The Basics of Bankruptcy
by Robin I. Solomon
Controlling Statutes
The bankruptcy process is primarily governed by federal law. From 1898 to October 1978, bankruptcy proceedings were controlled by the provisions of the Bankruptcy Act of 1898, commonly referred to as the Act. Any cases still pending that were filed prior to October 1978 are still controlled by the Act.
In October 1978, Congress repealed the Act and replaced it with the Bankruptcy Reform Act of 1978. All cases filed after October 1, 1978, are governed by the Bankruptcy Reform Act of 1978, which is commonly referred to as the Bankruptcy Code or simply the Code. The Code is found in Title 11 of the United States Code at 11 U.S.C. §§ 101-1330.
In 1984, Congress passed the Bankruptcy Amendments and Federal Judgeship Act of 1984, and in 1986 passed the Bankruptcy Judges, United States Trustee and Family Farmers Bankruptcy Act of 1986. There have been several bills amending the Code that have been passed since 1986, and Congress is currently considering a new bill containing a number of substantial changes to the Code. Other statutory provisions relating to bankruptcy cases are found in Titles 18 and 28 of the United States Code. There are also local and district court rules, which must be consulted and followed in each case.
The Act was enacted to protect a debtor from its creditors and to provide a debtor with a "fresh start." Its other purposes include protection of creditors from their debtors, protection of creditors from each other, and conversion of the non-exempt assets of the debtor, if such assets exist, for equal distribution among the debtor's creditors.
Jurisdiction and Venue
The venue of a bankruptcy proceeding is almost always in federal court. A federal bankruptcy court has jurisdiction over all civil proceedings arising in or related to a bankruptcy proceeding filed in its court. A federal bankruptcy judge can, however, decline jurisdiction. In these cases, the debtor must rely on state bankruptcy or receivable laws, and a state court would hear the case and apply that particular state's bankruptcy law or its equivalent.
An individual who files for bankruptcy must file either in the district where he or she has resided for 180 days prior to the filing of the petition (or in the jurisdiction where the person has resided for the longest portion thereof) or in the location of his or her assets or place of business.
A corporation may file either in the state where it is incorporated, where it is qualified to do business, or where it is actively conducting business.
Documents to Be Filed
A bankruptcy petition is the first document that is filed at the commencement of a proceeding. The petition must be prepared and filed with the clerk of the bankruptcy court in the appropriate district. There is a statutory filing fee for all bankruptcy cases. The fees differ, depending in which chapter the bankruptcy is filed: Chapter 7, 9, 11, 12 or 13.
Since these fees change frequently, it is advisable to check the filing fee prior to filing. Upon proper application made to the court, it is also possible to pay the filing fee in installments. The number of copies of the petition may vary from district to district, so it is always wise to call the clerk's office to check on that court's specific requirements.
A list of creditors should be submitted with the petition. The list should contain each creditor's name, address (with ZIP code), the account number, if available, and the estimated balance due.
The Schedules and Statement of Financial Affairs must be filed within 15 days of the entry of the Order for Relief, which is usually the day the bankruptcy was initially filed. If these documents cannot be filed within the 15-day period, the debtor can file for an extension of time for cause shown. These documents are prepared using information relevant to the debtor as of the date of the filing of the petition. They reflect the financial condition of the debtor (assets and liabilities as of the filing date) and track transactions going back one year from the filing date.
With regard to the schedules of personal and exempt property, it is advisable to review the exemptions allowed under state law and under the Bankruptcy Code to determine which is most beneficial to the debtor/client. You cannot take both.
Amendments and/or supplemental schedules may be filed at any time after the initial filing and before the end of the bankruptcy case.
Types of Bankruptcy Cases
Five separate chapters of the Code create different types of relief and determine the nature of proceedings available to those seeking protection under the Code.
Chapter 7 - Liquidation (11 U.S.C. §§ 701-766);
Chapter 9 - Adjustment of Debts of a Municipality (11 U.S.C. §§ 901-946);
Chapter 11 - Reorganization (11 U.S.C. §§ 1101-1174);
Chapter 12 - Adjustment of Debts of a Family Farmer (11 U.S.C. §§ 1201-1231) and
Chapter 13 - Adjustment of Debts of an Individual with Regular Income (11 U.S.C. §§ 1301-1330).
The filing of a voluntary petition constitutes an order for relief (11 U.S.C. § 301). The order for relief triggers the automatic stay (11 U.S.C. § 362), creates the bankruptcy estate, and propels the debtor on the path towards the desired "fresh start."
Chapter 7
In a Chapter 7 case, a court-appointed liquidator, the Trustee, collects into the newly created bankruptcy estate all of the non-exempt assets a debtor owns as of the date of the filing of the petition (filing date). The trustee then sells those assets and distributes the proceeds in the following order:
first, to all creditors holding valid and enforceable liens on specific assets to the extent of the value of such assets;
second, to the debtor to the extent of all exemptions of the debtor's interest property to which the debtor may be entitled;
third, to those parties claiming administrative expenses incurred in the filing of the bankruptcy case (such as attorneys' fees and other priority claims such as taxes); and
last, to general unsecured creditors on a pro-rata basis.
The Trustee may determine at the beginning of a proceeding that it is a no-asset case, meaning that no property exists in the bankruptcy estate that could be sold to generate funds for distribution.
The debtor's objective in a Chapter 7 case is to be relieved of all unsecured debt. The debtor obtains this relief through the bankruptcy discharge, which forever bars creditors from trying to collect on prepetition debts. Some debts are non-dischargeable. Examples are alimony, child support, and obligations obtained through fraud.
Chapter 9
Chapter 9 was enacted to address the "adjustment of debts of a municipality." The most famous, or infamous, example of use of this chapter was the bankruptcy of California's Orange County. Since this is not a frequently used portion of the Code, suffice to say that it has specific sections and criteria set out in the Code, and one should consult the Code very carefully if presented with the filing of a petition under Chapter 9. One thing to remember, however, is that a Chapter 9 case may only be commenced on a voluntary basis. There are no involuntary Chapter 9 proceedings.
Chapter 11
A Chapter 11 case is commonly referred to as a business reorganization, but it is not limited to businesses, nor is it limited to reorganizations. Chapter 11 contemplates a business debtor, but the Supreme Court has upheld the right of an individual debtor to file Chapter 11 proceedings.
The provisions of Chapter 11 contemplate the continuation of an ongoing business, but a Chapter 11 debtor may liquidate assets instead of reorganizing its business. Individuals, sole proprietorships, corporations, unincorporated joint ventures, and general and limited partnerships may file for relief under Chapter 11. Chapter 11 relief is generally unavailable to the banking and insurance entities precluded from filing Chapter 7 cases, as well as stockbrokers or commodity brokers, who may only file liquidations.
Chapter 11 cases are usually more complex than either Chapter 7 or Chapter 13 cases. A Chapter 11 debtor must deal with other entities on an ongoing basis, including the Office of the United States Trustee (an arm of the U.S. Department of Justice), secured creditors, and any committees formed pursuant to the Code, such as an official committee of unsecured creditors. There are also many restrictions, such as the use of cash collateral, assumption and assignment of contracts and leases, and retention of professionals (attorneys, accountants, investment bankers, financial consultants, etc.). This is by no means an exhaustive list.
Chapter 12
The 1986 Bankruptcy Legislation created a new chapter to aid the family farmer. This was originally passed as a temporary measure set to expire in October 1993, but Congress has since extended the deadline. Chapter 12 was aptly placed between Chapters 11 and 13 because it has roots in the concepts of each of those chapters.
Chapter 12 has the most extensive and detailed eligibility requirements that a debtor must meet to take advantage of its provisions. The Code provides its own definition of "family farmer," basically restricting its use to relatively small farming operations. For example, the debts of the farming operation must not exceed $1,500,000. At least 80% of the debts, excluding certain debts on residences, must arise out of the farming operation.
Chapter 13
An individual who qualifies for Chapter 13 relief may be allowed to keep most assets and to pay creditors over a three- to five-year period through a repayment plan proposed by the individual. Chapter 13 allows an individual who has a regular income (hence its nickname as the "wage-earner's bankruptcy") to pay the disposable portion of that income on a monthly basis to a Chapter 13 trustee, who then distributes the payments to creditors. If the debtor successfully completes the plan, the debtor receives a discharge that is somewhat broader than the Chapter 7 discharge.
Chapter 13 is available to individuals with regular income whose debts do not exceed certain limits.
Parties/Proceedings in Bankruptcy Proceedings
The bankruptcy process, particularly the Chapter 11 process, is made up of compromise between many parties with different interests. The creditors naturally play a large role, and they may even commence the bankruptcy by filing an involuntary petition.
Creditors may fall into different groups with different agendas. Secured creditors often wish to be paid or to be able to exercise liens on the debtor's property. Unsecured creditors frequently desire to ensure that the business is preserved as an ongoing entity, because that is usually the only way they will be paid from the estate. Unsecured creditors may be represented by an official committee of unsecured creditors, who may retain counsel and other professionals.
Owners of the company may be concerned with the way their interests are treated. Large bankruptcy cases may have more than one committee appointed pursuant to the Code, such as an official committee of bondholders or noteholders, or an official committee of equity security holders. There may also be an indenture trustee, who represents these bondholders/noteholders. Landlords and other parties may also wish to assert their rights during the proceeding.
Further, if the court becomes convinced that the debtor is taking, or has taken, inappropriate action, it may appoint a trustee or an examiner.
Involuntary Petitions
Unsecured creditors may force a reticent entity into a bankruptcy by filing an involuntary petition. An involuntary petition may be commenced by either (a) three unsecured or undersecured creditors owed in the aggregate of at least $5,000 of noncontingent unsecured or undersecured deficiency, not subject to a bona fide dispute; or (b) if there are fewer than 12 creditors, one or more creditors owed collectively at least $5,000. It is important to note that creditors should not rush into filing an involuntary petition lightly, because if the court finds that an involuntary petition was filed in bad faith, punitive damages may be assessed against the petitioning creditors.
The Trustee
The term "trustee" has different meanings in bankruptcy proceedings and takes on different roles, depending on the type of bankruptcy filed.
The U.S. Trustee
First, there is the Office of the United States Trustee (U.S. Trustee), which functions as a part of the United States Department of Justice. 28 U.S.C. § 581 provides that the Attorney General shall appoint one U.S. Trustee for each federal judicial district as set forth therein. Each U.S. Trustee is appointed for a term of five years and shall continue to serve in that position until a successor is appointed and qualifies. The U.S. Trustee's duties are set out in 28 U.S.C. § 586, to which one may refer for a complete list of duties.
The Chapter 11 Trustee
A Chapter 11 Trustee may be appointed in a case for cause shown upon application by a party in interest, including the U.S. Trustee. The movant must show one of two grounds: (1) cause, including fraud, dishonesty, incompetence or gross mismanagement, before or after the case was filed; and (2) that the appointment is in the best interest of creditors and other parties in interest.
If the court is not convinced that the debtor should be replaced by a Chapter 11 Trustee, an examiner may be appointed under 11 U.S.C. § 1104(b). An examiner will conduct a thorough investigation of the debtor and any allegations of fraud or mismanagement. An examiner generally files a report with the court at the conclusion of the investigation, setting forth his or her findings.
The Chapter 7 Trustee
Most of the real work that occurs during a Chapter 7 proceeding is done by the Chapter 7 Trustee. The Chapter 7 Trustee is a court-appointed officer who must investigate the financial affairs of the debtor, collect any assets of the estate for liquidation into cash for distribution to creditors, and report on these activities. No trustee is generally appointed in an involuntary Chapter 7 proceeding until the order for relief is entered.
A party may move the court for appointment of an interim trustee prior to the entry of the order for relief. If the moving party can show that the appointment of a trustee is necessary to preserve the property of the estate or to avoid loss, the court may direct the U.S. Trustee to make the appointment.
Upon appointment, the Chapter 7 Trustee is the representative of the estate, with the ability to sue on the estate's behalf. The Chapter 7 Trustee can be sued, as well. Section 704 of the Code enumerates nine specific duties of the Chapter 7 Trustee.
The Chapter 13 Trustee
The role, duties, and powers of a trustee, including the U.S. Trustee, are more limited in a Chapter 13 proceeding, but the Chapter 13 Trustee may have a large impact on a case's progress.
In many districts, a standing Chapter 13 Trustee is appointed to administer all Chapter 13 cases filed in that district. The Chapter 13 Trustee's main function is to collect and distribute plan payments to the debtor's creditors. The Chapter 13 Trustee acts as a supervisor and disbursing agent but does not manage the affairs of the debtor or liquidate assets. The Chapter 13 Trustee also plays a role in the confirmation of Chapter 13 plans.
A Final Word of Advice
This information is a very basic and general outline of bankruptcy proceedings. Cases filed under Title 11, especially Chapter 11 cases, are often long and drawn out. There are many areas of bankruptcy that were not covered in this article, and I strongly suggest that anyone who is delving into the world of bankruptcy arm himself or herself with the Bankruptcy Code and a good textbook before trying to solve the mysteries of this area of the law.
Robin I. Solomon is a financial services paralegal, specializing in bankruptcy and creditors' rights, with the Philadelphia firm of Fox, Rothschild, O'Brien & Frankel, LLP. She has specialized in this area for 18 years, with the last 13 spent in her current position. Solomon is currently NFPA's board advisor and immediate past president. In addition to other activities, she serves on the board of directors of the Consumer Bankruptcy Assistance Project, the first bankruptcy pro bono project in the nation, which was formed in 1994.
