Publication

By: Joyce Kuhns 

The United States Bankruptcy Code governs bankruptcy cases throughout the United States. Its impact cannot be overstated, having critically influenced outcomes for global companies, the Mom and Pop down the street, and your next-door neighbor.  Its purpose is twofold: providing the honest debtor with a “fresh start” while ensuring “fair” treatment to creditors.  This article will cover the key players, terminology, and processes in the three most prevalent types of bankruptcy proceedings: chapter 7 (liquidation); chapter 11 (reorganization); and chapter 13 (debt adjustment for individuals with regular income).

Key Concepts

A separate bankruptcy court with its own rules presides over bankruptcy cases. On the filing of a petition, a bankruptcy case commences and the debtor’s legal and equitable interests in property become part of the bankruptcy “estate.”  A debtor may use applicable Maryland exemptions to “exempt out” certain assets from the estate.  A statutory injunction known as the “automatic stay” immediately goes into effect on filing, barring creditors from pursuing actions against the debtor and estate property based on pre-filing claims.  Within a prescribed time, a debtor is required to file a Statement of Financial Affairs (“SOFA”) about the state of the debtor’s finances and recent financial transactions and Schedules of Assets and Liabilities (“Schedules”), under penalties of perjury.  The debtor is required to attend a meeting of creditors and answer questions about its financial affairs and scheduled assets and liabilities.

Chapter 7 Liquidation

Chapter 7 is the most common bankruptcy proceeding.  Its purpose is to liquidate a debtor’s non-exempt assets to satisfy its creditors.  The liquidation of non-exempt assets is administered by a chapter 7 trustee, typically appointed by the Office of the United States Trustee (“OUST”), the part of the Department of Justice charged with administrating bankruptcy proceedings. The chapter 7 trustee’s responsibilities include investigating the debtor’s financial affairs, collecting available property and reducing it to money, making distributions to creditors, and closing the case.

Once all available property is distributed under a complex set of Bankruptcy Code priorities or the trustee determines there are no assets available for distribution, the individual debtor is granted a discharge by the bankruptcy court.

A discharge is a permanent injunction protecting the debtor against creditors pursuing debts scheduled in the case and subject to the discharge. The bankruptcy discharge is the vehicle to provide the chapter 7 individual debtor with its “fresh start”, free of discharged debt.  Business entities may also seek relief under chapter 7 and turn over their assets to a chapter 7 trustee for liquidation and distribution.  However, there is no discharge granted to a business entity under chapter 7.  The entity simply dissolves, having surrendered its assets to a trustee and ceased operations.

The discharge is a powerful rehabilitative tool.  Currently, a “means test” is imposed to determine eligibility for chapter 7. The “means” test ascertains whether an individual’s debts are primarily consumer and the debtor has sufficient income, after deducting allowable expenses, to pay some portion of the debt through a chapter 13 plan (discussed below) as opposed to having the debt discharged in chapter 7. A bankruptcy court must dismiss the case or convert the case to a chapter 13 case if the individual debtor is unable to satisfy the “means” test.

Chapter 11 Reorganization

Chapter 11’s primary purpose is to adjust the obligations of a business entity’s creditors and equity holders and preserve it as a going concern through a court-approved plan. Although intended as a reorganization vehicle, chapter 11 also creates a forum for a businesses’ orderly partial or total liquidation. Individual debtors who do not engage in business or do not qualify for chapter 7 or 13 because their income or debts exceed certain limits may also file under chapter 11, which has no statutory thresholds.

Absent fraud or mismanagement, a debtor operates as a “debtor-in-possession” in management and control of its assets and business. Generally, a debtor may engage in day-to-day transactions in the ordinary course of its business although with advance notice, hearing and court approval are required for actions outside the ordinary course, such as borrowing money or selling substantially all of its assets.

In addition to the debtor, other key Chapter 11 players are the secured lenders (granted special protections for use of their collateral in the case) and statutory committees appointed by the OUST to represent key constituents in the case such as general unsecured creditors or equity holders.

A debtor may propose a plan at any time but has the exclusive right to do so within the first 120 days of the case, which period may be extended by the bankruptcy court up to an 18-month maximum. Once the exclusive period expires, any party in interest may propose a plan. The Bankruptcy Code sets out plan requirements, including: (i) placing similarly-situated debt or equity holders in separate classes; (ii) identifying impaired classes; (iii) providing the same treatment to every class member; and (iv) providing adequate means for plan implementation, including the unique ability to swap debt for equity without invoking typical securities procedures.

Adversely affected or “impaired” parties may vote on the plan. Once approved by the bankruptcy court as providing “adequate information” to enable an “informal judgment” whether to vote in a plan’s favor, a disclosure statement is disseminated with a ballot to those eligible to vote.  Bankruptcy voting rules are complex and will not be discussed here.  Voting is by class.

The bankruptcy court must independently decide all elements of section 1129 of the Bankruptcy Code have been met to approve the plan. Once confirmed, a chapter 11 plan binds the debtor, all creditors (whether or not they voted), and certain other enumerated parties to its terms.  On the plan’s effective date, estate property revests in the debtor and the automatic stay terminates, unless the plan provides otherwise.   A chapter 11 plan discharges the debtor’s debt through the confirmation date, acting as a permanent injunction against any party collecting a debt outside the plan’s terms and conditions.

Chapter 13 Debt Adjustment for Individuals with Regular Income   

Chapter 13 allows eligible individuals to repay a portion or substantially all of their debts, through installments, from future income, over a 3-5-year plan, under bankruptcy court supervision.  A chapter 13 trustee is appointed by OUST to investigate the financial affairs of the debtor, ensure the debtor makes timely payments and distribute monthly payments the trustee receives under the plan to creditors. Only a debtor may propose a plan.

Unlike chapter 7, a chapter 13 debtor is not required to turn over non-exempt assets to the trustee but may retain possession and control of debtor property so long as the debtor makes certain payments on secured debt (e.g., installment payments on vehicle loans) pending confirmation and honors plan obligations, and post-confirmation. If a chapter 13 debtor has defaulted on mortgage payments before the filing date, the debtor may seek to modify the repayment schedule and “cure” its arrearages overtime, a significant Chapter 13 benefit.

A more streamlined proceeding than chapter 11, chapter 13 does not require disclosure statement or creditor vote for plan approval. So long as the chapter 13 plan complies with chapter 13 confirmation requirements, the bankruptcy court must confirm it. A confirmed chapter 13 plan binds the debtor and each of its creditors to its terms. Unlike in chapter 7 or 11, the debtor is not discharged and the automatic stay is not terminated as to the debtor until all plan payments are made or the case is dismissed. If plan payments are missed, the trustee may ask the court to dismiss the case, convert the case to chapter 7, or modify the plan.

Conclusion

The Bankruptcy Code provides a unique vehicle for debtors to attain a fresh start unburdened by past debt and a challenge for creditors to maximize recovery. Inherent tensions between the chapters inevitably exist, with debtors pursuing a quick exit with the broadest discharge and creditors seeking the biggest recovery.  Knowing the bankruptcy essentials should help a non-bankruptcy lawyer decide next steps, including whether to consult with a bankruptcy professional.