If your entrepreneurial dream has struck a reef, don't despair: You can file for bankruptcy to stay afloat.

I've previously examined Chapter 7 as a means for struggling individuals and small businesspeople to start over. Here, I discuss Chapter 11, which allows debtors to restructure their obligations, and whether it's right for you. It's among several proven tactics that can rescue your retirement years from poverty.

Individuals

To file Chapter 11, the debtor files a petition with the local bankruptcy court. The debtor must open the books and give the court important tax and financial data, including a comprehensive list of creditors and outstanding debts. Typically, the court mandates proof that the individual has sought credit counseling. Filing a Chapter 11 petition usually stops most collection actions against the debtor, including lawsuits, garnishments and pestering phone calls.

Chapter 11 is for businesses, not individuals. This does not mean it's strictly off-limits to individuals, but filing Chapter 13 is often easier and more advantageous for individuals. Individuals who operate sole proprietorships, partnerships or other businesses that are closely integrated with their personal assets are best suited for Chapter 11.

Businesses

Let's say that Company ABC has run out of cash and is finding it impossible to service its debt load. This situation makes it a prime candidate for filing Chapter 11.

By doing so, Company ABC is required to submit a plan of reorganization that outlines to the bankruptcy court, the company's lenders, and its shareholders precisely how it will conduct its business and repay its debt. Public companies must also file a form 8-K with the U.S. Securities and Exchange Commission (SEC) to alert shareholders of the bankruptcy proceedings.

The U.S. Trustee, which is the bankruptcy division of the Justice Department, will appoint one or more committees to represent Company ABC's creditors and shareholders. The committees negotiate with Company ABC to receive as much back of the owed money as possible.

The reorganization plan is subject to approval by creditors, shareholders and the bankruptcy court, which can simply overrule any objections from the parties and certify the plan regardless. The SEC also scrutinizes the plan to ensure it follows all legal strictures and is transparent.

Chapter 11 permits Company ABC's existing management to continue operating the business, a process known as "debtor in possession," or DIP. However, the bankruptcy court must approve key decisions, such as the sale of any piece of the business. During bankruptcy, Company ABC typically won't have to honor interest, principal or dividend payments.

The seniority of lenders is crucial under Chapter 11. Secured lenders (i.e., those whose debt is backed by collateral) are repaid first, followed by unsecured lenders, and finally shareholders. Most reorganization plans permit Company ABC to pay back lenders with Company ABC stock.

The Power of Rehabilitation

The greatest advantage of Chapter 11 can be summed up in one word: rehabilitation. The entire scope of Chapter 11, which usually takes several months to complete, gives companies the opportunity to simultaneously remain in business, control the bankruptcy process, and spot future vulnerabilities. An effective wealth-building roadmap should include reconnaissance of potential landmines ahead.

However, reorganization is complex and requires expensive legal assistance. In addition, shareholders and bondholders involved with Chapter 11 run the risk that their securities will end up being worth mere pennies on the dollar -- or less.

Major stock exchanges typically delist companies in Chapter 11. Nonetheless, Company ABC can still trade on the over-the-counter (OTC) market or the Pink Sheets, where the ticker will end with the letter Q to denote bankruptcy. This designation is akin to a Scarlett Letter, but it doesn't have to be permanent.

Moreover, Company ABC might also issue a new class of common stock to replace the Q stock; investors must stay alert to which shares they are buying.

If its shares continue to trade, Company ABC will still have to file SEC reports, even if it's under Chapter 11 protection. If Company ABC manages to emerge from bankruptcy, its lenders typically become the new owners and existing shares canceled or at least significantly diluted.

But keep the faith: Heroic turnarounds under Chapter 11 are indeed possible. In these cases, investors can handsomely profit.

However, if Chapter 11 reorganization fails, companies can file bankruptcy under Chapter 7 of the code. In this scenario, the company halts all operations, sells its assets, uses the proceeds to pay off any debt, and shuts its doors for good.

For further advice on surviving tough financial times, you can consult the trained brokers and financial advisers at Charles Schwab (SCHW - Get Report) , T. Rowe Price (TROW - Get Report) , or TD Ameritrade (AMTD - Get Report) .

As I've explained, Chapter 11 can protect your financial future. Have you saved enough for your retirement? To avoid common money mistakes that can ruin your nest egg, download our free report: The Ultimate Retirement Guide.

 

John Persinos is editorial manager and investment analyst at Investing Daily. At the time of publication, the author held no positions in the stocks mentioned.