UPDATE: THE NEW BANKRUPTCY LAW OF 2005
Our original article, written in 2002, should be read with the following update in mind:
This article provides basic information on The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005. This law represents a major reform of the US bankruptcy system. Changes instituted by this new law took effect on October 17, 2005. Below are some of the key changes that came about as a result of this new bankruptcy law.
- Mandatory Credit Counseling -
As of October 17, 2005, before filing for bankruptcy most applicants must now undergo credit counseling in a government-approved program. You can get more information on the procedure for pre-filing credit counseling (and a list of approved credit counseling agencies) from the U.S. Trustee Program at www.usdoj.gov/ust (a component of the Department of Justice responsible for overseeing the administration of bankruptcy cases).
- Stricter Eligibility for Chapter 7 Filing -
Under the new law, bankruptcy applicants who wish to file under Chapter 7 must meet certain eligibility requirements under a "means test." Under the "means test," if your current monthly income is less than the median income in your state, you can file for bankruptcy under Chapter 7. But if your current monthly income is above the median income in your state, and you can afford to pay $100 per month toward paying off your debt, you cannot file under Chapter 7 and must proceed under Chapter 13 (more on Chapter 13 below). Whether you can afford to pay $100 per month (or $6,000 over a five-year period) is based on a formula that includes your monthly income, your expenses, and the total amount of your debt. You can get more information on means testing from the U.S. Trustee Program as indicated above.
- Tax Returns and Proof of Income Required -
Under the new bankruptcy law, people wishing to file bankruptcy under Chapter 7 or Chapter 13 must show proof of their income by providing federal tax returns from the last tax year. If a bankruptcy filer has not paid taxes for the previous tax year, he or she must do so before the bankruptcy can proceed.
- More Filings Under Chapter 13 -
As discussed above, if a bankruptcy applicant is ineligible for filing under Chapter 7 based on the "means test," he or she must file under Chapter 13 instead. There are a number of major differences between Chapter 7 and Chapter 13 bankruptcy, but the main distinction is that under Chapter 13, the debtor enters into a five-year repayment plan in which he or she must pay a certain amount of money to creditors, based on a strict expenses-to-income formula.
- Fewer "Automatic Stay" Protections for Filers -
People who file for bankruptcy have traditionally been entitled to certain immediate protections from creditors and others -- including most debt collection and lawsuit actions. These protections are part of what is called the "automatic stay" effect of a bankruptcy filing, because many potential legal actions against the filer are stopped. But, under the new bankruptcy law, some of these protections have been eliminated. For example, filing for bankruptcy no longer delays or stops eviction actions, driver's license suspensions, legal actions for child support, or divorce proceedings.
- New Priority for Unpaid Child Support and Alimony -
Bankruptcy laws provide a system of re-payment priority for people and companies that are owed money ("creditors"). Under the new bankruptcy law, among the changes in creditor priority is that people who are owed unpaid child support and alimony (i.e. the bankruptcy filer's family members) take priority over any other creditor.
- Mandatory Financial Management Education -
After the conclusion of bankruptcy proceedings, but before any debt can be discharged, bankruptcy debtors must participate in a government-approved financial management education program. You can get more information on the procedure for financial management education (and a list of approved debtor education providers) from the U.S. Trustee Program, previously mentioned.
The law imposes new duties on debtors and their attorneys, and failure to timely perform those duties will result in dismissal of the case or lifting of the automatic stay. Coupled with the new limitations on a second filing, the consequences of mistakes, inattention, or misfortune become far more serious, as the court and the trustee have less discretion to deal with human error and intervening circumstances. The presumption that the debtor is entitled to relief from his debts is effectively replaced by presumptions that the debtor’s filing is abusive until the debtor proves otherwise.
BASIC LAW BEFORE THE 2005 ACT:
Many people are unaware that it is the Constitution of the United States of America that provides to its citizens the constitutional right to file bankruptcy and begin anew one’s economic life. This was not an “after thought” by our Founders. It was a vital and central right, to their way of thinking a right as important and as basic as the other constitutional rights to freedom of speech, assembly and religion.
Debtor’s prisons were a common danger faced by English citizens prior to the founding of the United States and, indeed, in many of the states, themselves. Under that system, a creditor who was unpaid could have a debtor arrested indefinitely, until the creditor was paid. It was not uncommon for a debtor to spend longer in prison than a felon convicted of theft or assault.
The men who drafted the Constitution were adamant that one should not lose one’s freedom because one was in debt, but even went further, allowing a citizen, once every seven years or so, to file proceedings in the Federal Courts to discharge most debts and begin again without the overwhelming burden of debt. The Founders were convinced that the American nation could best be served by allowing those citizens who had found themselves buried in debt to pour their remaining assets into the Court, keep enough back for the necessities of life, distribute the rest among the creditors prorata, and begin anew.
That process, far more complicated after two hundred and fifty years of the workings of the Bankruptcy Courts, remains the basic bankruptcy process even today and an option available to any debtor who finds him or herself so undermined by debt that no other solution seems workable.
For the creditor it is equally vital to know and understand the basics of bankruptcy since the decision as to whether to loan or sell to a person must be based, in part, on whether bankruptcy may render the debt uncollectible. Further, certain types of debts and obligations are NOT discharged by bankruptcy and the creditor must know and understand how to utilize the creditor rights granted under the bankruptcy laws.
The topic is a broad one requiring good legal and tax advice for both the creditor and debtor, but this article shall seek to outline the basics of bankruptcy so that the debtor or creditor will understand his or her basic rights and remedies. Good professional advice is recommended before acting on the advice in this article. This article is no substitute for obtaining such advice,
The Types of Bankruptcy
While there are various types of bankruptcy available for public and semi public entities, the ones that concern the average person are Chapter 7 Bankruptcy in which the individual or business liquidates its assets under the auspices of the Trustee appointed by the court, keeps certain “exempt” assets, and is discharged from all debts but those predicated on taxes, child support and/or intentional wrong doing (discussed in more detail below.); Chapter 13 Wage Earner Plan in which the regularly employed individual, instead of surrendering his or her assets to the Trustee, develops a plan for paying off all or a portion of his or her debts over time under the supervision of the Court (subject to objections by Creditors); and Chapter 11 Reorganization in which a business creates a plan to pay off all or part of its debt subject to court supervision and creditor review.
The purpose of the Chapter 7 proceeding is not to pay off creditors but to simply deliver what nonexempt assets one has to the Trustee, get the debts discharged, and start anew. The purpose of the Chapter 13 and 11 proceedings is to halt creditor action long enough to develop a plan to pay them off in whole or part, with the supervision of the Court and creditor’s committee. Due to their complexity, both Chapter 11 and Chapter 13 proceedings are normally far more expensive to file and conclude and Chapter 11 business reorganizations can easily cost fifty thousand dollars for attorneys and accountants and many cost well over one hundred and fifty thousand dollars for a typical medium to large business. Indeed, when major companies such as P G & E file bankruptcy the cost for attorneys can run in the millions of dollars.
Chapter 7 proceedings, on the other hand, are relatively cheap and there are law offices which handle hundreds of them a month for less than a thousand dollars each. That method works for many of the simpler bankrupt clients, but is not the best choice if there are any complexities to the filing or if the client wishes any personal contact with the attorney, for the bankruptcy “factories” cannot allocate personnel to do more than fill in the form and perhaps meet the client a few minutes before the hearing in bankruptcy court. There are also excellent books available which enable people to draft and file their own simple Chapter 7 proceedings and such bookstores as Stacey’s stocks those types of books.
Chapter 11 and Chapter 13s, however, almost always require competent legal advice, as does any business bankruptcy or any bankruptcy which has business, trust, family, divorce, or international complications.
Basic Procedure in Bankruptcy…What Happens When You File
Once the Petition for Bankruptcy (or Reorganization) is filed with the Court the creditors receive an immediate order from the Court (a “stay”) ordering them to refrain from taking any further action to collect the debt. This order supersedes all jurisdiction of any State court and stops all writs of execution, garnishments, foreclosures, etc, immediately. Any creditor ignoring the order faces severe penalties from the Federal Court. Even efforts to evict a tenant are halted by the stay. Further, the debtor’s assets are “frozen” at that moment, and except for exempt assets (discussed below), the Trustee now has control of all assets of the bankrupt and holds them for eventual distribution to the creditors.
For creditors who feel they have rights not stopped by bankruptcy, they still must go to Federal Court to obtain any and all relief. Assuming that a creditor has rights that are not stopped by bankruptcy (such as the right to foreclose on a Deed of Trust or reclaim occupancy of rented space or foreclose on a mechanics’ lien) that creditor must petition the Bankruptcy court for relief from the stay and only then, should the Bankruptcy court grant it, may the creditor proceed. Thus, filing the Petition automatically delays all actions to collect and for the average unsecured creditor, stops collection actions permanently.
One begins bankruptcy by filing a Petition with the Court and the type of petition filed depends on the type of bankruptcy one is planning. It is important to note that either voluntarily (or involuntarily if the Court so determines) a Chapter 13 or 11 which is not progressing according to plan or in which the plan is considered inappropriate may be converted to a Chapter 7 liquidation bankruptcy after being filed. Indeed, most Chapter 11s do end up ultimately failing and being converted into Chapter 7 bankruptcies.
(This article shall only discuss voluntary petitions in bankruptcy and shall not discuss involuntary bankruptcy in which creditors seek to force a person or entity into bankruptcy, a topic of some magnitude requiring its own article.)
Once the Petition is filed, the stay is immediately sent out by the Court to all creditors listed and, in the case of Chapter 7, a hearing is set by the court at which the Trustee appointed by the court and any creditors wishing my examine the debtor to make sure that all assets and liabilities are properly listed. The duty of the Trustee is to represent the creditors in making sure all debts are listed, all assets that are not exempt surrendered to the Court’s jurisdiction, and to collect as much of the nonexempt assets as possible for the benefit of the creditors. The Trustee is paid based on the assets in the Bankrupt estate so obviously wishes to maximize what can be obtained from the bankrupt for the benefit of the creditors. The average Trustee is a professional attorney who specializes in such work and has hundreds of bankruptcy files to deal with each month. They cannot spend a great deal of time with any file unless the assets or facts are remarkable in size or complexity.
For Chapter 13 and Chapter 11 bankruptcies, the procedure is much more complicated with the debtor submitting a plan to the Court for consideration by the creditors and the Court. The process is too complex to explain here, but suffice to state that the plan must be approved by the Court and at a minimum must pay to the creditors what they otherwise would have received had a Chapter 7 rather a Chapter 11 or 13 have been filed.
The Chapter 7 hearing is usually quite short and uneventful, with the Trustee asking a few basic questions and with the actual creditors being quite limited on what they are allowed to ask. The key issues are whether all assets have been properly listed and whether any assets were improperly transferred prior to bankruptcy…for if they were, the bankruptcy court has the right to insist that the transferee return the assets to the Court for dispersal pro rata to the various creditors. To simplify, a transfer is considered “preferential” thus subject to being returned to court, if it was made within ninety days of filing bankruptcy or, in the event of a transfer to an “insider”, within one year of filing bankruptcy. There are many exceptions to the preferential transfer rule, and good legal advice and advanced planning is vital long before one files bankruptcy…but suffice to state that if one transfers valuable assets to friends or relatives in a hope to avoid having to surrender them to the bankruptcy trustee, one will usually fail in that effort.
If the debtor contests a claim from a creditor, a trial (“adversarial hearing”) may be held in the bankruptcy court usually within a year of the initial filing. Assuming the Chapter 7 goes the way of most, no such hearing will be required and after several months the court will discharge the debts and the bankrupt individual is finished with the entire process.
For Chapter 13 and 11s, however, the court and creditors committee continue monitoring the success of the plan (typically, to pay only a portion of the debts over a three or five year period) and the discharge occurs when the plan is successful…or, if unsuccessful, when the court dismisses the entire process or converts it to a Chapter 7 liquidation bankruptcy.
Ultimately the Court sends a discharge order to the various creditors and to the debtor and the matter is concluded. In a Chapter 7 proceeding, it is usually only necessary to go to court once. In a Chapter 11 or 13 proceeding, more appearances are usually necessary. If the plan adopted in the Chapter 11 or 13 fails, it can be dismissed (allowing creditors to again begin legal action) or converted to a Chapter 7 liquidation. If the Plan is successful and all the payments made, then the proceeding is closed once that is demonstrated to the Court’s satisfaction. In a Chapter 7, the final order of the Court is a discharge of all debts and the matter is concluded.
LIMITATIONS ON THE BENEFITS OF BANKRUPTCY: NONDISCHARGEABLE DEBTS
The purpose of bankruptcy is to eliminate the burden of debt or, at the least to get time to put your business life back together long enough to pay off your debts. This works for most unsecured debts, but the exceptions are many and most be noted.
Debts based on certain types of wrongful acts are not necessarily eliminated by bankruptcy. Debts based on judgments or claims predicated on intentional wrong doing (assault; battery; fraud (if Chapter 7 or 11); conversion, etc.) are normally not dischargeable.
Debts owed the government such as taxes and liens are usually not dischargeable. Debts based on fines or penalties levied by the governmental authorities or court are usually not dischargeable. (Indeed, tax refunds due you are usually listed as part of your assets and transferred to the Trustee in bankruptcy.) Student loans are no longer dischargeable in most cases.
Credit cards are usually dischargeable (so far though there is pressure to change the law) but there are exceptions. If luxury goods were purchased forty five days before bankruptcy or cash advances made, there is a presumption that they are not dischargeable. There are other exceptions but careful analysis of the source of the debt must be carefully considered before the decision to file bankruptcy is made.
Court imposed obligations such as child support and, often, alimony are usually not dischargeable, and orders involving clean up of toxic wastes and restitution for such damages may not be dischargeable.
And secured obligations normally require the surrender of the security to the creditor. Thus Deeds of Trusts, Mortgages, Mechanics Liens, secured commercial transactions, conditional sales contracts and the like often allow the asset to be foreclosed upon by the creditor once they obtain leave of the bankruptcy court.
And note that if one has personally guaranteed a debt, the filing of the bankruptcy petition by one’s limited liability entity will not stop the creditor from seeking to enforce the guaranty…one may be forced into bankruptcy because one’s corporation or limited liability company files bankruptcy and now the creditors seek to enforce such guarantees.
WHAT DO YOU NORMALLY GET TO KEEP?
Each State has its own level of exemption from execution on the family home and the Federal Bankruptcy law normally gives one the choice of taking a flat exemption of approximately fifteen thousand eight hundred dollars or maintaining up to a certain amount of equity in the family home. The amount of equity allowed depends on whether one is head of a family, married or single. A rough estimate in California is that one can normally keep about one hundred and twenty five thousand dollars in equity or the flat amount.
Tools of the trade, household furniture and clothing is also normally not seized by the Trustee in bankruptcy unless there are items of remarkable value, such as antiques or very valuable jewelry. (Remember that one must list all assets and liabilities under oath in the Petition for Bankruptcy and failure to list all of those correctly can lead to dismissal of the Petition with prejudice ( meaning one cannot file again for seven years) or even criminal sanctions if perjury is proven.)
Thus, if one’s home has appreciated in value so that one has several hundred thousand dollars in equity when one files bankruptcy, the odds are the Trustee will seize it for sale. It would be better to borrow on the home so that the amount left is below the limit of exemption and use the proceeds to pay off secured obligations such as a vehicle, etc…so long as the vehicle is not too valuable, for it can also be seized by the Trustee if worth too much.
It is also important to note that community property assets are subject to the jurisdiction of the bankruptcy court even if the spouse is not filing bankruptcy. Thus even if legally the bankrupt only owns half of the home, if it is community property, the spouse not filing bankruptcy may very well see the home seized and sold assuming the equity is above the exempt amount. Community property, in California, is usually subject to claims of creditors even if the spouse did not sign onto the creditor’s obligation directly. Put simply, one’s separate property and the couple’s entire community property must be included in the bankruptcy estate.
As for retirement savings, one normally may keep whatever is in one’s 401K but for IRAs, one only keeps an amount equal to , “what is reasonable support of the debtor and the family upon retirement.” Thus, for an IRA, if one is in one’s forties one will be able to keep far more than if one is in one’s twenties. (Note the inherent advantage of using a 401K rather than an IRA for retirement purposes.) Realistically, for most people they need not worry if their IRA is at the level of one hundred thousand dollars or less…they will probably be able to keep it even after filing bankruptcy.
One also will lose one’s credit standing and, depending on the nature of the credit one seeks, one can expect one’s credit to be affected for at least five years and perhaps as long as ten years. This is less of an issue than it may first appear since most people do not even consider bankruptcy until their credit is already eroded to the point that they have little left to lose. Bankruptcy, if decided upon, merely extends the length of time that credit is likely to be effected. Further, one can often immediately begin to rebuild credit with certain credit card companies and loan companies via various programs they have…albeit usually at extra interest cost.
But the main advantage, the main thing one “keeps” is freedom from the demands of creditors and legal actions they bring. One can eliminate for the most part the daily hassle of constant demands for payment and the need to respond to collection actions brought or writs of attachment served on your business or employer.
One will lose most of what one has left…but one is able to begin the process of rebuilding assets and credit with what amounts to a clean slate.
TRANSFERS VOIDED BY THE BANKRUPTCY COURT
It is not uncommon for potential bankrupts to seek to protect assets that would otherwise be seized by the Trustee by transferring them to friends or family, thinking to eventually retrieve them or, at least, to have the asset enjoyed by a friend or business colleague to whom one “owes” gratitude, etc. This seldom works. The law is simple: any transfer to an “insider” within one year of bankruptcy filing may be voided and reclaimed by the Trustee. An “insider” is normally defined as a family, friend, or business associate. Further, any transfer to anyone within ninety days of bankruptcy is normally voided unless for ongoing new obligations associated with daily business or personal needs. (Thus paying rent on your apartment or commercial building would not be voided…that is a new debt paid as accrued. But paying your landlord for long past due rent for the last six months and then filing bankruptcy ten days later will probably have the Trustee insisting that the landlord return the extra rent for sharing, prorata, with the other creditors.)
Assuming the party receiving the transfer refuses to return it, the Trustee can (and often does) commence a proceeding in bankruptcy court to retrieve the extra payment.
Practicality again pertains. Trustees are busy and very small transfers will probably not be a matter of deep concern unless a creditor pushes them. But a transfer approaching one hundred thousand dollars will almost always be spotted and pulled back by the Trustee and if one’s creditors are aggressive, this writer has seen payments as small at two thousand dollars retrieved by aggressive Trustees.
Note that these transfers give rise to “presumptions.” They are not automatically void, just presumed void until the bankrupt can demonstrate that the transfers were somehow related to appropriate payments, e.g. for present needed services in the day to day business, etc. Wholesale transfers of one’s assets, however, will seldom work and can result in severe penalties and must be avoided.
PLANNING FOR FILING OF BANKRUPTCY; THE EFFECT OF BANKRUPTCY
It is vitally important to obtain good advice before one files bankruptcy and long before if at all possible. Careful planning can prepare one’s assets to maximize what is exempt and avoid some very upsetting surprises. For instance, if one files bankruptcy without using one’s equity line to bring the debt below the exemption, or without taking into account accrued tax refunds or security deposits with one’s landlord, one can very well lose important advantages. It is important to consider the effect on assets that one normally never thinks about as “assets”…trade names; damages for personal injury; intellectual property or copyrights…all these things are ripe for seizure by the Trustee unless structured in the correct way.
Further, it is possible to lose an asset to the Trustee but then buy it back from the Trustee in later negotiations. While one will have to bid against any third parties or creditors, the fact is that normally no one else can make good use of certain assets, such as a trade name or intellectual property, and the plan to somehow retrieve such assets can form part of the advance planning for a business bankruptcy.
Ideally, one obtains good legal advice six months before bankruptcy is needed…the more time to plan the better. It makes sense to plan ahead so that even if one ultimately does not need to file for protection, one is informed and the structures in place for that perhaps necessary eventuality. The worst thing one can do is wait until one has no choice and must rush to file without advance planning or structuring of assets and debts. That occasionally occurs, but if you can anticipate that necessity by even a few months, there are definite advantages available by careful planning.
How do you know if bankruptcy is necessary? A good if not infallible rule of thumb is that if your debts cannot be substantially eliminated or entirely paid off at your current rate in five years (not counting mortgages and such debts) and if you are not likely to have a raise or other influx of money, then you are likely to remain in debt forever. Simple computation of interest charges should demonstrate to you if you can make progress in paying down your debts. Many debtors find to their horror once they perform their computation that even if they make all payments on a timely basis, the reduction in their debt is almost nil on an annual basis…that it is likely that eventually they will either ultimately fail to make payments (if illness or job loss occurs) or will be in debt for the rest of their lives.
If such is your case, and if you cannot alter your spending habits to generate a surplus to pay down the debts, then you must seriously consider bankruptcy. It is a serious decision requiring good advice and not to be taken in haste.
But it is also a Constitutional Right, one of the sacred rights considered so important by our founding fathers as to be included in the same documents as the right to vote, to have free speech or freedom of religion. It is not a disgrace to be insolvent and to require the use of rights placed in our Constitution by the people who founded our nation. It is a fact of economic life that from time to time one may fail in one’s efforts to meet one’s financial commitments or obligations…and should that time arise, the powerful tool of bankruptcy is a device that should be considered without hesitation…but with care.
Equally vital is the need to consider the effect on family and spouses. Put simply, all community property is normally subject to creditor’s remedies even if the debt was only incurred by one spouse. Thus the filing by a spouse often requires the filing by both spouses, unless there is a prenuptial agreement or some other method which defeated community property. The key is advance planning and analysis of both assets and liabilities of the debtor BEFORE any decision to file is made.
It is common to hear potential bankrupts state that they cannot file for bankruptcy since their “credit will be ruined.” In most cases, however, the credit is already ruined before the issue of bankruptcy even becomes discussed. One must be realistic. If one is failing to pay bills and has been doing so for months or years, one’s credit cannot be much more damaged.
It is true that a bankruptcy will stay on one’s credit history for perhaps ten years and its existence will make credit much more expensive to obtain. It is true that one must start from scratch, often slowly and only obtaining small credit at first, and slowly building it up. It is true that it is often a psychological blow to have to “admit failure” and this writer is often surprised at the emotional reaction of otherwise calm and intelligent business people when faced with the necessity to use their constitutional right to file bankruptcy. In our society it is often seen as a stigma, a sign of “defeat.” One must have the mental discipline to overcome such labels if one wishes to begin again one’s economic recovery.
And if you are a creditor, you must recognize that the specter of bankruptcy haunts every business transaction and you must carefully evaluate the likelihood of such a procedure before granting credit and must learn and understand the rules for voiding transfers and of exempt assets to ensure that a person filing bankruptcy does not somehow escape the strict rules of surrendering assets that are normally imposed. Creditors should not just “give up” their claims once receiving the stay from the Bankruptcy Court. The rules and procedures change, but the creditor must learn them and continue to seek to maximize the chances for maximum collection within the bankruptcy arena. To ignore the debt because one receives notice from the Court may lose one the opportunity to at least retrieve a portion of the debt.
One of our clients who died a multi millionaire had filed bankruptcy twice in his long career. He once commented to this writer that he often thought with amazement of the “fools’ who remained in debt rather than used bankruptcy to begin economic life again without undue burden. “Anyone can get into a hole. It is a typical danger of taking economic risks. Only the fools stay in the hole hoping to dig their way out. If the government gives me a right to start over, I think I owe it to myself…and to my family for that matter…to take that chance and try again.”
He said that, but this writer also remembers the anxiety and near agony he felt when he faced the “disgrace” of filing the Petition. He struggled long and hard to avoid that both times and only became philosophical about the need once he rebuilt his fortune.
And perhaps that is the best way to consider bankruptcy…it is not a way to escape debt so much as a way to begin again the effort to build one’s fortune. One pays a large price in term of lost credit, emotional turmoil and perhaps a feeling of failure…but the alternative of trying to do the impossible of paying off huge debt for the rest of one’s life is to guaranty a life of toil with little benefit. Once one’s fortune is again made, one can always elect to pay off the prior debts…which is what our client did before he died, enjoying the surprise on the face of creditors who had written off those debts almost a decade before! He once told this writer that what kept him “sane” during the depressing period of filing his bankruptcies was his conviction that someday, down the road, he would pay off these debts voluntarily, proving that it could be done if he was just given the chance to start again.