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Understanding Bankruptcy

Bankruptcy is a set of federal laws and rules that can help individuals and businesses who owe more debt than they can pay. Each of the 94 federal judicial districts handles bankruptcy matters, and in almost all districts, bankruptcy cases are filed in the bankruptcy court. Bankruptcy cases cannot be filed in state court. Bankruptcy laws help people who can no longer pay their creditors get a fresh start by liquidating their assets to pay their debts, or by creating a repayment plan.

Bankruptcy laws also protect troubled businesses and provide for orderly distributions to business creditors through reorganization or liquidation. These procedures are covered under Title 11 of the United States Code (the Bankruptcy Code). The vast majority of cases are filed under the three main chapters of the Bankruptcy Code, which are Chapter 7, Chapter 11, and Chapter 13.

Federal courts have exclusive jurisdiction over bankruptcy cases. This means that a bankruptcy case cannot be filed in a state court.

The primary purposes of the law of bankruptcy are:

  • to give an honest debtor a "fresh start" in life by relieving the debtor of most debts, and
  • to repay creditors in an orderly manner to the extent that the debtor has property available for payment.

Some bankruptcy cases are filed to allow a debtor to reorganize and establish a plan to repay creditors, while other cases involve liquidation of the debtor's property.

A bankruptcy case normally begins by the debtor filing a petition with the bankruptcy court. A petition may be filed by an individual, by a husband and wife together, or by a corporation or other entity. The debtor is also required to file statements listing assets, income, liabilities, and the names and addresses of all creditors and how much they are owed. The filing of the petition automatically prevents, or "stays," debt collection actions against the debtor and the debtor's property. As long as the stay remains in effect, creditors cannot bring or continue lawsuits, make wage garnishments, or even make telephone calls demanding payment.

Creditors receive notice from the clerk of court that the debtor has filed a bankruptcy petition. Some bankruptcy cases are filed to allow a debtor to reorganize and establish a plan to repay creditors, while other cases involve liquidation of the debtor's property. In many bankruptcy cases involving liquidation of the property of individual consumers, there is little or no money available from the debtor's estate to pay creditors. As a result, in these cases there are few issues or disputes, and the debtor is normally granted a "discharge" of most debts without objection. This means that the debtor will no longer be personally liable for repaying the debts.

In other cases, however, disputes may give rise to litigation in a bankruptcy case over such matters as who owns certain property, how it should be used, what the property is worth, how much is owed on a debt, whether the debtor should be discharged from certain debts, or how much money should be paid to lawyers, accountants, auctioneers, or other professionals. Litigation in the bankruptcy court is conducted in much the same way that civil cases are handled in the district court. There may be discovery, pretrial proceedings, settlement efforts, and a trial.

Chapters of Bankruptcy

Chapter 7

A chapter 7 debtor may be an individual, a partnership or a corporation or other business entity. Chapter 7 does not involve the filing of a plan of repayment as in chapter 13 and is sometimes referred to as "straight bankruptcy". Instead, a trustee is appointed in the case and sells the debtor’s nonexempt assets and uses the proceeds to pay the creditors of the debtor. The Bankruptcy Code will allow the debtor to keep certain “exempt” property, but the trustee will liquidate the debtor’s remaining assets. Chapter 7 debtors should realize that the filing of chapter 7 may result in the loss of property.
Chapter 7 is used by individuals to free themselves of debt and is used by businesses to liquidate and terminate their business. One of the primary purposes of straight bankruptcy is to discharge certain debts to give the debtor a “fresh start”. However, a discharge is only available to individual debtors, not to partnerships or corporations.
If the debtor’s current monthly income is more than the state median, the Bankruptcy Code requires application of a "means test" to determine whether the chapter 7 filing is presumptively abusive. The debtor may rebut a presumption of abuse by showing of special circumstances that justify additional expenses or adjustments of current monthly income.
Individual debtors must file a Certificate of Credit Counseling and a copy of any debt repayment plan developed through credit counseling.
Individual debtors must also complete a financial management course before they are eligible for a discharge.

Chapter 11

A chapter 11 debtor is usually a corporation, sole proprietorship or partnership, but an individual may also file chapter 11. Chapter 11 is typically used to reorganize a business and the debtor usually files a plan of reorganization to keep the business operating and pay creditors over time. Upon filing a petition for relief under chapter 11, the debtor assumes the additional identity of “debtor-in-possession,” and continues to operate the business and keeps possession and control of its assets while undergoing a reorganization under chapter 11.
Generally, a disclosure statement, which contains information about the assets, liabilities and business affairs of the debtor sufficient to enable a creditor to make an informed judgment about the debtor’s plan of reorganization, must be filed with the court. The plan of reorganization also must be filed with the court, and must include a classification of claims and must specify how each class of claims will be treated under the plan.
Effective, April 1, 2002, chapter 11 cases are subject to a quarterly fee, payable to the Clerk, U. S. Bankruptcy Court, from the time the petition is filed until the date of entry of an order dismissing, converting or closing the case. The amount due is based on all disbursements made during the portion of the calendar quarter the case is pending in chapter 11.

Chapter 12

A chapter 12 debtor is primarily a family farmer or family fishermen. The Bankruptcy Code provides that only a family farmer or fisherman with regular annual income may file a petition under chapter 12. The purpose of this requirement is to ensure that the debtor’s annual income is stable and regular to permit the debtor to make payments under a chapter 12 plan. However, allowance is made for situations in which family farmers or fishermen have income that is seasonal in nature. Family farmers and family fishermen fall into two categories: (1) an individual or individual and spouse and (2) a corporation or partnership.

To meet the economic realities of family farming and the family fisherman, chapter 12 eliminates many barriers the debtor might face if filing under chapter 11 or 13. Chapter 12 is more streamlined, less complicated and less expensive than chapter 11. Few family farmers or fishermen find chapter 13 to be advantageous because it is designed for wage earners who have smaller debts.

Upon the filing of a chapter 12 petition, a trustee is appointed to administer the case, evaluating the case and making distributions to creditors. The debtor proposes a repayment plan to creditors over three to five years. The plan, which must be approved by the court, provides for payments of fixed amounts to the trustee. The trustee then distributes the funds to creditors according to the terms of the plan, which typically offers creditors less than full payment on their claims. One of the features of chapter 12 is that payments to secured creditors can sometimes continue longer than the three-to-five year period of the plan.

The bankruptcy law concerning a chapter 12 discharge is complex and the debtor should consult competent legal counsel in this regard prior to filing. Those debts which will not be discharged should be paid in full under a plan. Secured debts may be paid beyond the end of the plan payment period and are not discharged. The court may grant a hardship discharge to a chapter 12 debtor even though the debtor has failed to complete plan payments. Generally, a hardship discharge is available only to a debtor who fails to complete plan payments due to circumstances beyond the debtor’s control and through no fault of the debtor. Creditors must have received at least as much as they would have received in a chapter 7 liquidation case, and the debtor must be unable to modify the plan.

Chapter 13

A chapter 13 debtor is an individual with regular income. A chapter 13 bankruptcy is also called a “wage earner’s plan” and allows the debtor to keep property and pay all or part of his debts over time, usually three to five years. An individual who is self-employed or operating an unincorporated business is also eligible for chapter 13. A corporation or partnership may not be a chapter 13 debtor.

The debtor must file a plan with the court for approval and must make fixed payments to the trustee on a regular basis (usually biweekly or monthly). The plan will be for three years if the debtor’s current monthly income is less than the applicable state median, unless the court approves a longer period “for cause.” The plan generally must be for five years if the debtor’s current monthly income is greater than the applicable state median.

The debtor must file a Certificate of Credit Counseling and a copy of any debt repayment plan developed through credit counseling.

The trustee both evaluates the case and serves as a disbursing agent, collecting payments from the debtor and making distributions to the creditors according to the terms of the plan, which may offer creditors less than full payment on their claims.

Chapter 13 offers individuals an opportunity to save their homes from foreclosure. Individuals can stop foreclosure proceedings by filing this chapter and make delinquent mortgage payments over time. However, they must continue to make all mortgage payments on time that come due during the chapter 13 plan. Filing a chapter 13 bankruptcy stops most collection actions against the debtor or the debtor’s property. 11 U.S.C. Sec. 362; however, it does not stay certain types of actions listed under 11 U.S.C. Sec. 362

When all payments have been made under the chapter 13 plan, the chapter 13 debtor is entitled to a discharge, which releases the debtor from all debts provided for by the plan or disallowed, with limited exceptions (under sec. 502). The bankruptcy law concerning the chapter 13 discharge is complex and has undergone major changes. Therefore, the debtor should consult competent legal counsel prior to filing chapter 13.