With Chrysler in bankruptcy and GM most likely entering into bankruptcy within a few days, there are a number of questions surrounding bankruptcy law. Here is a primer on what it is and what to expect.

What is Chapter 11 bankruptcy?
Chapter 11 bankruptcy is a form of corporate restructuring in which a company puts together a plan to eliminate some of its debt so it can survive after it reorganizes. Professor Robert M. Lawless from the University of Illinois, College of Law calls this a re-contracting of obligations and says it allows companies to change the terms of the debt with the creditors, including reducing the principal.

Filing for Chapter 11 bankruptcy helps the company get rid of financial baggage and get its productive assets working again. Companies continue to function as they have been and many consumers will not see a change. Most changes occur behind the scenes.

During bankruptcy proceedings, a judge keeps a close watch on the company and any decisions are subject to review and approval through bankruptcy court. Through this process it is determined whether a company can successfully reduce its debt, sell assets, and emerge stronger.

Chrysler (and GM, it is anticipated) is doing what is called a “363 sale” after the section of U.S. bankruptcy law that allows a quick sale of assets to a new company, with a court hearing. In Chrysler’s case, that company is Fiat. The Chrysler sale is happening within about a month after it filed for bankruptcy.

After the new company emerges, the old company continues in bankruptcy court to liquidate, sell assets, and adjust claims. That process can take months or even years to settle. The creation of a new company and the selling of good assets is done before the end of that part of bankruptcy case.  

How are liabilities paid off?
There are three groups of investors in a company and that generally determines the order of who gets paid back first. First, secured creditors with collateral get paid up to the value of the collateral. Next comes  creditors with priorities, which include professional and legal fees. After these groups are paid off, the next in line are unsecured creditors including other banks and bondholders without collateral or to the extent their claims exceed the value of their collateral, suppliers,  and some consumers with claims against the company. Shareholders are the last to get any money back. Most take a significant loss on their investment and are likely to leave court empty handed.

What is the difference between Chapter 7 and Chapter 11?
Chapter 7 is a liquidation of assets to pay off debt, while Chapter 11 is a reorganization that reduces debt and allows the company to continue operations. Companies who enter Chapter 7 are past the stage where they can reorganize and have a profitable future. They must sell off what they can to repay creditors. However, a number of companies who file Chapter 11 have to liquidate remaining “bad” assets which they can do either within the Chapter 11 or by converting what remains to a Chapter 7 bankruptcy.

We will continue to monitor the news from Chrysler and GM, reporting here in the Cars blog and also updating advice and news on the Auto Crisis hub.

—Liza Barth