1. Public Policies Behind Bankruptcy
The fundamental notion of bankruptcy can be traced to, among other things, the Bible. The Old Testament, book of Deuteronomy (15:1-2) states “Every seventh year you shall practice release of debts. This shall be the nature of the release: Every creditor shall forgive the due that he claims from his neighbor; he shall not dun his neighbor or kinsman.”
The American forms of bankruptcy law have largely been inherited from the bankruptcy laws of old England. Originally the primary purpose was to protect the creditors, not provide relief for debtors. The English bankruptcy scheme in the beginning did not include the notion of forgiveness of debt for the debtor; there was no such thing as a “fresh start.” Rather, the purpose of a bankruptcy was to put a freeze on the debtor’s assets, that is, preserve the status quo in order to avoid a free-for-all raid on the assets resulting in an unfair distribution of the pickings. The assets were to be frozen until a fair and equitable distribution of the assets could be accomplished. Only with time did the idea of giving the debtor a “fresh start” develop.
Although the notion of a legal remedy of bankruptcy goes back quite far in English history, and the “moral” notion of it goes back even as far as the Old Testament, it is not clearly established that bankruptcy rises to the level of a “constitutional right” in the United States:
There is no constitutional right to a bankruptcy discharge, and the ‘fresh start’ provided for by the [Bankruptcy Code] is a creature of congressional policy. United States v. Kras, 409 U.S. 434, 446-47, 93 S.Ct. 631, 638-39 (1973). Congress, within limits set by the Constitution, is free to deny access to bankruptcy as it sees fit.
Held, in dicta, “… the debtor has no fundamental right to a discharge …”
Bankruptcy is not popular with creditors, because they typically lose a lot of money when a debtor files. In fact, it has been described by some creditors as “court approved robbery.” However, such characterizations, while containing a painful kernel of truth, do not give due consideration to the idea of fairness behind bankruptcy.
2. Preserve the Status Quo
The basic idea of bankruptcy is that the federal court (U.S. Bankruptcy Court) intervenes in the relationship between a debtor and his or her creditors, and preserves the status quo in order to bring about an orderly and equitable (i.e., fair) distribution of the assets among the creditors.
Accordingly, one policy behind bankruptcy is to preserve the assets, liquidate them, and then distribute the cash proceeds among the creditors in as orderly and fair a manner as possible.
3. Fresh start for the Debtor
A second, equally important policy is to provide the debtor with a fresh start by preserving some of the most basic and fundamental assets in the hands of the debtor, and erasing the debtor’s legal obligation to pay the discharged debts.
[T]he original purpose of our bankruptcy acts was the equal distribution of the debtor’s property among his creditors … But, the scope of the bankruptcy power … has been gradually extended so … the discharge of the debtor has come to be an object of no less concern than the distribution of his property.
The notion of a fresh start is well stated by the U.S. Supreme Court:
[O]ne of the primary purposes of the Bankruptcy Act is to give debtors a ‘new opportunity in life and a clear field for future effort, unhampered by the pressure and discouragement of preexisting debt.’
While it might seem that bankruptcy is primarily intended as a remedy primarily for poor or destitute people, in reality it has been recognized as more important in connection with America’s middle class:
The bankruptcy laws are first and foremost intended to maintain a viable property-owning middle class, as such citizens are the backbone of this society and the source of its stability.
And the balancing of competing interests in the Bankruptcy Reform Act of 1978 has been noticed in bankruptcy literature:
The treatment of individual debtors otherwise represented a fairly even balance between the interests of the credit industry and debtors (although creditors might take issue with that assertion!).
By proposing a truly equitable balance between the debtor and his creditors, the legislation obtained the support of a broad spectrum of the community having an interest in bankruptcy proceedings. In connection with proposals to allow the discharge of some taxes, the report observed that:
[the report] recognizes the principal that trade creditors and taxing authorities would both benefit more in the long run if they work together rather than in competition for the assets of the estate.
This policy requires that the interest of the debtor and all creditors, not merely the government, be considered and treated equitably vis-a-vis their sometimes competing interests.
One fundamental precept of consumer bankruptcy is that the fresh start ” … is properly limited to the honest but unfortunate debtor.”
THE BANKRUPTCY SYSTEM
The bankruptcy code and courts
Today, Bankruptcy law in the United States is found principally in the United States Bankruptcy Code (Title 11). It is a federal system of laws regulated by federal courts called Bankruptcy Courts. In addition to the Code, additional regulations are found in the official Bankruptcy Rules and Forms.
In addition to the Code and the Rules, and an extensive body of published case law, local bankruptcy practice is regulated by the promulgation of local rules. Local rules cannot expand or reduce substantive rights under the Code, nor contradict the Code. The court in In re Walat stated –
Local rules may not rise higher than the bankruptcy court’s derivative power. Therefore, [local rule] cannot (1) abridge, enlarge or modify any substantive right established by the Constitution or the Bankruptcy Code, (2) be classified as any thing other than practice or procedure, nor (3) be inconsistent with the national Bankruptcy Rules.
However, local rules typically govern procedure, notice requirements, forms, and compensation of professionals in bankruptcy cases; accordingly, it is important for debtor’s counsel to be familiar with such local rules as may have been adopted by the local bankruptcy courts.
The basic concepts and vocabulary that enable the bankruptcy system to achieve its goals are the debtor, the petition, the automatic stay, the estate, the trustee, exemptions, claims, the final discharge, and the permanent stay.
Most major cities in the United States have bankruptcy courts. Assisting the courts in the administration of the bankruptcy system is a special office of the U.S. Department of Justice called the United States Trustee (or “U.S. Trustee”). The basic purpose of the U.S. Trustee’s office is to keep an eye on all bankruptcy cases filed to see that the rules are followed and the cases administered as fairly and efficiently as possible. Another function of the trustee is to marshal and liquidate assets for distribution to the creditors. The U.S. Trustee in turn appoints trustees to actually conduct the administration of the individual bankruptcy cases.
Debtors and Creditors
The consumer client is known in bankruptcy jargon as the “debtor” as soon as the case is filed.
People or entities to whom the debtor owes money as of the date of filing the petition are called “creditors.” A creditor is anyone having right to payment that arose at the time of or before the order for relief (i.e. before the bankruptcy petition was filed).
Commencing a Bankruptcy Case
The petition is the legal document that, when filed with the clerk of the U.S. Bankruptcy Court, commences a bankruptcy case.
The petition typically consists of a two-page front, followed by lists of creditors and debts, assets and leases called “schedules.” Also included in the documents filed with the petition are the debtor’s budget containing his income and necessary living expenses, and a statement of financial affairs providing additional data and information about the debtor and his situation. These documents are filed at the bankruptcy courthouse by lodging a signed set with the U.S. bankruptcy court clerk, and paying a filing fee. The debtor is in bankruptcy the moment the clerk stamps the original for filing.
The Automatic Stay
The automatic stay may be thought of as a restraining order which is issued by the bankruptcy court immediately upon the filing of a bankruptcy petition. It is automatic in the sense that it comes into existence by operation of law the moment the petition is filed, and does not require that the judge actually issue an order or that the order be in writing. The automatic stay blocks any creditor, including any state or federal tax collector, from initiating or continuing any act to collect on a debt once the bankruptcy is filed. An important feature of the automatic stay is that it need not be actually served on a creditor in order to restrain that creditor … the restraint is created automatically by operation of law regardless of whether an individual creditor actually received written notice of it.
The automatic stay remains in effect as to property of the estate until such property is no longer property of the estate, the case is dismissed, the case is closed, or upon granting of the discharge.
The Bankruptcy Estate
Immediately upon filing the petition an artificial legal entity pops into existence called the estate. The estate consists of all property and assets belonging to the debtor, except certain trusts containing anti-alienation provisions, such as ERISA retirement plans. Unless exempt the property of the estate may be seized by the bankruptcy court, operating through the office of the trustee, and liquidated for distribution to the creditors.
The trustee is the person in whom is entrusted the duty to locate, marshal and liquidate (sell) the debtor’s assets and to arrange to distribute the proceeds in a fair and equitable manner in accordance with established rules of priority of distribution. In addition, it is the trustee’s duty to generally oversee the conduct of the case to assure that all parties act in good faith and within the bankruptcy statutes and rules.
Following the commencement of the case the trustee has the duty of marshaling and liquidating the debtor’s assets on be half of the creditors. However, Congress has provided that certain items of property are “exempt” from liquidation by the trustee and must be left in the hands of the debtor. These are referred to as exempt assets.
In most states the debtor may elect to choose from a list of exempt assets provided by Congress or a list created by the debtor’s state of residence. The lists have differences which may provide certain advantages, thus making one list more preferable from the debtor’s point of view than another. The debtor may not pick and choose from both, however, but must stick with the exemptions described on either one list or the other.
The typical exemptions provided in both federal and state lists include the debtor’s home as long as the equity does not exceed certain limits, a car if its equity value is not too high, clothing, basic furniture and furnishings, retirement funds or plans, small amounts of jewelry, personal items, tools of a trade or profession, some proceeds of personal injury settlements, cemetery plots, etc. Some states have very large exemptions for homes or other assets.
Equity, as used in this context, is the fair market value of an item over and above the balance owed on it, including liens against it. An asset in which the debtor has no equity is not seized by the bankruptcy court for liquidation, for the simple reason that after it is sold there would be no money left over for distribution to creditors. So, for example, a debtor could keep a Rolls Royce in bankruptcy, as long as the value of the car was equal to or less than the balance owed on it (i.e., no equity in it). In some cases the debtor could keep the Rolls Royce even if there is some equity in it, depending on the applicable bankruptcy exemptions.
A claim is money owed to a person, company or entity. An entity may be a person, estate, trust or governmental unit.
More specifically, a “claim” may be:
[R]ight to payment, whether or not such right is reduced to judgment, liquidated, unliquidated, fixed, contingent, matured, unmatured, disputed, undisputed, legal, equitable, secured or unsecured, or
[R]ight to an equitable remedy for breach of performance if such breach gives rise to a right to payment, whether or not such right to an equitable remedy is reduced to judgment, fixed, contingent, matured, unmatured, disputed, undisputed, secured or unsecured.
The Meeting of Creditors
Approximately thirty days following the filing of the petition the trustee conducts a meeting of creditors which the debtor is required to attend. The meeting, sometimes called the “341” meeting due to the code section authorizing it, is presided over by the trustee. The trustee is required to examine the debtor as to the debtor’s financial affairs. Creditors, as well, are entitled to attend and examine the debtor.
In the vast majority of cases no creditors actually appear at this meeting, and the trustee’s examination takes only a few minutes.
The Final Discharge
At the conclusion of the case, unless an objection to discharge has been filed the debtor typically receives a notice of final discharge. This is a notice that the debtor has been released from personal liability for any debt subject to the discharge. The discharge does not erase the debt per se, but only the debtor’s liability for the debt; the creditors are free to pursue collection of the debt against any other person who may be liable for it, such as a co-signer.
The final discharge does not necessarily erase liability for all debts listed in the schedules, but only those debts that are legally dischargeable in bankruptcy.
Congress has created a laundry list of debts that are either never dischargeable in any form of bankruptcy, or may be dischargeable in some forms of bankruptcy but not in others, or may or may not be dischargeable depending on various circumstances.
If the debtor or any creditor has any doubts about whether or not a particular debt was discharged in the bankruptcy, he or she may obtain a bankruptcy judge’s ruling on the matter by filing a complaint to determine dischargeability in the bankruptcy court.
The final discharge is granted unless there is an objection to discharge based on allegations of debtor misconduct, such as fraud against the bankruptcy court.
Exceptions to Discharge
As mentioned above, certain categories of debts are either not dischargeable in chapter 7, or are nondischargeable depending on circumstances. The typical kinds of claims that may not be dischargeable in bankruptcy, depending on the circumstances and the type of bankruptcy, are; claims for recent income taxes, trust-fund taxes, damages and fines from drunk driving accidents, claims arising from fraud or willful injury to person or property, federally guaranteed educational loans, family support, certain benefits owed to employees, and depending on the jurisdiction, debts which were not listed in the bankruptcy. Also, any secured claim where the debtor wishes to retain the collateral must be paid (e.g. installment payments on a car, or mortgage payments on a home).
Administration of the Estate and Case Closing
Following the meeting of creditors the trustee will typically file an abandonment of any claim in the debtor’s exempt assets and close the case. If there are non-exempt assets, or the trustee takes action to investigate further to collect assets that may be assets of the estate, and such assets are liquidated, the case will continue in an active status even after the final discharge has been entered. The case may remain open for as long as it takes to fully administer the estate and pay out any dividends due the creditors. During this period of time the trustee may seek recovery of as sets fraudulently transferred by the debtor, and payments made to creditors that constitute preferential payments.
The Discharge Injunction
A permanent injunction may be thought of as an extension of the automatic stay. The permanent stay comes into being the moment the bankruptcy case is concluded and enjoins any creditor from attempting to collect from the debtor on a debt that was discharged in the bankruptcy. If a creditor attempts to collect on such a debt the creditor is subject to severe penalties or sanctions in the form of fines and awards for damages by the bankruptcy court.
In order to encourage the notion of fairness towards the creditors the Bankruptcy Code prohibits the debtor from playing favorites with creditors just prior to filing bankruptcy.
Thus, a payment to a particular creditor to pay off an arrears on a debt may not be made within 90 days of filing bankruptcy, and payoff to an insider (typically a family member or business associate) within one year of filing. Such payments are called “preference” payments. If such a payment is made, the trustee may order the creditor to disgorge the payment. This is called “preference avoidance.”
Ordinary monthly payments, however, may be made during the 90-day preference period.
Some taxpayers attempt to hide valuable assets from creditors, collection agencies or the bankruptcy trustee by transferring title to another person, ostensibly as a gift, or for a nominal payment which is less than the fair value of the item. Such transfers are considered by the bankruptcy court to be fraudulent, and the trustee has the power to force the return of such a phony gift, or rescission of such a phony sale, in order to bring the assets back into the bankruptcy estate. Even transfers made to a “family trust” or similar trust are suspect and may be subject to the trustee’s avoidance powers. The trustee may take action to set aside such transfers made within one year of the filing of the bankruptcy. However, other creditors may have the right to set aside such a transfer made even prior to one year, depending on applicable statutes of limitations for fraudulent conveyances under state law.
Typically, liens create secured claims, and valid liens on the debtor’s property survive the bankruptcy. However, in many cases the bankruptcy code allows the debtor to set aside or “avoid” judgment creditor liens on exempt property, or non-possessory non-purchase money liens on certain specified exempt property. Under these provisions it is fairly common and routine for the debtor’s attorney to file lien avoidance motions for judgment creditor liens on the homestead exemption, and to avoid non-purchase money loans secured on the exempt personal personal property of the debtor. This allows the debt to be extinguished as though the claim were a general unsecured claim, and the lien on the property is also extinguished. Invalid or defective liens may also be set aside by means of an adversary proceeding filed in the bankruptcy court.
The role of the debtor’s attorney
Consumer bankruptcy lawyers are expected to be the screening apparatus of the bankruptcy system, rejecting those debtors who do not need bankruptcy, or who do not deserve it, while accepting those who are suitable and guiding them into what ever chapter of bankruptcy is most suitable to their financial circumstances. Thus, they should make a reasonable inquiry into the debtor’s financial affairs to assure that there has been no fraud and that the debtor is acting in good faith.
A fairly good comment on the duties of a debtor’s attorney is found in In re Jones, as follows –
Much more is required of the debtor’s attorney than simply knowledge of the forms and procedures. That is why it is the work of lawyers as learned intermediaries.
That requires analysis of the particular financial circumstances of the debtor, including a cost-benefit analysis with respect to debts to be discharged and any debts not subject to discharge, the property rights of all secured creditors and what obligations the debtor may wish to reaffirm. Other factors to be considered are the potential effects on the debtor’s present and future employment, the consequences to the family and the emotional overburden of admitting failure in the management and conduct of one’s affairs.
Adequate analysis and counseling should also include consideration of the alternatives of a Chapter 13 filing.
By signing the bankruptcy documents the attorney makes a certification to the court that, to the best of the lawyer’s knowledge, information and belief he or she has performed an inquiry “reasonable under the circumstances” and has formed the opinion that the information, claims, defenses or allegations contained in the documents signed have not been presented for any improper purpose, such as to harass or to cause unnecessary delay or needless increase in the cost of litigation, that the legal contentions are reasonable based on current law or a reasonable assertion to extend, modify or reverse existing law, and that the factual allegations are supported by evidence or are likely to be supported by evidence after reasonable discovery and investigation.
The attorney for the debtor in bankruptcy is deemed a “fiduciary and an officer of the court.”
As is true of all areas of law in the United States, there exists at the outset an attorney-client privilege as to communications between the client and the attorney.
In bankruptcy cases it has been held that the attorney-client privilege prevented the Chapter 13 debtor’s attorney and his employee from testifying about intake interview procedures and reasons for debtor’s omission of a personal injury settlement from the bankruptcy schedules. Held, lawyer’s ethical obligation to preserve confidences and secrets of client is broader than attorney-client privilege; ethical precept, unlike evidentiary privilege, exists without regard to nature or source of information or fact that others share the knowledge. Held, attorney-client privilege applied to testimony of bankruptcy attorney in connection with his conversations with debtor-defendant about duty to disclose all property in his bankruptcy petition, and perjury implications of falsifying the petition.
TYPES OF BANKRUPTCY
Chapter 7, or liquidation, is the basic bankruptcy. Sometimes called a simple or straight bankruptcy, and sometimes a liquidation bankruptcy, the idea is to liquidate all assets, distribute the proceeds to the creditors, and wipe out all debts on behalf of the debtor, thus providing him or her with a fresh start.
This is the form of bankruptcy most often chosen by individuals and families. In actual practice, the vast majority of chapter 7 cases are no asset cases, meaning that what few assets the debtor has are fully protected by the various exemptions, leaving nothing for liquidation or distribution to the creditors. And, in actual practice in many cases not all of the debtor’s debts are wiped out.
A debtor may file chapter 7 once every six years. The six-year period commences on the filing date of the previous bankruptcy.
Individuals, husband-wife, or certain business entities (including sole proprietorships, partnerships, and corporations) are eligible to file chapter 7.
Chapter 13 may be thought of as a court-approved debt consolidation plan. Officially it is referred to as Adjustment of Debts of an Individual With Regular Income. The idea is to consolidate all debts into one monthly payment, which is paid to the trustee. The trustee then distributes the money to the creditors in an extended deferred payment plan. As long as the debtor is in chapter 13 the creditors are barred from attempting to collect the debt directly from the debtor. And, as long as the debtor makes his payments, his assets remain under his control (even non-exempt assets).
This type of bankruptcy was established to encourage debtors to pay their debts while receiving the protection of the automatic stay.
It is ideal for debtors who just need time to pay their debts. Specifically, it is an excellent method for a small business to retain its assets and keep operating as usual, while paying off debts through the chapter 13 plan.
It is also helpful to debtors who have large nondischargeable debts. These debts cannot be erased in a chapter 7, and the debtor needs time in order to pay them off.
Another advantage of chapter 13 is that, in a great many cases the court will erase, or discharge, a substantial portion of the debt altogether, thus combining the discharge benefits of a chapter 7 with the payment plan features of the chapter 13.
Chapter 13 does not require the approval of the creditors. As long as the debtor is acting in good faith, is paying all of his disposable income into the plan, and as long as general unsecured creditors receive at least as much as they would have received had the debtor filed a chapter 7 instead, the court will approve the plan regardless of creditor objections.
Only individuals, families or sole proprietorships are eligible for chapter 13. Partnerships or corporations are not eligible for this remedy. And, only those individuals or families with liquidated unsecured debts under $269,250 and liquidated secured debts under $807,750 are eligible.
Unlike chapter 7 which limits the taxpayer to one filing every six years, there is no such limitation for Chapter 13. Accordingly, a debtor may file repeat chapter 13 cases, or file a chapter 13 immediately after filing a chapter 7 (sometimes called a “chapter 20”). This privilege presumes, however, that the debtor is acting in “good faith” if the court determines that the debtor is unfairly attempting to exploit the chapter 13 protection it may dismiss the case.
Chapter 11 is the large, industrial size version of chapter 13. It is intended to help reorganize the finances of large business enterprises in order to provide them with enhanced opportunities for surviving a debt crisis, thus keeping their employees working and the wheels of commerce turning.
Like chapter 13, chapter 11 is a court-approved debt consolidation plan which may provide for discharge of some of the debt. However, it is a complicated, highly ritualized program in terms of court procedure, and requires the approval of most of the key creditors. Handled by a competent bankruptcy attorney, it is quite costly in terms of legal fees and thus is typically not the preferred remedy for individuals or small businesses.
Individuals, husband-wife, or business entities of any kind are eligible to file chapter 11.
Chapter 12 is, in a nutshell, a chapter 11 for family farmers. The bankruptcy code provides some special features in the procedure, but the basic idea is the same as chapter 11. Incorporated farming businesses and partnerships, as well as sole proprietorships, are eligible for chapter 12.
Chapter 9 is, in a nutshell, a chapter 11 for a public entity such as a city, county or school district.