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Bankruptcy law in the United States is intended to be a “fresh start for the honest but unfortunate debtor.” Article I, Section 8 of the United States Constitution authorizes Congress to enact “uniform Laws on the subject of Bankruptcies.” Under this grant of authority, Congress enacted the “Bankruptcy Code” in 1978. The Bankruptcy Code, which is found in title 11 of the United States Code, has been amended several times since its enactment, most notably in 2005 with the enactment of the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA).
The Bankruptcy Code consists of nine chapters – numbered 1, 3, 5, 7, 9, 11, 12, 13, and 15. Chapters 1, 3, and 5 contain provisions that apply to all chapters. Chapter 1 contains definitions, Chapter 3 sets forth rules for the administration of the bankruptcy estate, and Chapter 5 provides for the creditors’ rights and claims, the avoidance powers of the Trustee, the effect of a discharge, objections to discharge, and property of the estate. The remaining chapters set forth several different kinds of bankruptcy relief and so we refer to these different types of bankruptcy by the chapter of the bankruptcy code that deals with that type.
Three of the Chapters are quite rare and will not be discussed at length here. Chapter 9 provides for the reorganization of a municipality. Chapter 12 provides for a family farmer or family fisherman rehabilitation, and Chapter 15 is for cross-border bankruptcy proceedings. The most common types of bankruptcy cases are Chapter 7 and Chapter 13. These are discussed in more detail below.
Chapter 7 Bankruptcy
Chapter 7 is a straight liquidation and is usually what people think of when they think of bankruptcy. A trustee is appointed who is charged with collecting and liquidating the debtor’s non-exempt assets and distributing any funds to creditors.
Business Chapter 7
The most intuitive type of bankruptcy is a Chapter 7 liquidation of a corporation or limited liability company. In such a case, a trustee takes possession of the business, the business’s doors are closed for good, the company’s assets are liquidated, and the company ceases to exist. This provides an orderly way to wind down a business and to deal with the company’s debts when it is no longer feasible to continue doing business. Small business owners should be aware, however, that filing a Chapter 7 for their corporation or LLC does not stop creditors from pursuing the guarantors of the company’s debts. Since most small business owners have guaranteed at least some of the debts of their business, this can be a significant concern and often results in the business owner filing a personal bankruptcy.
Individual Chapter 7
As in a business Chapter 7, a trustee is appointed to administer a Chapter 7 individual bankruptcy. The trustee’s job is to liquidate the bankruptcy estate and to distribute any funds to creditors. However, unlike a business, an individual does not cease to exist after the bankruptcy filing. Therefore, there are two important concepts that are introduced in an individual bankruptcy to allow an individual to obtain a fresh start: exemptions in bankruptcy and the bankruptcy discharge.
Exemptions in Bankruptcy
Certain assets of an individual debtor, such as a homestead, a vehicle, and certain household goods are “exempt” from the ability of a creditor or a bankruptcy trustee to seize those assets to satisfy a debt. Each state has its own set of exemptions, and the exemptions vary widely from state to state. When the bankruptcy laws were changed in 2005, one of the changes was to prevent people from moving to a state with more generous exemptions and then filing bankruptcy. Therefore, a debtor must have lived in a state for at least two years prior to a bankruptcy filing to use that state’s exemptions. Otherwise, the exemptions to be used are those of the state in which the debtor lived for the 6 months prior to that two-year period.
The Bankruptcy Discharge
A bankruptcy discharge releases an individual debtor from personal liability for all but certain specified types of debts. In other words, the debtor is no longer legally required to pay any debts that are discharged. The discharge is a permanent order prohibiting the creditors of the debtor from taking any form of collection action on discharged debts, including legal action and communications with the debtor, such as telephone calls, letters, and personal contact. Although a debtor is not personally liable for discharged debts, a valid lien that has not been avoided in the bankruptcy case will remain after the bankruptcy is concluded. Therefore, a secured creditor may enforce a lien to recover the property secured by the lien.
Some debt may not be discharged in bankruptcy. The most common types of non-dischargeable debts are certain types of tax claims, debts not listed on the debtor’s schedules, debts for spousal or child support, and certain school loans. In addition, creditors may seek to have a debt declared non-dischargeable if the debt was obtained by false pretenses, fraud, embezzlement, or larceny, or was a debt “for willful and malicious injury by the debtor.”
Chapter 13 Bankruptcy
Chapter 13 is a rehabilitation that is available only to individuals with regular income and no more than $360,475 in unsecured debt and no more than $1,081,400 in secured debt. Chapter 13 involves a plan to make payments to the trustee over 3 to 5 years. Unless the court grants an extension, the debtor must file a repayment plan with the petition or within 15 days after the petition is filed. A plan must be submitted for court approval and must provide for payments of fixed amounts to the trustee on a regular basis, typically monthly. The trustee then distributes the funds to creditors according to the terms of the plan, which may offer creditors less than full payment on their claims.
Under Chapter 13, the debtor’s assets are not liquidated, but the debtor must make payments for up to 5 years. So why would someone choose Chapter 13 rather than Chapter 7? For some, it is not a choice. If one’s income is above the median income for the area, he or she may not qualify for a Chapter 7. However, many people do choose to file Chapter 13 rather than Chapter 7, especially if they have tax debt or are trying to remove a second mortgage from their home.
In addition to bankruptcy petitions, a number of lawsuits are filed in bankruptcy courts. These are known as “adversary proceedings,” and for the most part they proceed just like lawsuits that are filed in other courts. They begin with a complaint being filed by a plaintiff, to which an answer must be filed by the defendant. A period of time is set aside for the parties to exchange documents and to interview witnesses, after which a trial is held if the parties are not able to settle the matter beforehand.
In order for a bankruptcy court to have jurisdiction over a lawsuit, the lawsuit has to be related to a bankruptcy case. Below are some of the most common adversary proceedings that are filed in bankruptcy court.
Fraudulent Transfer Actions
Two different provisions in the Bankruptcy Code grant the trustee the right to avoid fraudulent transfers. First, section 544(b) provides that the trustee may avoid a transfer that is voidable by a creditor under state law. Second, section 548 provides that the trustee may avoid transfers that were made with the actual intent to hinder, delay or defraud creditors. That section also gives the trustee the power to avoid a transfer if the debtor “received less than a reasonably equivalent value” in exchange for the transfer if the transfer occurred while the debtor was insolvent or if the debtor was rendered insolvent by the transfer.
Section 547 of the Bankruptcy Code allows the trustee to avoid transfers:
to a creditor
on behalf of an antecedent debt (a debt that existed before the transfer)
made while the debtor was insolvent
made within 90 days before the bankruptcy (or one year if the recipient was an insider), and
that permit the creditor to receive more than he would receive in a chapter 7 liquidation.It is important to note that, in most cases, neither the debtor nor the creditor did anything wrong in entering into the preferential transfer. Defendants in preference lawsuits are often very frustrated and angry at being sued when they have done nothing wrong, and for good reason. But the Bankruptcy Code allows the trustee to undo otherwise unobjectionable transactions to make sure that similarly-situated creditors are treated equally in the bankruptcy process. Preference actions ensure that the debtor cannot frustrate the purposes of the Bankruptcy Code by paying certain creditors and not others on the eve of bankruptcy.
The two most common defenses to a preference action are (1) that the transaction occurred in the “ordinary course of business” and (2) that the creditor gave “subsequent new value” to the debtor after the transfer in question was made. If a creditor is required to turn over money or property as a result of an avoidance action, he will have a claim against the bankruptcy estate under section 502(h) for the amount that he was required to turn over.
Objections to Discharge
Section 727 of the Bankruptcy Code provides several circumstances under which a debtor is not entitled to receive a discharge in bankruptcy. For example, a debtor may not be entitled to a discharge if he destroyed or falsified records or transferred property prior to the bankruptcy filing “with intent to hinder, delay, or defraud a creditor. An objection to the debtor’s discharge under section 727 is, in effect, an objection to the bankruptcy as a whole.
Creditors may also file a complaint to determine the dischargeability of a particular debt. Section 523(a) of the Bankruptcy Code specifically except certain categories of debts from the discharge granted to individual debtors. In most cases, the exceptions to discharge apply automatically if the language prescribed by section 523(a) applies. However, other types of debt may be discharged unless a creditor files an adversary proceeding seeking to accept the debt for the discharge. These debts include debts obtained by false pretenses or fraud, debts “for fraud or defalcation while acting in a fiduciary capacity,” embezzlement or larceny, and debts “for willful and malicious injury by the debtor.”
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