Bankruptcy is the state of a person, whether natural or not, by a judicial process who declares that they are unable to pay their debt. There are several different types of bankruptcy under Title 11 of the United States Code. They are broken down into chapters, nine in all. They are: Chapters 1, 3, 5, 7, 9, 11, 12, 13, and 15. Chapter 15 is newly added. Chapters 1, 3 & 5 are general and contain definitional provisions. The other six contain different types of respite that a debtor may seek from creditors. All are sub divided into sections for easier reference.
There are several other words that people use when truly meaning bankruptcy; such words as insolvency, liquidation, impoverishment, etc. These are similar, but different. Bankruptcy results from legal proceedings to relieve them of debt while insolvency means that the debtor is unable to pay its creditors. This is not always the case.
Chapters of the United States Code Title 11
- Chapter 1 - General Provisions
- Chapter 3 - Case Administration
- Chapter 5 - Creditors, the Debtor, & the Estate
- Chapter 7 - Liquidation
- Chapter 9 - Adjustment of Debts of a Municipality
- Chapter 11 - Reorganization
- Chapter 12 - Adjustment of Debts of a Family Farmer or Fisherman with a regular annual income
- Chapter 13 - Adjustment of Debts of an Individual with Regular Income
- Chapter 15 – Ancillary & Other Cross-Border Cases
This chapter of the code gives definitions, rules and parameters. This chapter also gives timelines, eligibilities and penalties. This is a reference to help understand the rest of Title 11.
Subchapter I – Commencement of a case
Types of cases:
- Voluntary §301– A single debtor seeks a legal means to remedy their debt.
- Joint §302 – This is a voluntary filing with the bankruptcy court of a single petition is drawn for both the debtor and their spouse.
- Involuntary §303 – An involuntary case may only be commenced under Chapters 7 & 11. This is broken down into many parts dealing with framers, individuals, corporations, partnerships, etc.
Subchapter II – Officers
This subchapter refers to the trustees of the assets in question during the proceedings. There are references to qualifications, roles and removal of a trustee
Subchapter III – Administration
This deals with how the bankruptcy case is administered and the considerations taken into account in order to make a judgment.
Subchapter IV - Administrative powers
This subchapter deals with the administering of the assets including leases and rentals.
Subchapter I – Creditors and Claims
Guidance for determining which creditor has the better or primary claim on the assets along with the treatment to pay taxes and compensation for administrative services.
Subchapter II – Debtor’s Duties and Benefits
Timeline for the debtor to present a list of the creditors, schedules for assets and liabilities, current income and expenditures, and a statement of the debtor’s financial affairs as well as all assets that are exempt from the bankruptcy.
Subchapter III – The Estate
Subchapter III accounts for all legal or equitable interests of the debtor and the debtor’s spouse in property as of the commencement of the case.
The purpose of filing for Chapter 7 is for liquidation of the debtor’s assets, meaning that most of the debtor’s debts are terminated. This is typically what people think about when they hear about a bankruptcy.
There is a two part test that was instituted after amendments to the bankruptcy law went into effect in October 2005.
- Determination of Ability to Repay. The debtor's income is examined under a formula which exempts certain necessary expenses, such as food and rent, to determine if the debtor will be able to repay 25% of their non-priority unsecured debt.
- Comparison to State Median Income. The debtor's income is compared to the median state income.
In the event that the debtor earns more than the state’s median income and is able to repay 25% of their non-priority unsecured debt, then the debtor will not qualify for Chapter 7 and will have to file under Chapter 13.
Debtors will also be required to meet with a credit counselor in the six months before filing for bankruptcy.
After the debtor files, the debtor’s assets will be protected by an "automatic stay." This means that the creditors are not allowed to try to claim assets to satisfy the debt owed without permission of the bankruptcy court. This provides immediate protection against foreclosure, repossession of your car, eviction from your apartment, garnishment of your wages or bank accounts, or other measures creditors may take to try to recover monies owed. Any new debt incurred after the bankruptcy filing is not subject to these protections.
The trustee appointed by the bankruptcy court to oversee the distribution of the assets divides the assets into two separate categories; exempt and non-exempt. Determination of which assets are exempt from the bankruptcy is described within the code under Chapter 5.
The trustee must also divide the creditors in to two separate categories: secured creditor and unsecured creditors. Debtors have an obligation with a secured creditor when there is collateral attached to the debt.
There are some debts that are not able to be non-dischargeable. Examples of debts which cannot ordinarily be discharged in bankruptcy include child support obligations, student loans and taxes.
There are some debtors that seek to hide assets by transferring them to friends or relatives before filing for bankruptcy. This is called a fraudulent transfer and if discovered, the debtor’s bankruptcy may be dismissed and may also be subject to criminal charges for fraud.
The debtor may wish to have their bankruptcy transferred to Chapter 13 through a process called conversion. This is a one time switch if the debtor feels that they are better suited for reorganization.
This chapter provides for reorganization of municipalities (which includes cities and towns, as well as villages, counties, taxing districts, municipal utilities, and school districts).
The purpose of chapter 9 is to provide a financially distressed municipality protection from its creditors while it develops and negotiates a plan for adjusting its debts. Reorganization of the debts of a municipality is typically accomplished either by extending debt maturities, reducing the amount of principal or interest, or refinancing the debt by obtaining a new loan.
In order for the municipality to qualify for Chapter 9, there are specific criteria that are set forth by the code that must be passed:
- The municipality must be specifically authorized to be a debtor by State law or by a governmental officer or organization empowered by State law to authorize the municipality to be a debtor.
- The municipality must be insolvent.
- The municipality must desire to create a plan to adjust its debts.
- Lastly, the municipality must either:
- Obtain the agreement of creditors holding at least a majority in amount of the claims of each class that the debtor intends to impair under a plan in a case under chapter 9.
- Negotiate in good faith with creditors and fail to obtain the agreement of creditors holding at least a majority in amount of the claims of each class that the debtor intends to impair under a plan.
- Be unable to negotiate with creditors because such negotiation is impracticable.
- Reasonably believe that a creditor may attempt to obtain a preference
Federal bankruptcy laws govern how companies go out of business or recover from crippling debt. A bankrupt company might use Chapter 11 to "reorganize" its business and try to become profitable again. Management continues to run the day-to-day business operations but all significant business decisions must be approved by a bankruptcy court.
Assets are generally divided in the following order:
- Secured Creditors - often a bank, is paid first.
- Unsecured Creditors - such as banks, suppliers, and bondholders, have the next claim.
- Stockholders - owners of the company, have the last claim on assets and may not receive anything if the Secured and Unsecured Creditors' claims are not fully repaid.
This chapter was added to the Bankruptcy Code in 1986. It is designed specifically for the reorganization of family farms. It is closely modeled after Chapter 13, although it has a higher debt ceiling, and therefore applies to many more farm operations.
To be eligible for Chapter 12, there are several requirements that must be met:
- The farmer's debts cannot exceed $1.5 million.
- Eighty percent of this debt must arise from the farming operation.
- For purposes of computing the debt ceiling, any debt on a homestead will not be included unless it was granted in connection with the farm operation.
- The farmer debtors must have earned more than one half of their gross income from farming in the year prior to the filing of the Chapter 12 petition.
- Regular annual income that must be "sufficiently stable and regular to enable such family farmer to make payments" under a Chapter 12 plan.
Just as in a Chapter 11 bankruptcy, the debtor may not use cash collateral, such as crop or livestock proceeds, without either court or creditor approval. To obtain such approval, the debtor must provide the creditor who holds a lien on such property with adequate protection. This protection prevents the creditor from being harmed by the debtor's use of the collateral.
A chapter 13 bankruptcy is also called a wage earner's plan. It enables individuals with regular income to develop a plan to repay all or part of their debts. Debtors formulate a plan to repay their debt over the course of three to five years. If the debtor’s income is less than the state’s median income the plan will be for three years. The court could extend the period if the debtor can show cause. If the debtor’s income is above the state’s median income, then the debt will be paid over five years.
There are many advantages to choose Chapter 13 over Chapter 7. By choosing to reorganize the debt, it gives the debtor the opportunity to retain some assets, such as the house, that would otherwise be used to settle the debt. Debtors also have the ability to lower their monthly payments on secured debts and repay them over the life of their plan. Lastly, the debtor is isolated from the creditors during the life of their plan. The debtor makes the payments to the trustee, who then repays the creditors.
Under Chapter 13, any individual, even if self-employed or operating an unincorporated business, is eligible for relief as long as the individual's unsecured debts are less than $307,675 and secured debts are less than $922,975. These amounts are periodically changed to correspond with changes to the consumer price index (CPI).
The purpose of Chapter 15, and the Model Law on which it is based, is to provide effective ways for dealing with insolvency cases involving debtors, assets, claimants and other parties in interest involving more than one country. Chapter 15 is the U.S. domestic adoption of the Model Law on Cross-Border Insolvency promulgated by the United Nations Commission on International Trade Law ("UNCITRAL") in 1997, and it replaces §304 of the Bankruptcy Code.
Chapter 15 operates as the principal door of a foreign representative to the federal and state courts of the United States and gives foreign creditors the right to participate in U.S. bankruptcy cases and it prohibits discrimination against foreign creditors.
This is not a specific chapter under the U.S. Code, but rather a combination of Chapters 7 & 13. Debtors sometime will file for Chapter 7 and then Chapter 13 in order to release their debt from unsecured creditors and the devise a plan for repayment on their primary residence. There are restrictions on the frequency of filing for the chapters to reduce the possibility of abusing the system.
Bankruptcy has become a hot topic due to the large quantity of home repossessions.
Debtor-in-possession financing (DIP) provides the credit priority over existing debt, equity and other claims. The authority to continue in business includes the right to obtain credit and incur unsecured debt to fund ordinary operating expenses.
Two tests should be applied to determine whether a new credit transaction is in the ordinary course of a debtor's business and should be allowed protection through administrative status.
- The first test, called the horizontal dimension test, compares the debtor's business to other like businesses. The test is whether the creditor transaction in question is similar to those in which comparable businesses engage in their daily operations.
- The second test is the vertical dimension test, also called the creditor's expectation test. This test analyzes the credit transaction from the vantage point of a hypothetical creditor and inquires whether the transaction subjects a creditor to atypical economic risks.
Both the Senate and the House of Representatives have passed a bill to prevent individuals from filing chapter 7. This causes the individuals to become a slave to their debt; working hard just to pay off the expenses they have accrued. The credit card companies are not as forgiving or understanding as the court system and may take the debtor’s house, car and child support payments as well as other assets.
According to the Federal Bureau of Investigation bankruptcy fraud takes four general shapes:
- When a debtor conceals assets to avoid forfeiting them.
- When individuals file false or incomplete forms.
- When an individual files numerous times, either by using real information in several states or by using false information.
- When a court-appointed trustee is bribed.
In addition, bankruptcy fraud often involves other serious crimes such as mortgage fraud, identity theft, money laundering, and public corruption.
The Department of Justice estimates that of the average 1.4 million annual bankruptcies in the United States, 10% contain some type of fraud. Bankruptcy crimes carry a punishment by, among other things, imprisonment for up to five years.
In 1833 the practice of imprisoning people for debts was eliminated at the federal level. Before that time, people would be imprisoned in either special wings of prisons or in prisons devoted entirely to debtors. Although debtor’s prisons were abolished in the 19th century, it is still very possible to be imprisoned for debt. People are routinely put in jail for failure to pay child support, alimony and debts of fraud.
Bond Ratings and Default
Below is a chart of the bond ratings by both Standard and Poor’s and Moody’s, the two best known credit rating agencies. They rate companies on the likelihood of default. The lower the rating, the more likely the company issuing the bond will default on the payment. When a company defaults on their payment of a bond, they fail to payback all or part of the principle and/or interest. A rating on S&P's rating system of BB (Ba on Moody's) and lower is considered a “junk bond” and not of investment quality. Generally, the lower the rating, the higher the interest rate will be for taking an increased risk by investing in the company.