Bankruptcy 101: The Types of Bankruptcies, Part One
Although we touched on this when I provided a basic glossary of bankruptcy terms in a prior article, it bears spending a few more column inches to discuss the major types of bankruptcies in more detail. We’ll skip over the more obscure varieties—family farmers, municipalities and cross-border bankruptcies—and focus on the “Big Three”.
In this first installment of a two-part article, we’ll cover Chapter 7 and Chapter 13. In the second installment, we’ll discuss Chapter 11.
A Chapter 7 bankruptcy is a liquidation. It can be filed by a flesh-and-blood person, or a business entity. When a Chapter 7 petition is filed, a trustee automatically is appointed from a panel of approved trustees maintained by the Office of the United States Trustee, the administrative “watchdog” over bankruptcy matters.
If the Chapter 7 debtor is a person, the trustee is charged with marshaling and liquidating all of that person’s non-exempt property. The proceeds of that liquidation are used first to pay the administrative expenses of the bankruptcy (including compensating the trustee), and second to satisfy the claims of creditors that hold claims against the debtor.
As long as there is no question as to the truth and completeness of the information that the debtor provides about assets, liabilities and their general financial situation, and they haven’t filed another Chapter 7 bankruptcy too recently in the past, a flesh-and-blood debtor’s liability for all dischargeable debts is extinguished through the granting of a “discharge”. Examples of non-dischargeable debts include certain types of taxes, student loans, and claims arising from fraudulent activity by the debtor. In the absence of unanswered questions or complicating factors, a discharge usually is issued about 90-120 days after the case is commenced. Once the discharge is issued, the debtor usually has little to do with the bankruptcy case going forward, although the trustee may continue to liquidate assets, pursue recoveries, challenge creditor claims, and distribute cash for months or even—rarely—years longer.
Not every person can file a Chapter 7 bankruptcy. If the majority of a person’s debt is business-related, they may file a Chapter 7 bankruptcy regardless of their historical income or the amount of debt that they owe. Otherwise, a person may file a Chapter 7 bankruptcy only if they qualify under a “means test” that focuses on the person’s last six months of income and a normalized cost of living. To put it simply, a person that owes predominately consumer debt must be at or near the poverty level to qualify for a Chapter 7 bankruptcy.
If the Chapter 7 debtor is a business entity, the trustee’s basic job of liquidating assets is the same, although companies do not have exemptions. Occasionally, a company files a Chapter 7 bankruptcy while it still is operating, in which case the trustee may continue to operate the business either to wind it down, or to attempt to sell the assets of the business as a “package” in order to maximize value.
A Chapter 7 debtor that is a business entity does not receive a discharge. Rather, the trustee simply liquidates the company’s assets and distributes the proceeds to creditors, leaving an empty “shell”. The trustee does not typically dissolve the business entity, leaving that to the company’s owners to do at a later date, if appropriate.
A Chapter 13 bankruptcy is what formerly was referred to as a “wage-earner’s bankruptcy”, and can be filed only by a flesh-and-blood person with a regular income. Typically, a person files a Chapter 13 bankruptcy only when they cannot qualify to file a Chapter 7 bankruptcy.
In a Chapter 13 bankruptcy, a trustee is appointed to oversee the process but is not charged with liquidating the debtor’s non-exempt assets. Rather, a Chapter 13 debtor must file a proposed Chapter 13 plan pursuant to which their disposable income over a 3- to 5-year period is committed to paying creditor claims. If the Chapter 13 plan is approved and the debtor performs under the plan for its entire term, they receive a discharge of any indebtedness that remains after the plan payments have been made. The plan payments are made to the Chapter 13 trustee, who is charged with distributing the payments to the debtor’s creditors.
As is the case with Chapter 7 bankruptcies, not every person can qualify for a Chapter 13 bankruptcy. Not only must you have “regular income”, but you also may not have more than $360,475 in non-contingent, liquidated, unsecured debts, and more than $1,081,400 in non-contingent, liquidated, secured debts. Thus, in a maddening bit of Congressional humor, it’s possible for a person to fail to qualify for either a Chapter 7 or a Chapter 13 bankruptcy—in which case they are forced to file a personal Chapter 11 bankruptcy instead.
More on that next month.