Bankruptcy is the legal process through which individuals and businesses can eliminate their debts or repay them under the protection of the bankruptcy court. It allows people or businesses to make a fresh start after experiencing financial difficulties.
Under the United States Constitution, Congress has the power to establish bankruptcy laws throughout the United States. On October 22, 1994, the President signed into law the Bankruptcy Reform Act of 1994. The new law adopted and enacted major revisions to the bankruptcy code. Federal bankruptcy law controls over state legislation to the extent that it conflicts with federal legislation on the subject.
Depending on the type of bankruptcy that a debtor files, most debt will be eliminated or the debtor will have an opportunity to reorganize his debt (pay back the debt over a period of time and subject to certain conditions- see Chapter 13 bankruptcies, below.)
Filing for bankruptcy will seriously damage the debtor’s credit record. A bankruptcy will remain on the debtor’s credit record for up to ten years. This may make it difficult or impossible to obtain new credit, borrow money, or buy a home.
There is more than one type of bankruptcy. The most common types of bankruptcies are a Chapter 7 proceeding (a liquidation of debt, eliminating most debt but exposing the debtor to loss of property), and Chapter 13 proceedings (a court-supervised reorganization of debt, reducing a debtor’s monthly payment and allowing repayment to creditors over a specified period of time).
A bankruptcy may allow the debtor to extinguish all debts and still retain many assets after the proceeding is over.
CHAPTER 7 BANKRUPTCY
The Bankruptcy Petition
A Chapter 7 or ‘straight bankruptcy’ allows the debtor to discharge (extinguish) most debts. To begin a Chapter 7 bankruptcy, the debtor must file a petition (request) with the United States Bankruptcy Court asking it for protection under the bankruptcy law. The petition can be filed individually, or a husband and wife can file a joint petition. As of the date the petition is filed, all of the debtor’s assets come under the protection of the bankruptcy court. This means that creditors may not take any collection efforts against the debtor unless an order is obtained from the bankruptcy court; this is referred to as an ‘automatic stay’.
A filing fee must be paid at the time the bankruptcy petition is filed; the filing fee may be waived for people who receive public assistance or live below the poverty level.
When a Chapter 7 bankruptcy petition is filed, the debtor must also file a Statement of Financial Affairs and other schedules that describe the debtor’s personal background, financial history and income. A detailed inventory of debts and assets will also be filed with the petition. Debts and liabilities are broken down by category. Certain debts, such as taxes, are referred to as ‘priority debts’ and may not be dischargeable. ‘Secured debts’ (debts for which the debtor has given security or collateral), such as automobile debts and home mortgages, must also be identified. ‘Unsecured debts’, such as credit card obligations, are those obligations for which the debtor has given no security or collateral. In addition to scheduling liabilities, the debtor will be required to schedule all assets that the he/she owns, including real estate and personal property.
As was noted above, immediately upon the filing of a Chapter 7 bankruptcy petition, an automatic stay is invoked to stop creditors’ actions against the debtor. The protection of the automatic stay is enforced as long as the debtor is involved in an active bankruptcy. The automatic stay will afford the debtor immediate relief from collection efforts by creditors. When the bankruptcy petition is filed, creditors are notified of the filing and with some exceptions, all lawsuits against the debtor are stopped and creditors cannot enforce any judgments that were not collected before the bankruptcy filing. The automatic stay also prevents creditors, except for taxing authorities, from putting a lien on the debtor’s property.
Utility bills can also be included for discharge in a bankruptcy petition. Utility companies cannot discontinue service to the debtor once it receives notice that the debtor has filed for bankruptcy protection. The utility company can, however, demand that the debtor pay a reasonable deposit (generally two months of average services) to prevent utility service disconnection.
Any individuals or entities that have co-signed on a debt or note with the debtor do not receive any protection under the bankruptcy law in a Chapter 7 filing.
The Internal Revenue Service (IRS) cannot garnish the debtor’s wages or even continue a proceeding in the United States Tax Court after a petition is filed. See also the section discussing taxes below.
Relief /Exemption from Stay
The automatic stay will not, however, stop a criminal proceeding, such as may be brought if the debtor has issued a “bad check”. Likewise the automatic stay will not prevent a former spouse from collecting alimony or child support. In certain cases, creditors have the right to ask the bankruptcy court for relief or suspension of the automatic stay, as when the creditor has a lien on property (secured interest) and the creditor claims that the lien is not adequately protected and the property will lose value during the pendency of the bankruptcy proceeding(see below.)
Secured creditors may file a motion with the bankruptcy court to lift (cancel) the automatic stay in order to recover the collateral. A secured debt is one in which the debtor has given the creditor a lien or interest in property to assure that the debt will be repaid. The creditor can recover the collateral if there is proof that the debtor has no equity in the property, that is, that the collateral value is equal to or less than the principle amount of the debts.
After the bankruptcy petition is filed, the court will appoint a trustee to oversee the bankruptcy case.
Meeting of Creditors
Approximately one month after the Chapter 7 bankruptcy petition is filed, the debtor must attend a ‘meeting of creditors’. At this hearing the trustee will review the bankruptcy forms and may ask any questions necessary to verify that the information contained in the petition is true and accurate. The debtor will ordinarily be required to bring with him/her copies of recent tax returns and title documents to vehicles and other assets. Creditors may also attend this meeting, however, they rarely attend. The meeting lasts only a few moments.
Proof of Claim
In order to participate in the distribution of a debtor’s assets, a creditor must file a ‘proof of claim’ within the time specified by law, or the claim may be forfeited.
A Chapter 7 bankruptcy is often referred to as a ‘liquidating’ bankruptcy. This means that the debtor will lose all property that is not exempt. Exempt assets are those assets that are protected or shielded from creditors under federal or state law. In some states, the debtor may select either the federal or state exemptions; in some states the debtor may only use state exemptions. Exemptions vary widely among the states.
The federal bankruptcy exemptions are set out in section 522(d) of the bankruptcy code. The federal exemptions include up to $15,000 in value in real or personal property that a debtor uses as his residence; an interest not to exceed $2,400 in one motor vehicle (a couple filing jointly can each have a car with $2,400 of equity); up to $8,000 in aggregate value of household furnishings, clothing, and appliances held primarily for household use; up to $1,000 value in jewelry held primarily for personal use; any unmatured life insurance other than a credit life insurance contract; social security benefits, unemployment compensation or local public assistance benefits; veterans benefits, disability or illness benefits; alimony, support or separate maintenance; certain qualified stock bonus, pension, profit sharing or similar plans.
In many states, all or a portion of the debtor’s homestead, (real property and home used as the debtors primary residence) are exempt from creditor’s claims (except for mortgage holders). Many states have different regulations that limit the value of personal property that is exempt from the creditors claims.
As was noted above, if assets or property has been pledged as collateral on a loan (e.g., car or boat loan) and the debtor does not make required payments, the creditor has the right to take back the collateral after the automatic stay is lifted or at the conclusion of the bankruptcy proceeding. Under these circumstances, the debtor may choose to ‘reaffirm the debt’. A ‘reaffirmation agreement’ is a contract that the debtor may enter into with a secured creditor wherein the debtor agrees to bring payments current and to continue making payments in accordance with the terms of the financing agreement and/or mortgage. When a debtor and creditor have entered into a reaffirmation agreement, the debt will survive the bankruptcy and not be discharged, however, the debtor will be able to retain the property. Reaffirmation Agreements must be approved by the bankruptcy judge to be valid. If the debtor has entered into a reaffirmation agreement but fails to make payments as agreed, the creditor can repossess the property and sue for the difference between the value of the property and the amount of the debt.
Certain debts are not dischargeable in Chapter 7 proceedings. These debts include any that are not listed in the bankruptcy papers; child support and alimony; debts for personal injury or death caused by a drunk driver; student loans for which the first payment became due within the past seven years; criminal fines and penalties; recent income tax debts and taxes due for years in which the debtor failed to file a tax return; credit purchases for luxury goods or services made within sixty days of filing.
If a debtor treats one creditor better by making payments to that creditor and not to others for up to a year before filing bankruptcy, the court may view these payments as “preferential”. The bankruptcy trustee will attempt to recover any preferential transfers made to a creditor and bring those payments into the bankruptcy proceeding for distribution equally to all creditors.
Some kinds of taxes can be eliminated through bankruptcy. For example, income taxes that became due more than three years before the bankruptcy was filed can be discharged if the tax return had been filed on time or if it was filed more than two years before the bankruptcy and where the taxes were assessed more than 240 days before the filing of the bankruptcy.
Objections to Discharge
Creditors may file ‘objections’ to the bankruptcy discharge if they feel that the debtor has broken a bankruptcy rule or has tried to defraud the court. In the event a creditor files objections to discharge, the court will have a hearing on the matter.
Several months after the First Meeting of Creditors, the court will conduct a final hearing to approve the bankruptcy discharge. This hearing is largely a formality and no testimony or additional documentation is required or produced. The debtor will receive a document from the court confirming that all dischargeable debts have been extinguished and the Chapter 7 bankruptcy is over. By this time, the trustee will have collected all non-exempt assets of the debtor and distributed them to secured creditors or pro-rata to non-secured creditors.
Effects of Bankruptcy
The bankruptcy proceeding will have discharged most, if not all, of the petitioner’s debts. It is possible that a creditor may mistakenly file a lawsuit to collect a debt that has already been discharged in the bankruptcy proceeding. If the debtor is sued during the pendency of the bankruptcy, he/she must file a document in the court where the suit is pending to ‘stay’ or put the action on hold and assert that a bankruptcy petition has been filed. If a lawsuit to collect a discharged debt is filed after the debtor has obtained a bankruptcy discharge, he/she must respond to the lawsuit and file a document asserting that the debt was discharged and requesting the lawsuit be dismissed. Failure to file a pleading alleging the bankruptcy discharge may result in a judgment being rendered on a debt that no longer exists.
It is very difficult to function in today’s world without a credit card. It is highly recommended that after bankruptcy, the debtor obtain an ‘equity’ credit card- one for which the user has put money in an account to secure payment of any charges. An equity card will help an individual who has filed for bankruptcy protection re-establish credit.
Bankruptcy can be a complicated proceeding and it is highly recommended that an attorney be retained to assure that all technicalities are complied with and that full advantage is taken of all available exemptions. The legal fee for a ‘simple’ Chapter 7 bankruptcy can vary between a few hundred to a thousand dollars, plus filing fees.
The Bankruptcy Court will examine what the debtor’s attorney charges. All attorneys in bankruptcy proceedings must file a disclosure statement setting out their fee arrangements and the source of the funds. If the court decides that an attorney has overcharged, the court can require a refund of all or part of the fee.
CHAPTER 13 BANKRUPTCY
A Chapter 13 proceeding is a reorganization of debt in bankruptcy. In a Chapter 13 proceeding, the debtor will be allowed to propose a plan that will decrease the amount of debt payment to levels that the debtor can afford by extending the debt over a period of three to five years. If a debtor owes more than $250,000 in unsecured debt and more than $750,000 in secured debt a Chapter 13 bankruptcy is unavailable. Chapter 13 reorganization bankruptcies are more expensive and complicated than a Chapter 7 bankruptcy.
Chapter 13 allows individuals who have steady incomes to pay all or a portion of their debt under the protection and supervision of the court.
Chapter 13 Petition
A Chapter 13 bankruptcy begins with the filing of a petition and a proposed payment plan with the United States Bankruptcy Court. The law requires that the payments that will ultimately be made to creditors will have a value that is at least equal to what would have been distributed in a Chapter 7 liquidation case. During the Chapter 13 proceeding, debtors are permitted to keep all of their assets while the plan is in effect and to ultimately retain those assets after the debtor has complied with the Chapter 13 plan.
Limitations on Filing
Only individuals can seek protection under a Chapter 13 bankruptcy, although small businesses can use a Chapter 13 to reorganize if they are sole proprietorships and are owned either by an individual or a married couple. Corporations and partnerships, (other than a partnership between a husband and wife) do not qualify for Chapter 13 reorganizations.
Advantages of Chapter 13 Filing
There are several advantages to filing a Chapter 13 proceeding as opposed to a Chapter 7 liquidating bankruptcy.
Retention of Assets
A debtor will be able to retain and use all of his/her assets as long as payments are made to the trustee as agreed.
‘Cram Down’ of Secured Debt
A debtor may own an asset that he/she wishes to retain, but the value of the asset may be less than the amount owed on it. This situation can be dealt with in a Chapter 13 proceeding. Certain types of secured debts may be ‘crammed down’ by the Bankruptcy Court. For example, if the outstanding balance on an automobile loan is $12,000 but the value of the car is only $6,000, the court will approve a cram down of the loan to $6,000 and monthly payments will be reduced to reflect the lower loan balance.
The court will, however, generally not cram down home mortgages but will allow three to five years to make up payments that may have been missed on a mortgage (but see ‘home mortgages’, below).
In a Chapter 13 proceeding any cosigners on any of the debtors loans will also receive limited protection until it is determined that the Chapter 13 plan will not pay the entire amount owed to creditors.
Chapter 13 bankruptcies also allow the debtor up to five years to pay money that may be owed to IRS.
Chapter 13 Plans
Under the rules for a Chapter 13 filing, the debtor must prepare a plan providing for payment in whole or in part to creditors. The plan is submitted to the court and to a Chapter 13 trustee, who is appointed to handle Chapter 13 cases. The trustee verifies the accuracy and reasonableness of the plan and is in charge of distributing the proposal to the creditors. Creditors will have an opportunity to challenge the plan if they believe it is unreasonable. The ultimate issue is whether the debtor is making a “good faith” effort to repay debt. Once the court approves the payment plan, the debtor will make regular monthly payments to the trustee who distributes the payments among the creditors according to the plan.
If payments are not made as agreed, the creditors may seek to have the case converted to a Chapter 7 bankruptcy or simply to have the Chapter 13 case dismissed. If the case is dismissed, collection efforts by the creditors will again begin.
Thirty days after the bankruptcy plan is filed the debtor is expected to start making payments to the trustee. Some districts require payments to be deducted from the debtor’s paycheck. Creditors must be notified that the plan has been filed so that they will be able to oversee their collection activities.
After the plan is filed, the first meeting with the trustee will take place to determine whether the debtor’s budget allows for reasonable repayments. After the creditors meeting, the trustee will recommend or oppose confirmation (approval) of the plan. If the trustee believes that the proposed plan is impractical or not made in good faith, the trustee will oppose confirmation. The judge ultimately decides whether to grant a Chapter 13 reorganization, however, the recommendations of the trustee are given great weight. The trustees are paid up to ten percent of what is paid towards debt, i.e., ten dollars of every one hundred dollars that is paid to creditors.
Creditors are treated differently in a Chapter 13 proceeding than in a liquidating bankruptcy. Debts are divided into three major categories: priority, secured and unsecured claims.
Priority claims must be paid in full over the term of the plan. Taxes, alimony and child support are examples of priority claims.
Secured debt, that is debt that has a specific asset such as a car or house pledged to insure payment, also receives special treatment. For secured debt other than a home mortgage, the debtor is allowed to pay the value of the collateral over the term of the plan as opposed to paying the principle amount of the debt (see ‘cram down’, above).
A debtor cannot modify the rights of a creditor who has a lien on the debtor’s home. This means that the debtor will have to make the same payments each month as were originally contracted for. Nevertheless, if the debtor was four months or more behind on payments before the Chapter 13 proceeding was filed, the mortgage company will not able to foreclose on the property if a valid Chapter 13 plan is filed, and the debtor will be allowed to make past-due payments, plus interest, over the term of the plan. For mortgages acquired after October 22, 1994, the debtor is not required to pay interest on the amount of the mortgage that is in arrears, except under certain limited circumstances. A balloon mortgage, that is a mortgage where the entire balance becomes due on a date certain, can also be paid off over a period of five years under a Chapter 13 plan.
Meeting of Creditors
After the plan is filed and after the first meeting with the trustee, a creditors meeting will take place to discuss how the creditors’ claims are being treated. The tone of this meeting is usually informal, however the creditors’ attorneys may ask questions.
Proof of Claim
For creditors’ claims to be considered, the creditor must file a ‘proof of claim’ with the court within certain specified times. If the creditor fails to file a claim, the claim may be considered forfeited. Creditors generally have ninety days after the first meeting of creditors to file their proof of claim.
After meetings with the trustee and creditors, a confirmation hearing is scheduled before the judge who will determine whether the reorganization plan complies with the bankruptcy code. Specifically, the court will determine whether the plan is proposed in good faith, whether the unsecured creditors are receiving as much as they would have received in a Chapter 7 bankruptcy and whether the secured creditors have either received their collateral or will be paid the value of the collateral over the term of the plan. The court will also determine whether the debtor has the ability to make payments under the plan.
If an unexpected emergency or event takes place which makes it impossible for the debtor to continue making payments in accordance with the plan, a modification may be applied for requesting that the court extend the time over which the debtor is required to make payments and/or for a reduction in the amount that the unsecured creditors are to receive.
If the Chapter 13 petitioner is unable to make payments in accordance with the plan, the debtor may convert the case to a straight liquidating Chapter 7 bankruptcy.
Occasionally, and rarely, if the debtor’s failure to comply with the Chapter 13 reorganization plan is due to circumstances that were not the debtor’s fault or were beyond the debtor’s control, and if the unsecured creditors have received as much as they would have received under a straight liquidating bankruptcy, the court may discharge all remaining debt.
The bankruptcy court will examine what the debtor’s attorney charges for legal services. All attorneys in bankruptcy proceedings must file a disclosure statement setting out their fee arrangements and the source of the funds. If the court decides that an attorney has overcharged, the court can require a refund of all or part of the fee. Some attorneys will charge an hourly rate which will vary between $100 and $250 per hour depending on the area of the country where the debtor residence. The legal fee for a ‘simple’ Chapter 13 bankruptcy may be several th