Chapter 7 Bankruptcy

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What It Is and How It Can Help

Chapter 7 is a form of bankruptcy relief that allows a debtor to liquidate their assets in exchange for a discharge of all or most of their unsecured debts. Unsecured debts are ones that are not secured by collateral; they include things such as credit card debt, medical bills, utility bills, and other loans for which credit was given without any collateral requirement. A bankruptcy discharge releases the debtor from personal liability for certain specified types of debts. In other words, the debtor is no longer legally required to pay any debts that are discharged. In this way, the debtor is given a fresh start
Not all individuals qualify to file chapter 7. Under chapter 7 of the bankruptcy code, an individual may qualify to file by meeting certain income requirements. If a debtor’s current monthly income is less than the median income of their state for a household of their size, then they automatically qualify to file a chapter 7.

If the debtor’s current monthly income is greater than the median income of their state for a household of their size, then the bankruptcy court determines whether the debtor satisfies these income requirements through a “means test.” The means test does this by calculating your average disposable income, which is the difference between your current monthly income and monthly expenses. Current monthly income is the average of the debtor’s earnings over the six months prior to the filing of the bankruptcy petition. If a debtor has too much disposable income the bankruptcy judge may move to dismiss the chapter 7 filing or to convert it to a chapter 11 or chapter 13 bankruptcy with the debtor’s consent.
Just because the bankruptcy code limits Chapter 7 to those with a certain amount of disposable income, it does not mean that higher income filers are necessarily precluded from filing. Debtors with high monthly expenses relative to their current monthly income may nonetheless qualify. Typically, this happens when the debtor has a lot of secured or non-dischargeable debt. Secured debt includes things such as mortgages and car loans. Whereas non-dischargeable debt includes certain back taxes, child support, alimony, criminal penalties, and student loans, among other things.

When a debtor files for chapter 7, an order called the “automatic stay” immediately stops most creditors from pursuing collection efforts during the pendency of the bankruptcy case. Additionally, a bankruptcy trustee is appointed to administer your case. In administering the estate, the trustee tries to maximize the amount unsecured creditors get paid through liquidation of the debtor’s estate. The estate is formed upon the filing of a bankruptcy petition and includes almost all the debtor’s property interests with a few exceptions. Typically, the bankruptcy court will liquidate any property that is unencumbered (property on which there are no liens) and secured property (property which is the collateral of another creditor) in which the debtor has equity.

Although the process of chapter 7 involves the selling of the debtor’s assets to pay back debts, there are various ways a debtor can retain some of their property. One important way the debtor can do this is through the bankruptcy code’s provision of exemptions. Exemptions are laws that protect a debtor’s property up to a certain dollar amount. The amount of the exemptions depends on whether the debtor elects to use the exemptions provided for under state law or bankruptcy law. Whether a debtor may even elect to use the exemptions provided for under bankruptcy law depends on whether a state has “opted out” of the exemptions provided under bankruptcy law. Some states allow the debtor to choose the between the two. For the most part the exemptions under bankruptcy law tend to be more generous, although there are exceptions. Listed below are some of the exemptions provided for under the bankruptcy code.

– Real property, including mobile homes and co-ops, or burial plots up to $25,150. The unused portion of the homestead exemption up to $12,575 can be used for other property.
– Motor vehicle up to $4,000.
– Animals, crops, clothing, appliances and furnishings, books, household goods, and musical instruments up to $625 per item, and up to $13,400 total.
– Jewelry up to $1,700.
– Health aids.
– Wrongful death recovery for a person you depended upon.
– Tax exempt retirement accounts (including 401(k)s, 403(b)s, profit-sharing and money purchase plans, SEP and SIMPLE IRAs, and defined benefit plans).
– IRAs and Roth IRAs to $1,362,800.
– Alimony and child support needed for support.
– And more
Something else that happens following the filing of the bankruptcy petition is the 341 meeting of creditors. The purpose of this meeting is to give the bankruptcy trustee and creditors the opportunity to ask debtors under oath their bankruptcy petition and the documents filed therewith.

At the end of the bankruptcy process, all your debts are wiped out (discharged) by the court, except:

  • Debts that automatically survive bankruptcy, such as child support, most tax debts, and student loans, unless the court rules otherwise, and
  • Debts that the court has declared non-dischargeable because the creditor objected (for example, debts incurred by your fraud or malicious acts).

The most common limitation stems from a secured creditor’s right to demand adequate protection in connection with the value of their collateral. A secured creditor may be able to seek relief from the automatic stay if it can establish that their interest in the collateral is not adequately protected from diminution in value. Typically, a debtor can prove that a secured creditor is adequately protect by showing that the secured creditor is oversecured (that the value of the collateral exceeds the value of the collateral), or by the fact that the debtor has offered to cross collateralize its loan with the secured creditor by offering another piece of unencumbered property to secure the loan.

Additionally, the debtor may face some challenges in operating their business if they want to use “cash collateral.” Cash collateral is cash and equivalents collected and held for the benefit of creditors during Chapter 11 bankruptcy proceedings. Cash and cash equivalents include negotiable instruments, documents of title, securities, and deposit accounts. Cash collateral receives extra protection under the bankruptcy code because it so easy to liquidate. Under the code, a debtor cannot use cash collateral unless the secured creditor consents or is provided with adequate protection against the diminishment of cash.

Finally, unless there is some property that is unencumbered by a senior lien, a debtor may struggle to obtain necessary postpetition financing from creditors. However, the bankruptcy court can incentivize certain creditors to extend postpetition financing through various provisions even though the debtor may lack unencumbered property. In furtherance of this goal, the court may, in certain circumstances, permit lenders who provide such credit to do the following things:

  • Obtain a superpriority claim for such loans ahead of all other claims.
  • Obtain collateral for such loans
  • And prime existing security interests as long as the existing secured creditors’ interests in the collateral remain adequately protected and the debtor establishes that it could not negotiate better financing terms.

Claims and Interests

In bankruptcy court, creditors, secured or unsecured, are allowed to assert claims against the bankruptcy estate to get paid. In order to do so, they must file a proof of claim within a statutory time period. The bankruptcy code has an expansive definition of a claim. A claim is a right to repayment, whether or not such right is reduced to judgement, liquidated, unliquidated, fixed, contingent, matured, unmatured, disputed, undisputed, legal, equitable, secured or unsecured. Certain provisions of the bankruptcy code made limit or disallow certain claims. For example, unsecured claims for interest accrued during the bankruptcy case are typically precluded.

Chapter 11 Plans

In addition to filing the petition and schedules, the debtor must also file also file a disclosure statement and plan of reorganization. The Disclosure Statement provides creditors and other parties in interest a summary of the company’s history, financial standing, and operations, and the Plan of Reorganization outlines how the company intends to reorganize its business debt. In order for the Debtor Chapter 11 bankruptcy to continue, the Disclosure Statement and Plan of Reorganization must be approved by the bankruptcy court and a certain number of creditors must “accept,” or vote in favor of the proposed Plan of Reorganization.

The Discharge

The bankruptcy code generally provides that the confirmation of a plan discharges the debtor from any debt that arose before the date of confirmation.

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