Overview Of Bankruptcy Basics
By Dennis Wickham The purpose of bankruptcy laws has changed greatly over the years. The word “bankruptcy” stems from the practice in the middle ages when merchants could not pay their creditors. The unpaid creditors were entitled to break the tables or benches from which the merchants had sold their wares. “Banka rota” or “broken bench” was the fate of these early debtors. Indeed, the first bankruptcy laws adopted in the United States retained the notion that bankruptcy was exclusively a remedy for creditors to seize assets (and debtors) until bills were paid. In modern times, bankruptcy has developed into a system to protect debtors by granting them a right to a “fresh start” unless they have engaged in specific wrongful behavior. Many of the key elements of bankruptcy, however, reflect its roots as a remedy for creditors. Although some states have adopted laws governing debtors and creditors, bankruptcy law is based upon federal statutes and rules. The three main types of bankruptcy cases are named for the Chapter of the United States Code in which they appear. They are: Chapter 7 (liquidation); Chapter 11 (reorganization); and Chapter 13 (individual debt restructuring). Chapter 7. Liquidation under Chapter 7 of the United States Bankruptcy Code is what is commonly thought of as “bankruptcy.” When a Chapter 7 case is commenced, an independent trustee is appointed to liquidate assets (other than those assets that may be exempt under applicable state law or under the limited exemptions in the bankruptcy code), review claims, and pay creditors. The Trustee has the power to investigate payments and transfers by the bankruptcy before the case was filed, and to recover fraudulent transfers of assets1 or payments that are preferences.2 Except for certain specified debts and taxes, the debtor receives a discharge from debts, and can retain future earnings and assets free of creditor claims. Chapter 7 is relatively inexpensive and quick. These cases make up the bulk of the bankruptcy cases filed in the United States. In 1999, for example over 1 million cases under Chapter 7 were filed in the United States. Chapter 11. In Chapter 11, the goal is reorganization rather than liquidation. In most cases, a trustee is not appointed, and the debtor remains in control of the business, which continues to operate.3 The debtor is given a short period of time to have the exclusive right to propose a restructuring plan for its creditors to approve. While there are few limits to the structure of such plans, most provide either for a continuation of the business with creditors to be paid from future income, for a sale of some assets, or for creditors to receive stock in the debtor. The plan must provide dissenting creditors with at least what they would have received in liquidation. When the Plan is not approved by all creditors, it may still be confirmed by the bankruptcy court as a so-called “Cramdown Plan” if it meets certain requirements of the bankruptcy code. The confirmed plan becomes a contract among the parties, replacing the terms of the original obligations with the promises contained in the Plan. Chapter 11 can be very expensive and time consuming. Although it receives the most media attention, it makes up a small percentage of bankruptcy filings. In 1998, for example, only 8,000 chapter 11 cases were filed in the nation. Chapter 13. Chapter 13 combines some of the notions of Chapter 7 and Chapter 11 to permit individuals to retain their assets and pay creditors a portion of their income over time (not to exceed 5 years). Originally limited to individuals with small debts, an individual may use Chapter 13 with unsecured debts of up to $269,250 and secured debts of $807,750.4 The creditors do not vote on a Chapter 13 Plan. Rather, the Court reviews the income and expenses of the Debtor and determines whether or not the monthly payment that the debtor proposes is a good faith effort to pay creditors-is it the best the debtors can do under the circumstances. The monthly payments are made to a Chapter 13 Trustee, who distributes the funds to creditors. Chapter 13 is relatively inexpensive and quick, but is not used as frequently as Chapter 7. In 1998, for example, only 400,000 chapter 13 cases were filed in the United States (compare to over 1,000,000 chapter 7 cases). There has been substantial efforts in Congress to “reform” the bankruptcy laws by forcing debtors who have disposable incomes to use Chapter 13. ENDNOTES: 1 Transfers for less than fair value (usually to family or friends) or transfers made with the intent to hinder, delay, or defraud creditors. 2 Payments made on account of debts made less than 90 days (regular creditors) or one year (family members and insiders) before the filing of the case that permit the creditors to receive full payment while other creditors do not. 3 Although Chapter 11 is commonly called, “Business Reorganization,” there is no requirement that the debtor operate a business. 4 The amounts are adjusted for inflation.