What is Bankruptcy?

Bankruptcy often sounds scary or is thought of as an admission of failure, but it’s really just a legal process created under federal law to help individuals and businesses deal with debts that they are not able to pay back.  The purpose of bankruptcy is to provide a “fresh start” to the honest but unfortunate debtor whose financial problems have become too challenging to handle. 

Article I, Section 8 of the U.S. Constitution gives Congress the power to “establish uniform laws on the subject of bankruptcies”.  This was included in the Constitution because at the time, each state had their own legal process to address debts that were unmanageable, and our founding fathers sought consistency throughout the new country.  Make no mistake, state laws are still a significant factor in the bankruptcy process, but the foundation of bankruptcy is found in Title 11 of the United States Code (The Bankruptcy Code) and managed using the Federal Rules of Bankruptcy Procedure.

The current version of the Bankruptcy Code was adopted by Congress with the Bankruptcy Reform Act of 1978 and was significantly updated in 2005 with the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA).  The Code was developed around two primary concepts: 

1. Helping debtors get a fresh start by providing a legal framework to restructure and eliminate debt.
2. Ensuring that creditors are treated fairly and can recover as much of what they are owed as possible.

To understand bankruptcy, you must become familiar with a few key terms:

1. Debtor: This is the person or business entity with unmanageable debt that files for bankruptcy protection.
2. Creditor: This is the person or business entity to whom money is owed by the debtor.
3. Petition: This is the set of forms and schedules that are completed and filed with the federal court to start the bankruptcy process.  The petition is populated with all the debtor’s assets, debts, income, expenses and recent financial history.
4. Automatic Stay: This is a powerful injunction that is issued upon the filing of a bankruptcy case that immediately stops creditors from continuing collection actions, such as calls, letters, garnishments, lawsuits, foreclosures and repossessions.
5. Trustee: This is a person appointed by the court to oversee and manage the bankruptcy case.
6. U.S. Trustee:  This is an arm of the U.S. Department of Justice that oversees the bankruptcy process to ensure that all parties act within the law.
7. Discharge: This is the order, issued by the court, that eliminates debt, usually issued at the end of the case.  Once a debt is discharged, it can never be collected upon again.

There are six different types of bankruptcy cases, referred to as Chapters under the Bankruptcy Code.  They are Chapter 7, Chapter 9, Chapter 11, Chapter 12, Chapter 13 and Chapter 15.  In most years, Chapter 7 and Chapter 13 cases, those most commonly used for personal bankruptcies, make up about 98% of cases filed in the country.  Let’s discuss each Chapter in some detail:

Chapter 7 – Liquidation

Chapter 7 is the most common and straightforward type of bankruptcy case, usually making up about 60% of all bankruptcy filings.  This is also what most people think of when they think of bankruptcy.  The process is simple:

1. The debtor prepares and files their bankruptcy petition, usually with the assistance of an experienced bankruptcy attorney.
2. The Automatic Stay goes into effect, stopping all creditors from further collection actions.
3. The Trustee is appointed to the case.  One of the jobs of the Trustee is to review the debtor’s assets and exemptions claimed to see if any of their assets can be sold to pay down their debts. 
   1. About 96% of Chapter 7 cases are “no asset” cases, in which there are no unprotected assets available for the Trustee to sell.
   1. In the 4% of Chapter 7 cases that have assets, the Trustee will “liquidate” the assets, usually by selling them, and pay the proceeds from the sale to the creditors.
4. The Court then grants a discharge of all eligible debts, giving the debtor a “fresh start”.

Chapter 7 bankruptcy is typically filed by individuals with lower income, few assets and no realistic way to repay their debts, though it is also commonly used by businesses that are closing down as well.  Contrary to the belief of many, Chapter 7 bankruptcy is usually not a result of mismanaged finances.  Usually there is a negative life event that causes a person to file for Chapter 7 bankruptcy.  These most commonly include:

1. Job loss or reduction in income.
2. A major medical event within the household.
3. Divorce or a death in the family.
4. A failed business venture.

A typical Chapter 7 case will only last four to five months from filing to discharge.  That can extend in the few cases where there are assets to be liquidated, but the vast majority are very quick cases that result in a clean slate.

Chapter 13 – Adjustment of Debts of An Individual With Regular Income

Chapter 13 is the next most common type of bankruptcy case, comprising on average about 38% of the cases filed annually.  Often referred to as a “repayment plan bankruptcy” or “wage earner’s plan”, a Chapter 13 bankruptcy puts the debtor on a three-to-five year repayment plan wherein they pay back as much of their debt as they can afford, and the remainder gets discharged at the end of the case. 

The process of Chapter 13 bankruptcy is relatively straightforward as well:

1. The debtor prepares and files their bankruptcy petition, usually with the assistance of an experienced bankruptcy attorney.  Either with or soon after the petition is filed, a plan of reorganization is filed, stating how much the debtor will pay each month and how those funds are to be used to pay the creditors.
2. The Automatic Stay goes into effect, stopping all creditors from further collection actions.
3. The Trustee is appointed to the case.  The role of the Chapter 13 Trustee is broader and more involved than that of the Chapter 7 Trustee.
   1. The Trustee reviewed the petition and plan and verifies that all of the information is correct, accurate and meets the requirements of the Bankruptcy Code.
   1. The Trustee is the party that the debtor pays, usually monthly and usually starting thirty (30) days after the petition is filed.
   1. The Trustee deposits the funds paid by the debtor and distributes them to the creditors in the order in which the plan and the Code provide.
4. The plan of reorganization must be confirmed (approved) by the Court.  Creditors and the Trustee have the right to object to confirmation and the plan can be amended in order to overcome these objections.  The plan, once confirmed, is binding on all parties.
5. The plan can be modified after confirmation, usually because of a change of financial circumstances of the debtor.
6. At the end of the plan, after all payments are made and funds disbursed, the Trustee requests that the Court then grants a discharge of all eligible debts, giving the debtor a “fresh start”.

Chapter 13 is designed to help people with steady income, often with assets that they are seeking to protect, enter a payment plan that they can afford based on their budget.  The debtor pays as much as they can toward their debts and receives a discharge of any remaining eligible debts at the end of the plan. 

The most common reasons that people file for Chapter 13 bankruptcy are:

1. They fell behind on a secured debt, usually their mortgage payments or car note, and need the protection of the court provided by bankruptcy to cure the arrears and protect their asset.
2. They have an asset that is not protected by an exemption that they are seeking to keep, often excess equity in their home or a paid in full vehicle.
3. Their income is too high to file for Chapter 7 bankruptcy.  This is determined by a calculation known as the Means Test, which compares the debtor’s income to that of a median household in the same jurisdiction based on IRS tables.
4. They have debt that is not able to be discharged in bankruptcy, such as recent tax liabilities or past due child support payments, and need a structured plan to pay the debt off.

A typical Chapter 13 bankruptcy will last between three to five years, depending on factors specific to the case.  It allows a person to stop a foreclosure, repossession, wage garnishment and other collection actions, protect their valuable assets and put them into a payment plan that they can afford.  At the end, the debtor receives their fresh start.

Chapter 11: Reorganization

Chapter 11 bankruptcy is primarily used by businesses to reorganize their finances while continuing to operate.  It is available to and filed by individual consumers but is generally reserved for those individuals with very significant assets and streams of income.  Similar to a Chapter 13 bankruptcy, a Chapter 11 bankruptcy requires the filing of a plan of reorganization that states how the debtor will pay as much to their creditors as they can afford over the term of the plan.

A Chapter 11 case is more complex than a Chapter 7 or Chapter 13:

1. The debtor prepares and files their bankruptcy petition, usually with the assistance of an experienced bankruptcy attorney.
2. The debtor prepares and files:
   1. A disclosure statement, providing a brief financial history of the debtor and an explanation of how they ended up in bankruptcy.
   1. A plan of reorganization, stating how they intend to pay their creditors over time.  In Chapter 11 cases, other parties, usually creditors, will have an opportunity to file a competing plan with that of the debtor.
3. Unlike Chapter 7 or Chapter 13, there is no Trustee appointed to a Chapter 11 case immediately.  The business or individual becomes the “debtor in possession”, continuing to operate their business affairs.  The U.S. Trustee is responsible for overseeing the case to ensure that the requirements of the Code are met.
4. The U.S. Trustee conducts an Initial Debtor Interview (IDI) early in the case to ensure that all requirements of Chapter 11 are being met by the debtor.
5. The Meeting of Creditors is conducted under the oversight of the U.S. Trustee.
6. The debtor has to get creditor acceptance of their plan through direct voting in order to get it confirmed (approved) by the Court.
7. Upon confirmation, the debtor receives the discharge, before completion of the plan.  This is an area of debate in the legal community, as business entities seem to get better treatment than individual consumers.

There is a relatively new version of Chapter 11, referred to as Sub-Chapter V, that has a somewhat different set of rules.  Sub-V was written to streamline the process for small businesses seeking reorganization.  Incorporating concepts from Chapter 12 and Chapter 13 bankruptcy, Sub-V allows small businesses in Chapter 11 to avoid many of the significant administrative hurdles, and their associated costs, to effectively reorganize.  While only in effect since February 19, 2020, this new section of the Bankruptcy Code has so far been extremely effective.

The core purpose of Chapter 11 bankruptcy is to keep businesses operating, saving jobs and preserving value, while allowing them to restructure their financial situation.

Chapter 9:  Adjustments of Debts of a Municipality

Chapter 9 is a specialized type of reorganization that only applies to municipalities such as cities, towns, school districts or counties.  This chapter allows these municipal entities to reduce and restructure their debts without selling off public assets and while continuing to provide necessary public services.  Chapter 9 cases are very uncommon, with the most memorable being the filing by the city of Detroit in 2013.

Chapter 12:  Adjustment of Debts of Family Farmer or Fisherman with Regular Annual Income

As you can tell by the name, Chapter 12 bankruptcy applies to a small but important part of the population.  It is similar in concept to Chapter 13, but written to account for the unique income patterns of family farmers and fisherman, taking into account seasonal harvests and unpredictable catches.  While not frequently filed, Chapter 12 is a powerful legal tool to protect the breadbasket of the U.S.

Chapter 15:  Ancillary and Other Cross-Border Cases

The United States is far from the only country that has structured bankruptcy and insolvency proceedings within their legal framework.  Chapter 15 was enacted to promote cooperation between the U.S. and foreign courts in cases involving cross-border insolvency.  In a global economy, a troubled company who maintains operations in multiple countries and seeks protection from its creditors needs to ensure that they are protected and treated fairly in all of the geographies in which they conduct business.

Some Core Concepts in Bankruptcy

Debts in bankruptcy are generally classified into four categories:

1. Secured debts:  These are debts that have an asset attached them as collateral.  A house is secured by a mortgage, a car by the auto loan, etc. 
2. Priority debts:  These are debts given special treatment by the bankruptcy code and are generally non-dischargeable, though they can be paid off in a reorganization.  The most common priority debts are recent tax obligations and domestic support obligations, such as alimony or child support. 
3. Unsecured debts:  These are debts that have no collateral attached to them.  Credit cards, medical bills, personal and payday loans, student loans, most past due utility bills, etc.  These debts are generally dischargeable in bankruptcy, though student loans require additional actions.
4. Leases/Executory Contracts:  Unlike other debts, these are legal obligations that can create a debt.  Bankruptcy generally allows an individual to either assume the lease and continue paying or reject the lease and terminate the agreement.

   Property in bankruptcy and how it is protected:

1. Every asset held must be listed and included in a bankruptcy petition.
2. Assets that have secured debt attached are protected up to the amount of that debt.  It’s a simple concept, if the property was sold then the proceeds would have to go to the secured creditor anyway, so there is no point in selling it. 
3. If an asset is worth more than the debt securing it, or if there is no debt against the asset, then the value is referred to as the equity that the debtor has in the asset.
4. Equity in bankruptcy is usually protected by laws known as exemptions.  There are federal exemptions in the Bankruptcy Code, but each state has the right to use their own exemptions if they choose to.  Some of the most common exemptions are:
   1. Homestead exemptions:  Protecting equity in a primary residence up to a certain value
   1. Motor Vehicle exemptions:  Protecting equity in a motor vehicle
   1. Household Goods: Protecting equity in common household necessities such as furniture, cookware, electronics, etc.
   1. Wearing Apparel:  Protecting equity in a debtor’s clothing
   1. Tools of the Trade:  Protecting equity in tools and equipment that a debtor needs to make a living
   1. Retirement Accounts:  Protecting the money held in qualified retirement accounts such as pensions, 401(k) accounts, 403(b) accounts and most IRAs.
   1. “Wild Card”:  Many states, though not all, offer a fixed dollar limit exemption that the debtor may use on any property they choose in order to protect it.

The goal of the bankruptcy system is not to leave a debtor completely destitute, it is to provide a fresh start, so it is designed to allow people to keep the assets that they need to successfully start their financial lives over.

Considering filing for bankruptcy protection can be a scary thought, as some people believe the social stigma that filing is an admission of failure or of being irresponsible with your finances.  As proven repeatedly over many years, nothing could be further from the truth.  Bankruptcy exists as a fair and just legal process carefully designed to help people and business deal with debt that has become unmanageable, usually due to an unforeseen and uncontrollable event.  It allows a fair and honest debtor the opportunity to obtain a fresh start.