the Securities Investor Protection Act framework for broker-dealer liquidations.

The core points to retain are these: bankruptcy is a federal legal process under Title 11 of the United States Code grounded in the Bankruptcy Clause of Article I Section 8 Clause 4 of the Constitution; Chapter 7 is liquidation bankruptcy in which a trustee sells non-exempt assets and distributes proceeds to creditors, with individual debtors receiving a discharge of most remaining debts subject to the means test and with corporations receiving no discharge; Chapter 11 is reorganisation bankruptcy primarily for businesses in which the debtor-in-possession retains control and proposes a plan of reorganisation that, if it is confirmed over the objection of a dissenting class, must satisfy the absolute priority rule — no junior class receives anything until the dissenting senior class is paid in full; Chapter 13 is available exclusively to individual debtors with regular income whose debts fall below specific thresholds and allows repayment over three to five years while retaining assets and preventing foreclosure; the automatic stay under 11 U.S.C. Section 362 takes effect immediately upon the bankruptcy filing and halts all collection actions against the debtor and its property; the priority waterfall under 11 U.S.C. Section 507 pays secured creditors first against their collateral, then administrative expenses, then priority unsecured claims including employee wages up to seventeen thousand one hundred and fifty dollars per employee and certain taxes, then general unsecured creditors pro rata, then equity in order of seniority; and broker-dealer bankruptcies are governed by the Securities Investor Protection Act of 1970, which created SIPC to protect customers up to five hundred thousand dollars per account — with cash protection limited to two hundred and fifty thousand dollars — for losses of securities and cash resulting from broker-dealer failure, not from investment losses.