Bankruptcy (West's Encyclopedia of American Law)
A federally authorized procedure by which a debtorn individual, corporation, or municipality/i> is relieved of total liability for its debts by making court-approved arrangements for their partial repayment.
Once considered a shameful last resort, bankruptcy in the United States is emerging as an acceptable method of resolving serious financial troubles. A record one million individuals filed for bankruptcy protection in the United States in the peak year of 1992, and between 1984 and 1994 the number of personal bankruptcy filings doubled. Corporate bankruptcies are commonplace, particularly when corporations are the target of lawsuits, and even local governments seek debt relief through bankruptcy laws.
The goal of modern bankruptcy is to allow the debtor to have a "fresh start," and the creditor to be repaid. Through bankruptcy, debtors liquidate their assets or restructure their finances to fund their debts. Bankruptcy law provides that individual debtors may keep certain exempt assets, such as a home, a car, and common household goods, thus maintaining a basic standard of living while working to repay creditors. Debtors are then better able to emerge as productive members of society, albeit with significantly flawed credit records.
History of U.S. Bankruptcy Laws
U.S. bankruptcy laws have their roots in...
(The entire section is 5104 words.)
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Bankruptcy (Encyclopedia of Business and Finance)
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 establishuniform 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:
- Debtor's interest up to $16,150 in realty used as a principal residence or as a burial plot
- Debtor's interest in a motor vehicle up to $2,575 in value
- Debtor's interest up to $425 in any one item or aggregate of $8,075 of unused exemption in household goods
- Debtor's interest up to $1,075 in jewelry for personal, household, or family use
- Debtor's interest in any other property up to $850 plus unused amount of the $8,075 exemption
- Debtor's interest up to $1,625 in implements, professional books, or tools of the trade of the debtor or dependent
- Unmatured life insurance contract owned by the debtor, except a credit life insurance contract
- Debtor's interest up to $8,625 in unmatured life insurance
- Professionally prescribed health aids for the debtor or dependent
- Social Security, unemployment compensation, veteran's, disability, or illness benefits
- 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:
- Taxes due three years prior to filing
- Payment for property obtained under false pretenses
- Monies owed to creditors the debtor failed to list or schedule
- Monies obtained through fraud, embezzlement, or larceny
- Alimony, maintenance, and child support
- Monies owed for willful and malicious injury by the debtor
- Government fines, penalties, or forfeitures incurred within three years
- 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
- Debts not dischargeable under a prior bankruptcy proceeding
- Judgments arising due to driving while intoxicated
- 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:
- Administrative expenses incurred by the trustee
- Post-petition credit extended to debtors
- Claims up to $4,300 for wages, salaries, or commissions earned by an individual within ninety days of filing of the petition
- Claims for contributions to employee benefit plans up to $4,300 for services rendered up to 180 days before filing of petition
- Claims up to $4,300 for a person operating a grain storage or fish produce storage or processing facility
- 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
- Claims for alimony, maintenance, or child support
- Income and other taxes due to governmental units
- 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.
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.
Bankruptcy Code, Rules and Official Forms. (annual). St. Paul, MN: West Publishing.
Cowans, David R. (1998). Bankruptcy Law and Practice. New York: Lexus Publishing.
Epstein, David G., Nickles, Steve H., and White, James J. (1993). Bankruptcy. St. Paul, MN: West Publishing.
Bankruptcy (Encyclopedia of Small Business)
Bankruptcy is a legal proceeding, guided by federal law, designed to address situations wherein a debtorither an individual or a businessas accumulated debts so great that the individual or business is unable to pay them off. Bankruptcy law does not require filers to be financially insolvent at the time of the filing, but rather applies a criterion in which approval is granted if the filer is "unable to pay debts as they come due." Once a company is granted bankruptcy protection, it can terminate contractual obligations with workers and clients, avoid litigation claims, and explore possible reorganization avenues.
Bankruptcy laws are designed to distribute those assets held by the debtor as equitably as possible among creditors. Most of the time it also frees the debtor or "bankrupt" from further liability, but there are exceptions to this. Bankruptcy proceedings may be initiated either by the debtor voluntary processr by creditorsn involuntary process. "The Bankruptcy Code is a world of its own," wrote Lawrence Tuller in Getting Out: A Step-by-Step Guide to Selling a Business or Professional Practice. "A completely separate set of laws come into play under which a business or an individual must perform. State and federal laws that we all live by from day-to-day are not applicable. New laws, mysterious to all except the bankruptcy lawyers, concerning contracts, wages, debtor/creditor relations, individual rights, and so on, go into effect." For this reason, business consultants commonly urge their clientshether debtor or creditoro secure legal help in all instances in which bankruptcy comes into play.
Certainly, client/customer bankruptcy is a reality that many small business owners confront if they are in business for any length of time. Declarations of personal bankruptcy in the United States reached a record 1.35 million in 1997, and analysts expect that this surge will continue. "Bankruptcy in the United States is a form of credit insurance," explained Michelle Clark Neely in Business Perspectives. "Bankruptcy rates are rising because more Americans are living closer to the financial edge. For a variety of reasons strong economy, easier credit, a desire to not just keep up with, but also surpass, the Jonesesany households are biting off more than they can chew. Throw in a couple of curveballs like a divorce or a major medical illness, and it's not surprising that so many Americans are striking out."
CHAPTER 7 BANKRUPTCY
Individuals may file either Chapter 7 or Chapter 13 bankruptcy. Under Chapter 7 bankruptcy law, all of the debtor's assetsncluding any unincorporated businesses that he or she ownsre totally liquidated (with the exception of exempt assets that the law deems necessary to support the debtor and his dependents, such as home equity). This "liquidation bankruptcy" is the most common filing for business failures, accounting for about 75 percent of all business bankruptcy filings.
In these cases, the federal bankruptcy court hearing the case is provided with a full listing of all the debtor's assets and liabilities. The court then undertakes the process of dividing those assets among the various creditors by appointing a trustee to oversee distribution of proceeds. Unpaid taxes are given top priority, and secured creditors are generally the next entities to be considered. Indeed, the best protection that a small business can have when a customer enters bankruptcy is to obtain collateral for that debt (in the form of equipment, real estate property, etc.). According to many experts, secured creditors can expect to receive an average of 75 percent of what is owed them, whereas unsecured creditors receive less than 3 percent of owed monies from debtors that go bankrupt. "Because all assets are sold to pay outstanding debt, a liquidation bankruptcy terminates a business," observed John Pearce II and Samuel DiLullo in Business Horizons. "This type of filing is critically important to sole proprietors or partnerships, whose owners are personally liable for all business debts not covered by the sale of the assets unless they can secure a Chapter 7 bankruptcy allowing them to cancel any debt in excess of exempt assets. Although they will be left with little personal property, the liquidated debtor is discharged from paying the remaining debt."
In March 2001, however, the Bush Administration signed into law new regulations making it more difficult for individuals to file for Chapter 7 bankruptcy. Applicants for this type of protection must now meet a means test showing that they are unable to pay their creditors. If a bankruptcy court determines that the debtor can repay $10,000 or 25 percent of the total debt (whichever is less) over the course of five years, the debtor is required to file instead for Chapter 13 bankruptcy protection. The legislation also provides some shielding of retirement funds from creditors. Up to $1 million in IRA accounts is off-limits to creditors, as is all money in 401 (k) retirement accounts. Finally, the new laws shield up to $100,000 of a home's value if it is purchased within two years of a bankruptcy filing, and the entire value of the home if it was purchased more than two years before the bankruptcy filing.
CHAPTER 13 BANKRUPTCY
A far less severe bankruptcy option for individuals and businesses whose straits are not quite so hopeless is Chapter 13. Under Chapter 13 laws, debtors turn over their finances to the court, which subsequently allocates funds and payment plans at its discretion. "Chapter 13 filers re allowed to retain more assets than Chapter 7 filers, but must agree to pay creditors their outstanding debtn full or in partver a period of three to five years," stated Michelle Clark Neely in Business Perspectives. "In both types of bankruptcy, certain types of debt are not eligible for discharge, including alimony, recent income taxes, child support, and government-backed student loans." As with Chapter 7 bankruptcy cases, unsecured creditors are least likely to be compensated for their losses.
CHAPTER 11 BANKRUPTCY
"Chapter 11 laws exist to protect the company, pure and simple," commented Tuller. "The individual has no rights, the unsecured creditors have few rights, and the secured bank creditors have substantial rights. The court places the company's interests first, secured creditors second, and leaves the rest to fend for themselves, including the owner." This bankruptcy option is open to incorporated businesses who still hope to recover from their financial difficulties. It is utilized in situations wherein business operations can reasonably recover if granted a reduction in debt load and an opportunity to implement new strategic initiatives. Since there is no financial test to determine eligibility, a business can voluntarily elect to file for Chapter 11 protection at any time (involuntary Chapter 11 status can also be placed on a company if three or more creditors holding undisputed claims choose to take such a step). "Reorganization bankruptcy is a reasonable alternative for an endangered firm," wrote Pearce and DiLullo. "Chosen for the right reasons, and implemented in the right way, it can provide a financially, strategically, and ethically sound basis for advancing the interests of all the company's stake-olders."
Companies generally turn to Chapter 11 protection after they are no longer able to pay their creditors, but in some instances, businesses have been known to act proactively in anticipation of future liabilities. Once a company has filed under Chapter 11, its creditors are notified that they cannot press suits for repayment (though secured creditors may ask the court for a "hardship" exemption from the general debt freeze that is imposed). Creditors are, however, permitted to appear before the court to discuss their claims and provide data on the debtor's ability to reorganize. In addition, unsecured creditors may appoint representatives to negotiate a settlement with the debtor company. Finally, creditors who feel that the debtor company's financial straits are due to mismanagement or fraud may ask the court to appoint an examiner to look into such possibilities.
Once a company asks for Chapter 11 protection, it provides the court, lenders, and creditors with a wide range of financial information on its operations for analysis even as it continues with its day-to-day operations (during this period, major business expenditures must be approved by the court). The business will also prepare a reorganization plan, which, according to CPA Journal contributor Nancy Baldiga, "details the amount and timing of all creditor payments, the means for effectuating such payments (such as the sale of assets, refinancing, or compromise of disputed claims), and the essential legal and business structure of the debtor as it emerges from Chapter 11 protection." Another important component of this plan is the disclosure statement, which presents projected business fortunes, proposed financial settlements with creditors and equity holders, and estimates of the liquidation value of the company. "The information included in the disclosure statement is critical to a creditor's evaluation of the reorganization plans offered for acceptance, as compared to possible other plans or even liquidation," wrote Baldiga.
The reorganization plan, if approved by the court and a majority of creditors, becomes the blueprint for the company's future. Principal factors considered in determining the feasibility of reorganization proposals include:
- Status of the company's capital structure
- Availability of financing and credit
- Potential earnings of the company after reorganization
- Ability to make creditor payments
- Management stability
- General economic conditions in the industry
- General economic conditions in geographic regions of operation
SMALL BUSINESS CREDITORS
Small businesses that find themselves unable to collect on money owed them because of bankruptcy proceedings generally have few options with which to protect themselves. There are instances, howeversually when the debtor is engaged in questionable or fraudulent business activitieshen small business creditors do have additional legal avenues that they can explore. In situations where the debtor has incurred debt only a short time before filing before bankruptcy, creditors can sometimes obtain judgments that put added pressure on the debtor to make good on that liability. In addition, noted the Entrepreneur Magazine Small Business Advisor, "the law provides for a '60-day preference'rule. This rule is designed to prevent debtors from paying off their friends right before they file bankruptcy while leaving others stiffed. The 60-day rule allows the court to set aside any payments made up to 60 days before the actual filing of bankruptcy. Creditors who have been paid must return the money to the bankruptcy court for it to be placed in the pot. Business owners should keep in close contact with their ongoing customers so that they will have a good enough relationship to know far in advance to avoid being caught up in this rule." Indeed, small business owners in particular should always be watching for clients/customers who show signs of being in financial distress. If such indications become present, the owner needs to determine the depth of that distress and whether his or her small business can withstand the likely financial repercussions if that client/customer declares bankruptcy. If a bankruptcy declaration would be a significant blow, then the business owner should weigh various alternatives to protect his/her business, such as cutting back on business dealings with the endangered company or tightening up credit arrangements with the firm.
Finally, advisors typically counsel small business creditors to file confirmations of debt with the court even if it seems highly unlikely that they will ever be compensated. This filing allows creditors to write off the bad debts on their taxes.
ALTERNATIVES TO BANKRUPTCY
Companies that run into serious financial difficulties have several options other than bankruptcy that they can pursue, depending on their individual situations. One possibility is for the company to liquidate its own business assets in order to make payments to creditors. "Such action may be achieved efficiently if [the business's] creditors and assets are few in number and the assets are of a type that can readily be converted to cash," wrote Pearce and DiLullo. "If the number of creditors is large and the assets are numerous and difficult or time-consuming to sell (such as real estate), the protection, structure, and authority of the court may be needed."
Another option is for the company to voluntarily place liquidation of assets in the hands of a trustee, who subsequently pays creditors. The principal advantage of this avenue, say Pearce and DiLullo, is that the assets are thus protected from individual creditors who might otherwise file liens on the assets. "Composition agreements," meanwhile, can be used in situations where creditors agree to receive proportional (pro rata) payments of their claims in return for freeing the debtor company from the remainder of its debts.
These alternative strategies may enable some business owners to avoid the stigma of filing for bankruptcy But Pearce and DiLullo note that pursuing these options involves considerable risk: "astute creditors will recognize such actions as precursors to bankruptcy and may modify their relationships with [the company], which could precipitate a bankruptcy filing. If creditors believe that continuing in business will result in reduced assets, they may force a bankruptcy in order to stop operations and preserve the existing assets to pay outstanding debts."
Baldiga, Nancy R. "Practice Opportunities in Chapter 11." CPA Journal. May 1998.
Elias, Stephen, Albin Renauer, and Robin Leonard. How to File for Chapter 7 Bankruptcy. Nolo Press, 1999.
The Entrepreneur Magazine Small Business Advisor. John Wiley, 1995.
Neely, Michelle Clark. "Personal Bankruptcy: The New American Pastime?" Business Perspectives. January 1999.
Pearce II, John A, and Samuel A. DiLullo. "When a Strategic Plan Includes Bankruptcy." Business Horizons. September/October 1998.
Sheppard, J.P. "When the Going Gets Tough, the Tough Go Bankrupt: The Questionable Use of Chapter 11 as a Strategy." Journal of Management Inquiry. No. 1, 1992.
Snyder, Stephen. Credit After Bankruptcy. Bellwether, 2000.
Tuller, Lawrence W. Getting Out: A Step-by-Step Guide to Selling a Business or Professional Practice. Liberty Hall, 1990.
SEE ALSO: Business Failure/Dissolution