Introduction to bankruptcy

     Bankruptcy law is federal law, authorized by Article I, Section 8, Clause 4 of the United States Constitution. I offer here only a brief introduction to the basic purposes and features of federal bankruptcy law and overlook its interesting historical antecedents and history.

     Title 11 of the United States Code, the Bankruptcy Code, contains the substantive law of bankruptcy. Title 28 of the United States Code deals with bankruptcy courts, judges, jurisdiction, and venue.  Title 18, the federal criminal code, includes criminal offenses related to bankruptcy proceedings. The Federal Rules of Bankruptcy Procedure, which incorporate many rules from the Federal Rules of Civil Procedure, govern procedure in bankruptcy proceedings.

     A debtor looks to bankruptcy for relief from debt, either through a discharge (i.e. elimination of in personnam liability) of debt in a Chapter 7 case, or through a restructuring of debt in a Chapter 13 or Chapter 11 case. Restructuring typically takes the form of an extension of time to pay ("extension"), a reduction in the total amount of payment ("composition"), or some combination of both.  Corporate restructuring in bankruptcy often involves the issuance of new stock in exchange for the infusion of capital or in exchange for the elimination of debt.

     The filing of a voluntary petition by a debtor commences most bankruptcy cases.   In a very small percentage of Chapter 7 and Chapter 11 cases one or more creditors of the debtor (usually an unsecured creditor with a large claim who fears losing the race to assets in the state collection system) commence a bankruptcy case against a debtor by filing an involuntary petition.    The Bankruptcy Code does not permit the filing of an involuntary Chapter 13 case.

     Chapter 7

     Most Chapter 7 cases are consumer Chapter 7 cases, that is, they are filed by individuals (often husband and wife filing a joint voluntary petition) for whom most debt was incurred for personal, family, or household purposes. Typically, these individuals are overwhelmed by debt, with no realistic prospect of repayment within a reasonable time. In all but a handful of Chapter 7 cases, the bankruptcy court grants the debtor a discharge of debt incurred prior to the filing of the Chapter 7 petition, although in some cases particular debts, such as debts for certain taxes, fraud, wilfull or malicious injury to persons or property, student loans, or spousal or child support, will be excepted from discharge. Corporations may not receive a discharge in Chapter 7 and thus gain no benefit from Chapter 7.  The relatively small number of Chapter 7 cases in which the debtor is a corporation often involve cases that have been converted from a Chapter 11 proceeding to a Chapter 7 proceeding after a failed attempt at reorganization under Chapter 11 or cases in which a shareholder that has guaranteed debt of the corporation has also filed a Chapter 7.

     The price of the Chapter 7 discharge is surrender to a bankruptcy trustee (a fiduciary representing the interests of unsecured creditors of the debtor) of the debtor's non-exempt assets. Exempt assets as well as the debtor's future earnings are free from the reach of the trustee and the debtor's pre-petition creditors. The exemption of certain assets, the protection of the debtor's future earnings (i..e. earnings attributable to work performed following the filing of the petition), and the discharge collectively provide the debtor with a "fresh start." The trustee liquidates unencumbered or partially encumbered, non-exempt assets and, except for some favored unsecured creditors who are entitled to payment in full before others, pays unsecured creditors pro rata from the proceeds of the liquidation. To illustrate, suppose that a debtor owns unencumbered, non-exempt assets, and that the trustee reaps $5,000 from the liquidation of those assets, net of costs of liquidation and other administrative expenses. Suppose the debtor has only three unsecured creditors, A, B, and C, whose claims arose prior to the filing of the bankruptcy petition. A, B, and C have claims of $5,000, $10,000 and $15,000, respectively, against the debtor. Assume finally that none of these creditors is entitled to priority of payment under provisions of the Bankruptcy Code. The trustee will pay 1/6 of $5,000 to A, 1/3 $5,000 to B, and 1/2 of $5,000 to C.

     In well over 90% of consumer Chapter 7 cases all of the debtor's assets are exempt; accordingly, in most consumer Chapter 7 cases the price of discharge - - surrender of assets to the trustee - - is only theoretical.  In these cases, referred to as "no asset cases," unsecured creditors receive no payment.   While we do not consider the law governing bankruptcy exemptions in these materials, note three points: (1) exemptions are available only to individuals, not to partnerships, corporations, or other legal entities; (2) except for bankruptcy cases in fewer than ten states, the exemptions available to debtors in bankruptcy are the same exemptions that the debtor could use to resist enforcement of a money judgment under the state law of the state in which the bankruptcy court where the petition is filed is located; and (3) the well counseled debtor owning a significant amount of non-exempt assets will either work with a lawyer to convert the non-exempt assets to exempt assets prior to filing or will look to solutions other than Chapter 7 for resolution of financial difficulties.

     Secured creditors - - judicial, consensual, or statutory - - fare better than unsecured creditors in bankruptcy unless the lien of the secured creditor can be avoided under bankruptcy avoiding powers. In a Chapter 7 case, the unavoided lien "passes through bankruptcy," entitling the secured creditor (subject to a higher priority lien of another secured creditor) to satisfy its claim from the collateral even though the collateral is exempt from the reach of the trustee (recall that liens trump exemptions). If the amount of a secured debt equals or exceeds the value of the collateral, or if the amount of a secured debt plus the amount of a debtor's exemption equals or exceeds the value of the collateral, the trustee will abandon or simply not administer the relevant asset because liquidation of the asset by the trustee will not generate any funds payable to unsecured creditors. In such cases, the unavoided lien entitles the secured creditor to pursue its collateral through state law foreclosure, subject only to delay imposed by a temporary bankruptcy court injunction against creditor action known as the automatic stay. After termination of the automatic stay, a debtor may forestall or prevent foreclosure if the creditor agrees to the debtor's reaffirmation of the discharged debt or, in some circuits, if the debtor simply remains current on payments required under the original contract.  In addition, in some cases involving personal property, the debtor may redeem the collateral from the lien by a lump sum payment to the creditor equal to the value of the collateral, or the amount of the debt, whichever is less.  We explore these options more fully in Commentary.Consumer Chapter 7.

     The trustee may liquidate an asset subject to an unavoided lien or liens if the value of the collateral exceeds the amount of debts securing the liens plus the amount of any applicable exemption. In that case, from the proceeds of the liquidation, net of costs of liquidation, the trustee will pay those creditors with liens on the asset the full amount of their claims that are secured by the asset, will pay the debtor the amount of any exemption to which the debtor is entitled, and will reserve the balance for pro rata payment to unsecured creditors.

     Chapter 13    

     Relief under Chapter 13 is available only to individuals with regular income whose debts do not exceed prescribed limits; it is formally known as Adjustment of Debts of An Individual with Regular Income and colloquially referred to as a Chapter 13 plan or, sometimes, as a wage earner plan. In Chapter 13 the debtor proposes a plan to pay creditors from the debtor's future income. In contrast to Chapter 7, the debtor in Chapter 13 may keep all of his or her property, whether or not exempt. If the plan appears feasible and if the debtor complies with several other statutory requirements, the bankruptcy court will confirm the plan and the debtor and creditors will be bound by its terms. Creditors have no say in the formulation of the plan other than to object to the plan, if appropriate, on the grounds that it does not comply with one of the Code's statutory requirements. Most of the payments are made to a "standing Chapter 13 trustee" who then disburses funds in accordance with the terms of the debtor's plan. A standing Chapter 13 trustee is a person appointed to administer all of the Chapter 13 plans filed in a judicial district or division.  If and when the debtor completes payments required by the plan and complies with any other terms of the plan, the court will grant the debtor a discharge of the debts provided for in the plan. Of course, to the extent that the debtor's plan provided for full payment, the discharge is but a formality because payment has already extinguished the liability. If the debtor fails to make payments required under the plan, as happens in well over fifty percent of all confirmed Chapter 13 plans, and fails to seek or gain court approval of a modified plan, the debtor may convert the case to Chapter 7.   More often in such circumstances the bankruptcy court dismisses the case on the motion of the trustee because the debtor fails to respond to the motion.  In the event of dismissal, creditors may resume pursuit of state law remedies to the extent a debt remains unpaid.

     To supplement the foregoing commentary, you may find useful an introductory explanation of Chapters 7 and 13 prepared by the American Bankruptcy Institute for the general public.  The American Bankruptcy Institute, founded in 1982, is a non-partisan membership organization devoted to research and education concerning bankruptcy and insolvency.  Its home page provides a variety of useful links to current events and other information related to bankruptcy.  

     Chapter 11

     Relief under Chapter 11 is available to individuals, corporations, and other entities but is used predominantly by corporations, both privately and publicly held; it is formally known as Reorganization and colloquially referred to as Chapter 11 or corporate reorganization. Most Chapter 11 cases are considerably more complicated and time consuming than Chapter 13 cases, in part because the debt structure of a corporation is typically more complicated than that of an individual in Chapter 13 and because Chapter 11 cases involving a corporation must also readjust ownership interests. Among other things, the proponent of a Chapter 11 plan must prepare a thorough written disclosure statement, secure approval of the statement from the bankruptcy court, and solicit approval of the plan, based on the disclosure statement, from creditors and holders of ownership interests. Thus, unlike Chapter 13, creditors as well as holders of ownership interests are entitled to vote on the plan and the anticipated vote will influence the design of the plan. There are, however, some important similarities between Chapter 11 and Chapter 13. A Chapter 11 plan is usually proposed by the debtor and usually proposes repayment of creditors, in part or full. If the plan appears feasible and if the plan complies with a variety of other statutory requirements, the bankruptcy court will confirm the plan and the debtor and creditors will be bound by its terms. If no feasible plan is proposed, the case will either be converted to a Chapter 7 or dismissed. Unlike Chapter 13, discharge of debt in a Chapter 11 proceeding is effective upon confirmation of the plan. Thus, confirmation in a Chapter 11 creates a new legal relationship between the debtor and its creditors and holders of ownership interests, a relationship defined by the plan, that supplants the legal relationship that existed prior to the filing of the petition.

     As in Chapter 7, secured creditors fare better in either a Chapter 13 or Chapter 11 proceeding than their unsecured counterparts.   See Commentary. Chapter 13 and Commentary. Chapter 11.