Bankruptcy is the process by which a debtor who is unable to pay his creditors, can discharge his debts and get a “fresh financial start”. The most common types of bankruptcy are known as Chapter 7, Chapter 13 for individuals or small businesses and Chapter 11 for larger businesses. Chapter 7 is a liquidation of all the debtor’s assets where the proceeds are used to pay off your creditors. Once all the proceeds are spent, the debtor will be “discharged” from bankruptcy and will no longer be personally liable for most of the debts owed to creditors. Chapter 13 gives the debtor a little more control in how to manage his debt situation. Under Chapter 13 the debtor will be given a specified period of time (three to five years) to pay his debts with the caveat that during the repayment period he will have to report to a trustee or a person who will oversee the payback and make sure that the debtor is not wasting what should be paid to creditors. Chapter 11 gives a debtor business the opportunity to reorganize the firm (such as sell or merge money-losing divisions), while arranging a payment plan to pay off creditors with the assistance of a trustee. Under Chapter 11, the business is allowed to continue to operate as normal with the hope that it will eventually pay its debts and return to profitability.
A bankruptcy action begins with the filing of a petition in a U.S. Bankruptcy Court. The specific bankruptcy court to file a petition depends on the state and locality of where the debtor resides or does business in. The petition basically informs the court that the debtor is in financial trouble and in need assistance. Along with the petition, the debtor will also need to file a number of other documents such as a schedule of assets and liabilities, a schedule of current income and expenditures, a statement of financial affairs, a schedule of executory contracts and unexpired leases (if any) and a copy of the tax returns for the most recent year. Depending on the type of debt, there may also be other forms to file as well as a list of the assets you want exempted. There is also a filing fee, an administration fee and a trustee surcharge that will need to be included with the petition. Generally, once a petition is filed the court will begin the administration process.
The majority of bankruptcy actions are voluntary; meaning that the debtor voluntarily petitions a court to declare and administer the bankruptcy because they are unable to pay their debt. The only requirement to initiate a voluntary bankruptcy is that the individual satisfy the requirements of the specific chapter he will file under and file the appropriate paperwork (included all necessary fees) with the court.
An involuntary bankruptcy is less common but equally effective. Involuntary bankruptcy occurs when the creditors petition a court, against a debtor’s will, to make the debtor enter into a bankruptcy proceeding. An involuntary bankruptcy action is generally initiated when creditors determine that bankruptcy is the only way they will be able to collect on what they are owed.
In order for an involuntary bankruptcy petition to be successful, the debtor must be generally unwilling to pay his debts. There must also be at least one creditor who files the petition whose claim for payment reaches a certain amount and is not subject to a real dispute as to the amount owed. Moreover, an involuntary bankruptcy is only available for Chapter 7 or Chapter 11 actions. Finally, similar to a civil lawsuit, once the petition is filed, the debtor must be notified by service of the petition with a summons.
Not all assets are subject to liquidation in bankruptcy. Most bankruptcy laws allow a number of exemptions to liquidation. Exemptions are assets or property that a debtor is permitted to keep or, in the alternative, a cash value equivalent to the assets/property in question. Under Chapter 7 or Chapter 13 bankruptcies, the debtor will be able to set aside certain assets for exemption and so that they will not be sold off. The type and number of exemptions available to a debtor are based on both federal and state law. State law exemption laws have priority over federal exemption law. Some states allow you to choose between state or federal exemptions; however the requirement under most of these states forbids a debtor from mixing, matching or combining federal and state exemptions. For states that do not allow a choice, the debtor can only use the exemptions available under state law. Some common exemptions include: value limit exemptions such as automobiles and homestead equities; unlimited value exemptions such as household furniture, clothing and jewelry, life insurance proceeds and retirement plans including tax exempt retirement accounts, unemployment-workers comp-welfare benefits, IRAs and a certain amount of cash.
In addition to giving the debtor a “fresh financial start” a fundamental goal of bankruptcy is to pay off as many creditors as possible but under bankruptcy laws, not all creditors are created equal. A secured creditor, or one that has a security interest in certain assets or property of the debtor, must be paid before all other unsecured creditors. If a secured creditor cannot be paid in cash, they can ask to take the property in which they have an interest. Once all secured creditors are paid, the bankruptcy proceeds will be paid to any unsecured creditors according to the priority of their claim.
Under bankruptcy laws, there are ten priority categories and claims are paid in the order of their priority. Every creditor in a category must be paid in full before the next category of creditors below will have the chance to collect on their debt. If there are not enough funds to pay all creditors in a category the total amount of their claim, the remaining funds will be paid to all category members based on a pro rata share.
The ten priority categories for unsecured creditors in bankruptcy are: (1) domestic support obligations-child support/alimony payments, (2) administrative expenses-payments required to manage the bankruptcy case, (3) involuntary bankruptcy claims, (4) employee wages, (5) unpaid contributions to employee benefit plans, (6) claims from grain producers or fisherman for grain or fish, (7) consumer layaway deposits, (8) pre-petition taxes, (9) debtor’s obligations to a federal depository institution and (10) claims for death or personal injury where the debtor was intoxicated while operating a motor vehicle or vessel.
A bankruptcy officially ends when the debtor is “discharged” or forgiven for most of his debts and given his “fresh financial start.” Under bankruptcy laws, however, there are some debts that cannot be discharged. This is a way to ensure that the debtor is not abusing the bankruptcy process to avoid paying legitimate debts and creditors are fairly treated for their genuine claims. While the specific non-dischargeable debts are dependent on the precise chapter a debtor files under, they are generally debts that were incurred by fraud or other dishonest and illegal means; funds owed to the state, certain exemptions and any debt a creditor can convince the bankruptcy court should not be discharged.
More specifically, debts that can never be discharged include: unpaid taxes, debts that were not listed by the debtor when filing the bankruptcy petition, domestic support obligations (also the highest priority exemption), fines or penalties owed to the government, educational loans and debts for death or personal injury where the debtor was intoxicated while operating a motor vehicle or vessel (also the lowest priority exemption). Additionally, if a creditor can convince a court of their appropriateness, the following debts may not be dischargeable: debts accrued as a result of fraud, illegal behavior or willful/malicious injury.
Depending on the type and amount of debts a debtor has, the bankruptcy process can be fairly simple or extremely complicated. Still, it is a useful option to any and all debtors. Bankruptcy offers individuals and businesses that are legitimately unable to pay their creditors in a timely manner a means to relieve or discharge their debts and give them a “fresh financial start.” At the same time, bankruptcy laws work to ensure that debtors are not taking advantage of the system and creditors, especially secured creditors, are paid as much as possible without overburdening the debtor.
References
Ayotte, K.M. & Morrison, E.R. (2009). Creditor control and conflict in Chapter 11. Journal of Legal Analysis, 2, 511-551.
Hynes, R.M. (2004). Why (consumer) bankruptcy. Alabama Law Review, 56(1), 121-179.
Legal Information Institute at Cornell Law School. () Bankruptcy: An Overview. Retrieved on June 11, 2014, from http://www.law.cornell.edu/wex/bankruptcy
United States Courts. (2011, November) Bankruptcy Basics. Retrieved on June 11, 2014, from http://www.uscourts.gov/FederalCourts/Bankruptcy/BankruptcyBasics.aspx
