Bankruptcy Law Explained

Bankruptcy law lays out procedures for individuals and businesses to repay some or all debts or to restructure their debt in a way that eliminates or reduces interest rates and fees. Before filing, you or anyone helping you should thoroughly research the process and gather your financial records.

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Chapter 7 liquidates assets and distributes proceeds to creditors, subject to exemptions. Chapter 11 allows a debtor to propose a plan of reorganization.

History

Bankruptcy law is a system that allows debtors — individuals and businesses — to resolve their outstanding debts by developing plans of reorganization. It also protects creditors by preventing unfair treatment of their claims and ensuring that the debtor’s assets are used to pay them in full. These goals are accomplished through a series of rules and processes known as the “bankruptcy code.” These principles appear first in Jewish laws on shemittah and yovel and later in English and American bankruptcy legislation.

Complex historical processes forged radically different bankruptcy legislation in England, the US and Italy. Nevertheless, they all shared a common core: the compromise between the defense of creditors’ rights and the need to foster entrepreneurship and risk-taking.

In the early nineteenth century, the first federal bankruptcy laws were temporary responses to economic upheaval: a law was passed in 1800, then repealed; another was enacted in 1841 and again in 1867. The emergence of large railroads, however, led to the creation of the Chandler Act in 1938, which included substantial provisions for corporate reorganization.

The Bankruptcy Reform Act of 1978 dramatically overhauled bankruptcy practice, primarily through the creation of Chapter 11 for business reorganization. The law also expanded the powers of bankruptcy courts, granting them pervasive subject matter jurisdiction. This expansion posed constitutional problems, but those issues were likely best resolved in the context of broader considerations of Article III of the Constitution and the scope of the bankruptcy court’s jurisdiction.

Chapter 7

Chapter 7 of the Bankruptcy Code provides debtors with a fresh start by allowing them to discharge many types of unsecured debt. This type of bankruptcy typically involves liquidation (selling) of nonexempt assets to pay creditors, with priority claims paid first. The value of property that can be claimed as exempt varies from state to state. Liens on property survive bankruptcy, so secured creditors retain their rights to repossess or take other action to recover property that is pledged to them.

Debtors who are able to pass a means test can generally keep most of their property. A debtor who fails the means test is forced into a Chapter 13 bankruptcy, where a debtor must work out a plan to repay creditors over the course of three to five years.

A creditor that holds a security interest in an asset in a Chapter 7 case should consider whether the debtor has the right to reaffirm the debt, which allows the debtor to keep the secured property and promise to continue paying the debt even after a bankruptcy discharge. A debtor who decides to reaffirm a debt should consult with a bankruptcy attorney.

Debtors in a Chapter 7 bankruptcy are required to submit a detailed list of all of their assets, as well as the value of those assets. The trustee will then gather and sell nonexempt assets, with proceeds from those sales distributed to holders of claims in accordance with the priorities set out in the Bankruptcy Code.

Chapter 13

A Chapter 13 bankruptcy allows individual debtors with regular income to develop a plan to repay creditors over three to five years. This plan pays priority debts (such as alimony and child support) in full, expenses of administration (attorneys’ fees and trustee fees) on a pro rata basis, and, to the extent permitted by law, unsecured claims in proportion to their claim amount.

A debtor must pay all projected “disposable income” over an applicable commitment period, less certain statutorily allowed expenses and charitable contributions up to 15% of the debtor’s gross income. The remaining unsecured claims are discharged at the end of the case, but not all nonpriority debts are dischargeable. For example, home mortgages, unsecured taxes and student loans may not be discharged.

Filing a Chapter 13 petition “automatically stays” or stops most collection actions against the debtor and the debtor’s property (except for some types of tax collections). Creditors cannot resume lawsuits, wage garnishments or property repossession efforts without court approval. A bankruptcy stay also protects co-signers and guarantors, as long as the debtor fulfills his or her plan obligations. However, if the debtor fails to fulfill the terms of the bankruptcy, the protections are removed and the creditors can resume collection activities. This is one of the reasons it is important to seek competent legal counsel before filing a bankruptcy petition.

Reaffirmation

A reaffirmation agreement is an agreement by a debtor to pay some or all of the debt that would have otherwise been discharged in bankruptcy. It is typically used in cases where a borrower wants to retain property that secures a debt, such as a home or car. In addition, reaffirmation agreements can help to reduce the impact that bankruptcy has on a borrower’s credit score.

Reaffirmation agreements must be approved by a bankruptcy judge before they become binding. This is because they are contracts, and because the judge must make sure that the terms of the contract are fair to all parties. Debtors should always seek the advice of experienced bankruptcy attorneys before deciding whether or not to sign a reaffirmation agreement.

The decision to reaffirm a debt is a very serious one that should not be taken lightly. If the debtor fails to make the payments required under the agreement, they could be liable for the full amount of the debt. In addition, if the debtor loses possession of the collateral that secures the debt, they could be liable for the difference between what is owed on the property and what it is worth when sold.

It is important to remember that a reaffirmation agreement is only valid if it complies with the terms of Chapter 7 bankruptcy law. This means that a debtor must file two court forms – Form 27 and Form 240A – with the court before reaffirming any debt.