What It Is:
Liquidation refers to the selling of assets in return for cash.
How It Works/Example:
The term liquidation is most often used in discussions about Chapter 7 bankruptcy -- a section of U.S. bankruptcy law under which companies and individuals liquidate their assets in order to repay their debts.
Individuals, partnerships or corporations can liquidate assets. Here's how liquidation works in the case of bankruptcy.
To file Chapter 7, the debtor files a petition with the local bankruptcy court. (In some cases, creditors can force a debtor into Chapter 7 by filing the petition themselves.) The debtor must provide the court with financial and tax information, as well as a list of creditors and outstanding debts. In most cases, the court also requires proof that the individual has obtained credit counseling. Filing the Chapter 7 petition automatically stops most collection actions against the debtor, including lawsuits, garnishments, and phone calls.
The U.S. trustee (or the court itself, in some states) then appoints an impartial trustee to handle the case and liquidate the debtor's assets. If all the debtor's assets are exempt or subject to liens, there may not be any assets to liquidate and hence no money to distribute to creditors. If there are assets to liquidate, however, the creditors usually file a written claim so that they can receive some of the proceeds. The trustee handles the liquidation and determines which creditors are paid first.
Ultimately, a judge decides whether to discharge an individual's debt. The judge can deny the discharge if the debtor failed to keep adequate records, failed to explain the loss of any assets, committed a crime, disobeyed court orders, or did not seek credit counseling. Alimony, child support, and student loans generally cannot be discharged in a Chapter 7 case, nor can most judgments against the debtor for criminal acts.
The procedure for filing Chapter 7 bankruptcy is very similar for businesses. Public companies must also file a form 8-K with the SEC to notify shareholders of the bankruptcy proceedings.
Most companies do not file Chapter 7 until they've been unsuccessful with a Chapter 11 filing, which lets them attempt to restructure the company and restore the ability to service debt. In Chapter 7, a company ceases operations, and the appointed trustee liquidates the company's assets in order to repay its debts.
Lenders whose debt is backed by collateral are generally repaid first (via the receipt of the collateral), followed by the unsecured lenders and then the shareholders. In many cases, unsecured bondholders receive only pennies on the dollar. Shareholders almost never receive anything.
Why It Matters:
Liquidation is usually the last step in the effort to repay debt. However, the steps preceding liquidation usually involve bankruptcy, which -- at the individual level -- virtually ruins a person's credit for several years, making it very difficult and expensive to borrow money in the future.
For businesses, liquidation usually means closing for good and selling off all the assets. In the end, if a company's stock or bonds are deemed worthless by the bankruptcy court, investors might be able to deduct their losses on their tax returns.