Bankruptcy is the legal process that individuals and businesses may use to seek relief from debts. The goal of bankruptcy is to give the debtor a fresh financial start while being fair to creditors.

This guide will not be comprehensive, but is intended to give both creditors and debtors a general idea of bankruptcy law.

Sources of Bankruptcy Law

Bankruptcy law is primarily governed by federal law. The Bankruptcy Code is the main body of law for bankruptcy. However, states are permitted to legislate in one area of bankruptcy. Be aware that there are differences in bankruptcy exemptions and bankruptcy fraud depending on which state the debtor files in.

Different Types of Bankruptcy

The Bankruptcy Code is organized into different sections, or "chapters." There are several different types of bankruptcies, each of them governed and named after a chapter. The different types of bankruptcies are:

  • Chapter 7 – Chapter 7 bankruptcy is often called "liquidation bankruptcy." The court appoints a trustee who determines which, if any, of the individual's property must be sold off to pay their debts. This type of bankruptcy often takes six to eight months to complete.
  • Chapter 11 – Chapter 11 bankruptcy is business reorganization bankruptcy. Debtors are required to file a repayment plan to the court, but this is the most flexible type of bankruptcy. Depending on the size of the business, Chapter 11 bankruptcy may require decades to resolve.
  • Chapter 13 – Chapter 13 bankruptcy is reorganization bankruptcy for individuals. The debtor files and completes a repayment plan. This bankruptcy may take three or five years to complete.
  • Chapter 12 – Chapter 12 bankruptcy is reorganization bankruptcy for fishermen and family farms. Like Chapter 13, Chapter 12 bankruptcy may take three or five years to resolve.

Pre-Bankruptcy Planning

Filing for bankruptcy is rather easy. The debtor merely has to fill out a single page and the debtor has "filed for bankruptcy." After filling out that page though, the debtor will then be required to fill out a mountain of paperwork explaining the debtor’s finances, expenses, debts, and creditors.

There are certain issues that debtors should keep in mind while filling out that paperwork. These issues will affect the debtor’s bankruptcy as well as the debtor’s relationships:

  • State of Domicile – Under the Bankruptcy Code, the state that controls the case is the state where the debtor lived in during the last two years. If the debtor lived in more than one state during those two years, then the state of domicile, or residence, will be the state where the debtor lived in the most during the 180 days prior to the two years.
  • Filing for Bankruptcy Multiple Times – It’s permitted under certain circumstances, but it looks suspicious. Judges may remove protections or dismiss the case outright if they suspect that the debtor’s intentions are less than honest. The debtor may also be prohibited from filing for Chapter 13 depending on the timing of the bankruptcies.
  • Co-Signers – In Chapter 7, the co-signers will be liable for the debts. In Chapter 13, the co-signers may be liable if the debtor cannot repay the debts.
  • Spouses – Depending on the nature of marital property in the state the debtor resides in, it might be a good idea for the married couple to jointly file for bankruptcy. In other circumstances though, it will up to the debtor and the spouse.

Automatic Stay

One of the biggest reliefs for debtors is the automatic stay. Once a debtor files for bankruptcy, the court will immediately issue an injunction ordering creditors to cease all collection efforts. No more letters, phone calls, lawsuits, or anything else that could be viewed as an attempt to collect money from the debtor. The automatic stay is so strong it can even shield debtors from foreclosures. If the debtor has only filed for bankruptcy once this year, the stay will last until the bankruptcy case is over.

However, the automatic stay has limitations. First, the stay will shorten depending on the number of times the debtor has filed for bankruptcy during the preceding year. This limitation is designed so that homeowners in foreclosure cannot abuse the stay by filing for bankruptcy over and over again.

Second, there are some court proceedings that are immune from the stay. These proceedings include criminal trials; establishment of paternity, alimony, or child support; tax audits; and actions by co-signers or co-debtors.

Finally, creditors may ask the court to waive the stay. However, only secured creditors with a cause for relief may ask the court to waive the stay. Otherwise, the stay will hold until the expiration date.

What Is Chapter 7 Bankruptcy?

As mentioned above, Chapter 7 bankruptcy is liquidation bankruptcy. That means the debtor’s assets and property are sold to satisfy debts to creditors. Individuals and businesses are both permitted to file Chapter 7. Liquidation bankruptcy is usually quick and effective, but there are some issues that debtors and creditors should be aware of.

Qualifying For Chapter 7

Not everyone can file for Chapter 7 bankruptcy. To qualify for Chapter 7, debtors must meet the following requirements:

  • Means Test – Individuals with income under their state median income are permitted to file for Chapter 7 bankruptcy. Individuals with income over the state median income cannot file for Chapter 7 unless their deductible income meets certain benchmarks.
  • Credit Counseling – Individuals must attend credit counseling sessions before they can enter Chapter 7 bankruptcy. This requirement does not apply to business debtors.
  • Attend the 341 Meeting – Debtors are required to meet with the bankruptcy trustee and creditors to answer any questions they may have.
  • Good Faith – Debtors must file in good faith. If a judge finds that a debtor has filed for Chapter 7 to cheat creditors, the judge may dismiss the case.

Bankruptcy Exemptions

Although the purpose of Chapter 7 bankruptcy is to sell assets to satisfy debts, not all of the debtor’s property will be sold. The purpose of bankruptcy is to repay creditors and give debtors a fresh start, not leave the debtor a ward of the state. Thus, the Bankruptcy Code guarantees that some property will be left over for the debtor after the bankruptcy is over. The federal exemptions allow debtors to exempt home equity, automobiles, pensions, and certain jewelry, among other exemptions.

The Bankruptcy Code has certain property exemptions, but states are allowed to use their own. State exemptions are divided into three different groups: states that use the federal exemptions, states that create their own exemptions, and states that allow debtors to choose between the federal and state exemptions.

Since each state may have its own system of exemptions, it’s important for debtors to speak with an attorney to maximize the exemptions the debtor may use.

Priority of Claims

Creditors are paid in order according to the Bankruptcy Code. Creditors with the highest priority are secured creditors, or creditors who hold collateral. Creditors who are unsecured, don’t have collateral, are paid in the following order: child support and alimony, administrative fees, employees, and taxes. Note that this is a simplified list.

Discharge

There often isn’t enough property to pay all creditors. If the trustee runs out of property to sell before each creditor is paid in full, then the remaining debt will be discharged. That means the debtor will no longer be legally obligated to pay those debts.

However, there are some types of debts that cannot be discharged. These non-dischargeable debts will remain even after the bankruptcy is over.

What Is Chapter 13 Bankruptcy?

Chapter 13 bankruptcy is reorganization bankruptcy for individuals. This means that the debtor creates and implements a repayment plan. The bankruptcy court can reduce debts to certain levels so that the debtor can repay creditors at those levels. The remaining debts are discharged.

Qualifying for Chapter 13

To file for Chapter 13, the debtor must meet the following requirements:

  • Debtor Must Be an Individual – Businesses are not allowed to file Chapter 13.
  • Credit Counseling – Debtors must attend credit counseling sessions before they can enter Chapter 13 bankruptcy.
  • No Prior Bankruptcy – The debtor cannot file for Chapter 13 if the debtor already filed for Chapter 13 bankruptcy within the last two years or filed for Chapter 7 in the last four years. The debtor also cannot have had a prior bankruptcy dismissed in the last 180 days.
  • Debt Limit – Debtors cannot have more than $ $383,175 in unsecured debt and $1,149,525 in secured debt. Note that these numbers are subject to change every three years.

Payment Plan

The heart of the Chapter 13 bankruptcy is the repayment plan. The debtor can propose a repayment plan provided that the plan meets the following requirements:

  • Disposable Income – The debtor uses all of his or her disposable income in the plan.
  • Feasibility – The plan must have a realistic chance of working.
  • Best Interest – Creditors cannot be worse off than if they were in Chapter 7 bankruptcy.
  • Good Faith – The debtor must propose the plan in good faith without breaking any laws or violating any creditor rights.

Note that the plan can be modified by the debtor, trustee, or creditors if the circumstances warrant it. For instance, the court can order that payments be increased if the debtor gets a new job or a raise. Likewise, the court may reduce payments or change creditor distribution if the debtor has a child.

Reducing Debt

Debts are often reduced and/or reorganized in Chapter 13 so that the debtor has a realistic chance of repaying all debts. Secured debt can be reduced to the fair market value of the collateral. This is typically done by removing all liens on the collateral.

What Is Chapter 11 Bankruptcy?

Chapter 11 bankruptcy is reorganization bankruptcy for businesses and wealthy individuals. This means that the debtor creates and implements a reorganization plan. The goal of Chapter 11 bankruptcy is to return the business to profitable levels. There are no income requirements for Chapter 11 bankruptcy. Since non-individuals cannot receive a bankruptcy discharge, there are no income requirements for Chapter 11 debtors.

Maintaining Possession

Unlike the other chapters of bankruptcy, no trustee is appointed. In Chapter 11, the debtor is the trustee. The legal safeguard to abuse is making the debtor-trustee a fiduciary to the creditors.

Upon filing for Chapter 11 though, all of the debtor’s cash and assets are frozen. The debtor needs court approval to make any decisions regarding finances or money. Thus, when the debtor files for Chapter 11 bankruptcy, the debtor is also required to file paperwork with the court so that the debtor can restart normal functions, such as paying for electricity in stores, maintaining bank accounts, and retaining bankruptcy lawyers.

Classifying Creditors

In Chapter 11, the debtor submits the reorganization plan for the approval of the creditors. Creditors must vote for the plan before the debtor can execute the plan. However, the debtor has the power to classify creditors into different groups. Since businesses will have more creditors than most individuals, it’s easier for debtors to group creditors so that the groups will vote on whether to enact a plan. Groups of creditors may include investors, suppliers, employees, banks, government agencies, and personal injury victims. A vote by at least one group will result in a plan being enacted.

Although debtors are free to sort creditors into whatever groups the debtor deems sufficient, debtors are forbidden from abusing the system. The debtor cannot organize creditors so that certain creditors are cheated out of payment.

Enacting the Plan

Like Chapter 13, the Chapter 11 reorganization plan is subject to certain requirements:

  • Feasibility – The plan must have a realistic chance of working.
  • Best Interest – Creditors cannot be worse off than if they were in Chapter 7 bankruptcy.
  • Good Faith – The debtor must propose the plan in good faith without breaking any laws or violating any creditor rights.
  • Fair and Equitable – Secured creditors must be paid the value of their collateral before the end of the plan and the debtor’s owners cannot retain equity interest until the plan is over.
  • Creditor Approval – Unlike Chapter 13, the plan must be approved by creditors.

Avoidance Powers

In all bankruptcies, the trustee has the power to void unsecured transfers. In Chapter 11 though, the debtor is the trustee. While enacting a reorganization plan, the debtor-trustee may void any contracts necessary to repay creditors and get the business back to profitable levels.

Bankruptcy Fraud

Debtors are permitted to engage in pre-bankruptcy planning. Planning typically involves determining when to file, whether to file jointly with a spouse, and in some states conversion of non-exempt property into exempt property.

However, there are some types of behavior that the debtor should avoid. The court approvals transfers of property or repayment plans to ensure that debtors and creditors are justly compensated or protected. The debtor is forbidden from engaging in certain actions because such actions would interfere with the court’s role in overseeing a just bankruptcy. Bankruptcy fraud includes, but is not limited to:

  • Fraudulent Transfers – Debtors cannot sell or give away property to others with the intent to defraud or hide assets from creditors. Trustees and judges may void any transfers made in this way.
  • Misrepresenting Finances – Debtors are required to file out paperwork completely and accurately. Although honest mistakes may be permissible, lying or omitting information with the intent to deceive the court is fraudulent.
  • Purchasing Luxury Items – Some debtors may abuse bankruptcy by buying as much expensive things as possible in the hopes that the bankruptcy will relieve them of the obligation to repay those debts. It would be fraudulent for a debtor to buy a vintage ford mustang the night before they file for bankruptcy.
  • Destruction of Records – Hiding or destroying evidence before or during court proceedings is a serious crime regardless of the field of law one is involved in.

Should I Contact a Bankruptcy Attorney?

Bankruptcy can be a complicated process. It is vital to know how the law regulates bankruptcy in your state, including what property exemptions you can claim. A bankruptcy lawyer knows the ins-and-outs of filing for bankruptcy, and can recommend what chapter of bankruptcy is right for you.