Bankruptcy is a process provided under federal law that allows individuals, married couples, partnerships, corporations, municipalities, and certain other entities to reorganize or eliminate liability for debts, thereby allowing them either a fresh start or an orderly liquidation.
Our founding fathers recognized the need for laws that would allow some type of forgiveness or reorganization of debt. The Constitution, at Article 1, Section 8, Clause 4, authorizes legislation of “uniform Laws on the subject of Bankruptcies throughout the United States.” It took until 1800 before Congress acted to put a bankruptcy system into place, and the bankruptcy laws have changed much over the years.
For instance, the first legislation only allowed for creditors to file an involuntary case against a merchant or trader, and it required complete liquidation of the merchant’s assets. Since then, Congress has expanded both the types of bankruptcy and the types of people and entities who can file. Our modern system and courts have been in operation continuously since 1898, with major overhauls in 1978 and 2005.
Each of the 94 federal districts has a bankruptcy court that is supervised by the US District Court for that district. Unlike District Court judges, who are nominated by the president and appointed for life, bankruptcy judges are chosen by the appellate judges of the circuit in which their court is located and serve 14 years.
The Justice Department is also involved in the bankruptcy process through its office of the US Trustee. According to the mission statement of the US Trustee, the office is charged with the responsibility of maintaining the “integrity and efficiency” of the bankruptcy system.
They do that by supervising individual trustees, who are appointed in most bankruptcy cases, and by direct supervision of filers in Chapter 11 cases.
Types of Bankruptcy
Currently, there are six different types of bankruptcy. Each is designed to achieve a different purpose or is tailored to a particular type of debtor (the person or entity that files a bankruptcy case.) Each is designated by the chapter of the US Bankruptcy Code that governs it.
Chapter 7: This type is also known as straight or liquidation bankruptcy. In a Chapter 7, a debtor who is an individual or a married couple, seeks discharge (forgiveness) of debt in exchange for surrender and liquidation of assets that are not necessary for the debtor to obtain a fresh start.
For a corporate debtor, there is no discharge. Instead, Chapter 7 provides for an orderly liquidation of all assets. In either case, the proceeds are distributed to holders of valid claims. The process can take as few as four months.
Chapter 9: Chapter 9 is reserved for municipalities. Municipalities can include counties, cities, towns, and villages. But it also can include school districts, utilities, airports, and taxing entities like hospital districts, Municipalities do not close up and go out of business like a corporate debtor in Chapter 7. Instead, the municipality will reorganize its debt by renegotiating terms with its creditors.
Chapter 11: Chapter 11 is also known as reorganization bankruptcy. A business entity (and sometimes an individual) can file under Chapter 11 and take advantage of the protection of the bankruptcy court while it renegotiates the terms of its debt. Generally, the Chapter 11 debtor will continue in business during this process and is called a debtor-in-possession.
The goal of the Chapter 11 debtor is to formulate a plan for reorganizing its debt that will be acceptable to most of its creditors. The plan, as accepted by the creditors and confirmed (approved) by the court, replaces any prior contract with creditors. An individual who files a Chapter 11 will also propose a reorganization plan and can petition the court to grant a discharge of debts. In some cases, a debtor will use Chapter 11 to liquidate its assets, similar to Chapter 7 except that the debtor in a Chapter 11 retains control over the liquidation process.
Chapter 12: Chapter 12 was born of the struggles of small farming and fishing operations in the 1980s. It is designed with elements of Chapter 11 and Chapter 13 (see below), with more flexible repayment terms to acknowledge the realities of seasonal harvests.
Chapter 13: Chapter 13 allows an individual debtor or a married couple to propose a plan to repay outstanding debt over a period of three to five years. Those debts may include unsecured obligations like credit cards or medical bills.
It can also include car loans and past due mortgage payments. Chapter 13 has some decided advantages over Chapter 7 cases for debtors who are facing foreclosure or repossession, or who have significant past due domestic support obligations or taxes. Unlike Chapter 7, which has no provision for paying past due secured or priority debt under the protection of the bankruptcy court, Chapter 13 provides an orderly way for people with regular income to catch up arrearages and discharge unsecured debts.
Chapter 15: When a foreign entity has an insolvency proceeding pending outside the United States, but needs or wants access to the bankruptcy courts in this country to administer assets subject to the jurisdiction of the United States, it will file a Chapter 15 proceeding. Chapter 15 cases are often used to protect assets in the United States from attack by creditors or to ensure that parties in the United States are bound by agreements made in the main insolvency case.
Choosing the Type of Bankruptcy to File
The two most common types of bankruptcy filed in the United States today are Chapter 7 straight bankruptcy and Chapter 13 repayment plan bankruptcy.
Although Chapter 11 is available for individual debtors as well as for businesses, it is expensive to administer and only appropriate for people with much debt and a lot of property to protect. Most individual debtors and couples will file either a Chapter 7 or a Chapter 13.
There are many variables to consider in choosing the type of bankruptcy that will help a debtor achieve relief. Not every type of bankruptcy is available to every debtor. For instance, businesses cannot file a Chapter 13 case, but an individual debtor who has a sole proprietorship can file a Chapter 13 case.
Another factor is the debtor’s goals. A Chapter 13 repayment plan can work well for a debtor who needs time to catch up on past due payments on mortgages, taxes or domestic support obligations. In some cases, Chapter 13 can also be used to force better terms on a car loan.
In choosing between Chapter 7 and Chapter 13 for individual debtors, the deciding factor is often a formula called the Means Test, a calculation that compares a debtor’s income to the median income for the debtor’s state, taking into account the debtor’s payments on secured debts like mortgage and car payments and other reasonable and necessary expenses. The amount left over is called disposable income. If the disposable income amount is high, there is a presumption that the debtor is abusing the bankruptcy system by filing a Chapter 7 case instead of a Chapter 13 case. Absent special circumstances, this debtor would file a Chapter 13 case and use the disposable income to fund a three to 5-year plan for paying at least some of the outstanding debt.
Some concepts are important to understanding how the bankruptcy system helps individuals and businesses obtain relief or reorganize debt. These include the role of trustee, the automatic stay, property exemptions and discharge of debt.
The Trustee and the Bankruptcy Estate
When a bankruptcy case is filed, another entity called the bankruptcy estate is created. All of the debtor’s property goes into the estate. The bankruptcy court appoints a trustee to represent the estate.
In a Chapter 7 case, the trustee’s primary role is to find and liquidate nonexempt property and distribute the proceeds to creditors that hold valid and properly filed claims. To carry out this mission, the trustee is often required to file a lawsuit against the debtor or against a third party that holds property belonging to the debtor. Trustees often engage in litigation to determine the amount or validity of a creditor’s claim.
In Chapter 12 and Chapter 13 cases, debtors are required to make monthly payments to a trustee for a period of three to five years. The trustee distributes those payments to the creditors that have filed valid and complete claims according the payment plan proposed by the debtor and approved by the court. The bankruptcy code requires that the debtor devote all of the debtor’s disposable income to funding the plan. The debts treated in the plan can include the mortgage and car payments, arrearages owed on the house or car, other secured debts like furniture loans, priority debts like alimony, child support and recent income taxes, and all types of unsecured debt like credit cards and medical bills.
A trustee is not usually appointed in a Chapter 11 reorganization case or a Chapter 9 municipality proceeding unless the court is convinced that the debtor needs supervision and direction, usually after a petition filed by an interested party.
The Automatic Stay
A hallmark of the bankruptcy process is that each case is carried out under the protection of a bankruptcy court. The most powerful tool in the court’s arsenal is called the automatic stay, an injunction that prohibits creditors from taking action to collect debts. The automatic stay can stop foreclosures, repossessions, garnishments, lawsuits, calls, letters and other measures. The automatic stay makes an orderly and equitable proceeding more likely. Without it, powerful creditors could strip the debtor clean making recovery by smaller, weaker creditors difficult to impossible.
The automatic stay is not absolute. It can be delayed or modified, or not be imposed at all.
The automatic stay It does not apply to every action that a creditor can take. For instance, most bankruptcy courts will not apply the stay to family law proceedings involving divorce or child custody, although the bankruptcy court will often have the final say in any matters that involve a debtor’s assets. The stay will not prevent prosecution for crimes, and it does not apply to certain tax proceedings.
For most bankruptcies cases, the automatic stay goes into effect immediately when the case is filed with the court. But for others, the stay is not automatic at all, particularly those who file cases repeatedly, those who have had cases filed against them (called involuntary petitions), and Chapter 15s filed by foreign entities. In the cases for which the stay is not automatic, the debtor can petition the court to impose it.
The stay can also be modified or lifted altogether. This happens often when debtors fail to pay secured creditors like car loans and mortgage loans. It can also be lifted to allow proceedings outside the bankruptcy court that were pending when the bankruptcy was filed, if that would be the best use of judicial resources.
For individual debtors, the bankruptcy system is designed to allow for a “fresh start.” Recognizing that debtors cannot be left penniless and destitute, individual debtors are allowed to exempt certain types of property from the reach of the court. The bankruptcy code has a list of exemptions, but in some cases, debtors can use the exemptions defined by the state in which they live. Most states also have an exemption scheme that will prevent judgment creditors from levying against vital assets to satisfy claims. Congress gave each state the option to decide whether its residents must use the state exemptions, the federal exemptions or can choose between the two.
The types of property that can be exempted and the maximum values for the exempt property vary depending on which exemption scheme is in use. For instance, debtors using the Texas exemptions can exempt personal property up to a total value of $50,000 for a single adult without a family. Personal property includes household goods, furniture, clothing, books, jewelry, firearms, sports equipment, animals and other items. In Kentucky, a debtor can exempt “clothing, jewelry, articles of adornment and furnishings” up to a total of $3,000, plus a “wildcard” of up to $1,000 that can be applied to any property.
In contrast, the federal exemptions, which debtors in Texas or in Kentucky can elect to use, include an exemption of $12,625 in household goods, clothing, books, etc. There is a separate exemption of $1,600 for jewelry.
State and federal exemption schemes include other types of property in varying amounts, including cash, bank account balances, real property, wages, insurance cash value, tools of the trade, health aids, etc.
No matter which exemption scheme a debtor chooses or is required to use, if the debtor has property that cannot be exempted or that is worth more than the maximum value allowed the debtor may be required to turn that property over to a trustee appointed by the court or account for the value of that property in calculating the amount of the debtor’s Chapter 13 payments.
Dischargeability of Debts
When a debtor is absolved of the liability on a debt, we say that the debtor’s duty to pay the debt has been discharged. In most bankruptcy cases, the debtor’s goal is to discharge as much debt as possible.
But, not all debts are dischargeable. Some debts are generally not discharged except under rare and special circumstances. These include:
- Income taxes accrued during the three years preceding the bankruptcy case
- Alimony and child support
- Criminal fines, penalties, and restitution
- Debts that arise out of death or injury caused by the debtor while driving intoxicated
- Debts that the debtor fails to disclose to the bankruptcy court
- Student loans
Some debts are discharged unless a creditor petitions the court to declare them nondischargeable. Some examples:
- Charges for luxury goods and services made just before filing bankruptcy
- Amounts that arise out of the debtor’s fraud, embezzlement, larceny, or breach of fiduciary duty, or result from the debtor’s willful and malicious acts
This article is not intended to serve in any way as legal advice. It is for information and educational purposes only. You circumstances are unique. If you are experiencing financial distress and are considering bankruptcy, visit a qualified consumer bankruptcy attorney, who will analyze your situation and your goals and will advise you accordingly. You can obtain the names of qualified attorneys from your local bar association or through organizations like the National Association of Consumer Bankruptcy Attorneys.