The Process

Two forms of Although the process and history of bankruptcy, both in the United States and worldwide, are bankruptcy. fascinating, the full legal details of bankruptcy are beyond the scope of this book. In the United States, there are two legal forms of financial distress: Chapter 7 Liquidation and Chapter 11 Reorganization. Larger firms usually petition to enter Chapter 11, which gives them a stay from creditors trying to seize their vital assets. If the court determines that the business is still viable, the firm can reorganize its financial claims and emerge from bankruptcy if its creditors vote to agree to the reorganization. Otherwise, the case is converted into Chapter 7 and the firm is liquidated. Both forms are supervised by a Federal Judge (and/or Federal Bankruptcy Trustee) and last on average about 2-3 years. In real life, creditors in Chapter 11 sometimes agree to modest violations from the Absolute Priority Rule—which we have always used to construct our state-contingent tables—in order to reduce running bankruptcy costs. The firm typically pays for most of the legal fees of all participants—but even if it did not, creditors would ask for compensation for their expected legal fees up front, so one way or another, the firm has to carry the expected costs of bankruptcy.

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