Skip to content

FRM Exam Part II · Distress Symptoms and Remedies

Chapter 7 vs Chapter 11 Bankruptcy for FRM Part II

Updated 11 October 2026 · Fact-checked

Chapter 7 is liquidation: a trustee sells the assets and pays creditors by priority. Chapter 11 is reorganization: the firm keeps operating as debtor in possession, an automatic stay halts collection, and creditors vote on a plan. Solve questions by finding the procedure, then applying the stay, DIP financing and absolute priority rule.

Understand Formal Bankruptcy: Chapter 7 and Chapter 11

Formal bankruptcy is a court-supervised process for a firm that cannot pay its debts. In the US, two chapters of the Bankruptcy Code matter for this exam. Chapter 7 is liquidation. Chapter 11 is reorganization.

In Chapter 7, a trustee takes control, sells the assets and distributes the cash to creditors. The business usually stops operating and the firm does not continue as a going concern. In Chapter 11, management normally stays in control as the debtor in possession (DIP). The firm keeps trading while it negotiates a plan of reorganization with creditors.

The automatic stay takes effect when the petition is filed. It stops most creditor actions to collect, such as lawsuits, foreclosure and seizure of assets. It gives the firm breathing room and prevents a race among creditors. Secured creditors can ask the court for relief from the stay if their collateral is not adequately protected.

A firm in Chapter 11 needs cash to keep operating. DIP financing is new credit extended after filing. Lenders will only provide it if they get strong protection, so it is typically given superpriority status over existing unsecured claims and is often secured by liens. This is why DIP loans usually carry low credit risk for the lender.

The plan sorts claims into classes. Classes vote, and the court confirms the plan if legal tests are met. Distribution follows the absolute priority rule: senior claims are paid in full before junior claims receive anything. Secured creditors come first (up to collateral value), then unsecured creditors, then equity holders. In practice, priority is often deviated from in negotiated plans, so exam answers should say the rule is the legal benchmark, not a guarantee of outcomes.

Key formulas to remember

Absolute priority rule
Secured → administrative and priority claims → senior unsecured → junior/subordinated → equity
Each class must be paid in full before a lower class receives value. Secured claims are covered only up to collateral value; any shortfall becomes an unsecured claim. Administrative costs and DIP superpriority claims sit ahead of prepetition unsecured claims.
Recovery rate for a class
Recovery % = Value distributed to class ÷ Face amount of class claims
Use when the available value is less than total claims. Fill classes in order of priority.
Secured claim shortfall
Deficiency claim = Claim − Collateral value (if Claim > Collateral value)
The deficiency ranks as a general unsecured claim.
Chapter 7 vs Chapter 11 test
Liquidation: assets sold, firm ends. Reorganization: firm continues under a plan
A plan must usually give each dissenting creditor at least what it would get in Chapter 7 (best-interests test).

How to solve Formal Bankruptcy: Chapter 7 and Chapter 11 questions

Use the same sequence for any question on formal bankruptcy, whether it is conceptual or numerical.

  1. 1Identify the procedure: liquidation (Chapter 7) or reorganization (Chapter 11). Look for words such as trustee, sale of assets, debtor in possession, plan.
  2. 2Note what the filing triggers: the automatic stay halts collection actions. Check whether the question concerns a secured creditor seeking relief.
  3. 3Identify who controls the firm: a trustee in Chapter 7, usually management as DIP in Chapter 11.
  4. 4If new money is mentioned, treat it as DIP financing: post-filing credit with superpriority or priority liens.
  5. 5For numerical questions, list the claims in order of priority. Split any secured claim into the secured part (up to collateral value) and the deficiency.
  6. 6Allocate the distributable value down the list until it runs out. Compute each class recovery as value received ÷ claim.
  7. 7For plan questions, check voting by class and the best-interests test, which compares creditor recovery under the plan with Chapter 7 liquidation.
  8. 8State the answer with the interpretation: who is wiped out, who is paid in full, and whether equity gets anything.

Quickest way: Waterfall in four lines

When to use it: Use for any numerical question that asks for recovery, or which claim gets paid.

  1. Write the claims top to bottom: DIP/administrative, secured, senior unsecured, junior, equity.
  2. Subtract available value from the top. Stop when value hits zero.
  3. The class where value runs out gets a partial recovery equal to remaining value ÷ its claim.
  4. Everything below it gets zero. Check the four options for the one matching this pattern.

Common mistakes in Formal Bankruptcy: Chapter 7 and Chapter 11

  • Saying Chapter 11 always ends in liquidation or that Chapter 7 allows continued operation.

    The words reorganization and liquidation are mixed up under time pressure.

    Fix: Remember: 7 = sell and end, 11 = restructure and continue. A Chapter 11 plan can include a sale, but the default purpose is reorganization.

  • Thinking the automatic stay protects secured creditors fully or is permanent.

    Students read stay as a freeze that applies equally to everyone forever.

    Fix: The stay halts collection, but a secured creditor may seek court relief if its collateral is not adequately protected. It lasts while the case runs, subject to the court.

  • Paying secured creditors their full face claim when collateral is worth less.

    Seniority is confused with full coverage.

    Fix: Secured recovery is capped at collateral value. The shortfall is an unsecured deficiency claim that shares with other unsecured creditors.

  • Ranking DIP financing alongside existing unsecured debt.

    Students treat all debt as the same class.

    Fix: DIP loans are new post-filing credit with superpriority or senior liens, so they are repaid ahead of prepetition unsecured claims.

  • Stating that absolute priority is always followed in Chapter 11.

    The rule is learned as a law of nature.

    Fix: It is the legal benchmark, but negotiated plans often deviate, for example equity may get some value for consenting. Say so when the question hints at actual outcomes.

  • Giving equity a payout while unsecured creditors are not paid in full.

    Equity is treated as having a claim on remaining assets in the same way as debt.

    Fix: Equity is residual. It receives value only after all senior classes are paid in full, if the rule is applied strictly.

Worked examples

Example 1

A firm files for Chapter 7. Liquidation of assets raises $60 million. Claims: secured loan $30 million, backed by collateral worth $25 million (included in the $60 million), senior unsecured $50 million, subordinated debt $20 million, equity. Ignore administrative costs. What is the recovery rate for senior unsecured creditors, treating the secured deficiency as a senior unsecured claim?

Show the solution
  1. Secured creditor takes the collateral: $25 million. Deficiency = 30 − 25 = $5 million, treated as senior unsecured.
  2. Value left = 60 − 25 = $35 million.
  3. Senior unsecured pool = 50 + 5 = $55 million.
  4. Recovery = 35 ÷ 55 = 63.6% (rounded).
  5. Subordinated debt and equity receive nothing because value is exhausted.

Answer: Senior unsecured creditors (including the deficiency claim) recover about 63.6%; subordinated debt and equity recover 0%.

Example 2

A company in Chapter 11 obtains a $40 million DIP loan with superpriority status. The plan values the reorganized firm's distributable value at $100 million. Claims: DIP $40 million, secured $30 million (collateral worth $30 million), unsecured $80 million, equity. Under the absolute priority rule, what recovery do unsecured creditors get, and does equity receive anything?

Show the solution
  1. Pay DIP first: 100 − 40 = $60 million left.
  2. Pay secured claim from its collateral: 60 − 30 = $30 million left.
  3. Unsecured claims are $80 million, with $30 million available.
  4. Recovery = 30 ÷ 80 = 37.5%.
  5. Value is fully used, so equity gets nothing under strict absolute priority.

Answer: Unsecured creditors recover 37.5%; equity receives nothing.

Exam tips

  • Questions often ask which feature belongs to which chapter. Learn the triggers: trustee and sale means Chapter 7; debtor in possession and plan means Chapter 11.
  • For recovery calculations, always cap secured claims at collateral value and move the deficiency to the unsecured class.
  • If an option says DIP lenders rank behind existing unsecured creditors, it is wrong. DIP financing gets priority.
  • Watch wording such as strictly, always or guaranteed. Actual plans often deviate from absolute priority, so absolute statements about outcomes are suspect.
  • Link bankruptcy to credit risk: recovery rates feed LGD, so a question may ask how seniority changes loss given default.

Practice questions from Distress Symptoms and Remedies

Formal Bankruptcy: Chapter 7 and Chapter 11: frequently asked questions

What is the main difference between Chapter 7 and Chapter 11 bankruptcy?

Chapter 7 liquidates the firm: a trustee sells assets and pays creditors by priority. Chapter 11 reorganizes it: the firm continues operating, usually under management as debtor in possession, and proposes a plan that creditors vote on.

What does the automatic stay do?

It takes effect on filing and halts most creditor collection actions, such as lawsuits and seizing assets. This protects the estate and prevents a creditor race. Secured creditors can ask the court for relief if their collateral is not adequately protected.

What is debtor in possession financing?

It is new credit provided to a firm after it files for Chapter 11 so it can keep operating. Lenders usually receive superpriority status or senior liens, which makes the loan repaid ahead of prepetition unsecured claims.

What is the absolute priority rule?

It says senior classes must be paid in full before junior classes receive anything. The order is secured, then unsecured, then subordinated, then equity. Negotiated outcomes in practice can deviate from it.