Home > Encyclopedia of Business and Finance > Bankruptcy

Bankruptcy law was created initially to enable persons inundated with debt to have a new beginning. It is also designed to permit individuals and business entities to have additional time to pay and compromise existing debts without liquidating all assets. The U.S. Constitution, Article 1, Section 8(4) grants the power exclusively to Congress "[T]o establish… uniform laws on the subject of bankruptcies throughout the United States." The current Code is based on the Bankruptcy Reform Act of 1978 as amended. Bankruptcy Courts, under the supervision of U.S. District Courts, administer petitions under the statute.

The Code is divided into a number of chapters, the most important of which are Chapter 7 ("Liquidation"), Chapter 11, ("Reorganization"), and Chapter 13, ("Adjustment of Debts of an Individual with Regular Income"). The remaining chapters concern definitions, case administration, a discussion of creditors' claims, debtors' duties, estate of the debtor, U.S. trustees, municipal indebtedness, and debts of farm families.

CHAPTER 7: LIQUIDATION

A Chapter 7 proceeding is "bankruptcy" as envisioned by most persons. The crux of such a proceeding is the collection and reduction to cash of all nonexempt assets owned by the debtor; the monies, to the extent available, are distributed to classes of creditors.

Petition. The proceeding is begun by the filing of a petition with the clerk of the Bankruptcy Court. The petition may be "voluntary" or "in-voluntary." A "voluntary" petition is one filed by the debtor individually or with the debtor's spouse. The filing of a voluntary petition operates automatically as an order of relief, which means that all nonexempt civil lawsuits and any other civil proceedings (e.g., foreclosures and sheriff's seizures) are suspended.

An involuntary proceeding may be begun by the filing of a petition as follows: (1) Where there are twelve or more creditors, then three or more creditors who are owed a minimum amount of $10,775 are required to file; or (2) if there are fewer than twelve claimants, then any one or more creditors with claims totaling at least $10,775 may file the petition. Farmers and nonprofit corporations are exempted from an involuntary filing. The court, after notice and hearing for cause, may require creditors filing an involuntary petition to post a bond to indemnify the debtor for damages in the event of a dismissal of the involuntary petition.

Creditor's meeting and appointment of a trustee. The debtor is required to file a list of creditors, a schedule of assets and liabilities, and a statement concerning details of the debtor's financial affairs. Within a reasonable time of filing of the petition, the court appoints an interim trustee and a first meeting of creditors is called. At such meeting, the debtor is required to undergo an examination under oath by the creditors. The creditors may then select a qualified person to act as trustee. If none is selected, then the interim trustee remains in such capacity. The duties of a trustee include collecting all assets owned by or owed to the debtor, examining and determining debts payable, accounting for all property received, instituting lawsuits if necessary to collect indebtedness due the estate, and reporting to the creditors at the final meeting of creditors.

Exemptions. The Bankruptcy Code is rather generous in its provisions concerning property the debtor may keep after filing for bankruptcy. The debtor is given the choice of choosing either exemptions provided by the laws of the state in which the debtor resides or exemptions permitted under the Code, whichever is more generous.

Under the Bankruptcy Act, a debtor may keep the following assets:

1. Debtor's interest up to $16,150 in realty used as a principal residence or as a burial plot
2. Debtor's interest in a motor vehicle up to $2,575 in value
3. Debtor's interest up to $425 in any one item or aggregate of $8,075 of unused exemption in household goods
4. Debtor's interest up to $1,075 in jewelry for personal, household, or family use
5. Debtor's interest in any other property up to $850 plus unused amount of the $8,075 exemption
6. Debtor's interest up to $1,625 in implements, professional books, or tools of the trade of the debtor or dependent
7. Unmatured life insurance contract owned by the debtor, except a credit life insurance contract
8. Debtor's interest up to $8,625 in unmatured life insurance
9. Professionally prescribed health aids for the debtor or dependent
10. Social Security, unemployment compensation, veteran's, disability, or illness benefits
11. Payments for losses payable under a crime victim's reparation statute; wrongful death benefits, life insurance proceeds; and award up to $16,150 arising from personal injury award.

Voidable transfers. In order to prevent certain creditors and insiders from gaining an unfair advantage over other creditors, the Code permits the trustee to set aside certain transfers of property made by the debtor that enabled the creditor to receive more than would otherwise have been received. A trustee, except for certain limited exceptions, may avoid the transfer of property of the debtor made to a creditor on account of an antecedent debt owed by the debtor made while the debtor was insolvent within 90 days before filing of the petition. If the transfer was made to an insider (to a relative, partner, or corporation with whom the debtor has a close relationship), then a transfer made within one year of filing may be avoided.

Fraudulent transfers. The trustee may avoid a transfer of assets made by the debtor to any transferee within one year of filing the petition where such transfer was made to defraud creditors or where the transfer was made for less than its fair market value. The trustee is empowered to invalidate such transfer after having returned the amount paid by a good-faith purchaser.

Exceptions to discharge. Although the debtor has the right to keep certain property, the debtor is not discharged from all debts. The following sums continue to be due and owing even after relief is granted:

1. Taxes due three years prior to filing
2. Payment for property obtained under false pretenses
3. Monies owed to creditors the debtor failed to list or schedule
4. Monies obtained through fraud, embezzlement, or larceny
5. Alimony, maintenance, and child support
6. Monies owed for willful and malicious injury by the debtor
7. Government fines, penalties, or forfeitures incurred within three years
8. Money due to a government unit or nonprofit institution of higher education for an educational loan within seven years unless payment would impose undue hardship upon the debtor or the debtor's dependents
9. Debts not dischargeable under a prior bankruptcy proceeding
10. Judgments arising due to driving while intoxicated
11. Credit card debts and cash advances exceeding $1,075 incurred within sixty days of filing and debt incurred within sixty days of filing for purchase of luxury goods over the sum of $1,075 to any one creditor

Priority of distribution. All creditors are not treated equally. There are several levels of priority in the distribution of assets. A creditor with a security lien on property (e.g., bank mortgage) has priority over other creditors.

In descending order, the following unsecured creditors are entitled to the expenses and claims:

1. Administrative expenses incurred by the trustee
2. Post-petition credit extended to debtors
3. Claims up to $4,300 for wages, salaries, or commissions earned by an individual within ninety days of filing of the petition
4. Claims for contributions to employee benefit plans up to $4,300 for services rendered up to 180 days before filing of petition
5. Claims up to $4,300 for a person operating a grain storage or fish produce storage or processing facility
6. Claims by consumers up to $1,950 for deposits made for purchase, lease, or rental of property or for the purchase or consumer goods or services
7. Claims for alimony, maintenance, or child support
8. Income and other taxes due to governmental units
9. The remaining unsecured creditors

CHAPTER 11: REORGANIZATION

One of the goals of the Bankruptcy Act is to allow a business to continue to operate, if possible, in order to prevent the inevitable discharge of employees from a bankrupt firm. Accordingly, Congress permits either a voluntary petition or involuntary petition under this Chapter. The proceedings may be commenced, with certain exceptions, by an individual or business entity, such as a partnership or corporation.

The debtor may file a voluntary petition within 120 days of the order of relief. An involuntary petition may be filed by the trustee, creditor's committee, creditor, and other interested parties if the debtor has not filed a plan within the said 120 days, or the plan filed by the debtor has not been accepted within 180 days.

The plan permits the debtor to remain in possession of the business unless there is fraud or gross mismanagement. The plan has to specify those claims or interests not impaired under the plan from those that will be so impaired. Each class of claims is to be treated equally unless the claimant otherwise consents. The plan may provide for the debtor to remain in possession; for certain assets to be transferred to other entities; for a consolidation or merger; for the sale of property subject to the rights of lienholders; for the satisfaction or modification of a lien; and other terms. The plan may impair a class of claims whether they are secured or unsecured.

The court must confirm the plan. Confirmation may be granted only if the plan complies with the statute, has been proposed in good faith, is not forbidden by law, is fair and equitable, has been accepted by at least one class of claimants, and confirmation of it is not likely to end in liquidation. A plan is fair and equitable as to secured claims if the holders thereof retain their lien on the secured property or receive equivalent value.

Collective bargaining agreements previously entered into by the debtor are subject to the plan. The plan must be offered by the debtor to the union and be discussed with the union; if there is no resolution, a hearing must be held by the court to determine whether a modification will be permitted.

CHAPTER 13: ADJUSTMENT OF DEBTS OF INDIVIDUAL WITH REGULAR INCOME

A gainfully employed person may be inundated with debts that cannot be paid in full but may be paid if that person were extended additional time to pay. Accordingly, Congress created a Chapter 13 filing that permits such a debtor with unsecured debts of less than $269,250 and secured debts of less than $807,750 to voluntarily file a plan that provides for the submission of earnings to a trustee, the payment in full of all allowable claims unless a creditor agrees otherwise, and the classification of claims with the same treatment of all claims within each class. The plan may modify the rights of holders of secured claims except holders of a security interest in real property used as a principal residence by the debtor.

The plan must be confirmed by the Bankruptcy Court. The court will do so if the plan was properly filed, fees were paid, the plan was made in good faith, and the value of property to be distributed allows holders of unsecured claims to receive no less than what they would have received under Chapter 7. As to secured claimants, the plan will be allowed where the holder of the claim has agreed to the plan, the plan provides that the holder retains the lien securing the property, and the value of property to be distributed is not less than the allowed amount of such claim. The debtor may, in the alternative, surrender the property securing the claim to the holder of the lien. Once the plan is confirmed and lived up to, the debtor will be discharged.

FUTURE TRENDS

Because of intense lobbying efforts by banks and other creditors' organizations, there have been proposals for significant changes in the law, such as the Bankruptcy Reform Act of 2000. This act would make all exemptions federal in nature, so that debtors in one state are not treated more advantageously than those in another. Debtors would be required to undergo credit counseling before filing a petition. Substantially enhanced requirements of proof of inability to pay within a five-year period would be necessary. Credit card debts would undergo much greater scrutiny. Re sorting to Chapter 13 plans of payments would be made mandatory in some cases. Passage of such legislation appears to be dependent on the political party having control over both the Congress and the presidency.