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Three months ago, Janet Hart’s husband of twenty years died of cancer. Although he had medical insurance, he left Janet with outstanding medical bills of more than $50,000. Janet has worked at the local library for the past ten years, earning $1,500 per month. Since her husband’s death, Janet also has received $1,500 in Social Security benefits and $1,100 in life insurance proceeds every month, giving her a monthly income of $4,100. After she pays the mortgage payment of $1,500 and the amounts due on other debts each month, Janet barely has enough left over to buy groceries for her family (she has two teenage daughters at home). She decides to file for Chapter 7 bankruptcy, hoping for a fresh start. Using the information provided in the chapter, answer the following questions.
Under the Bankruptcy Code after the reform act, what must Janet do before filing a petition for relief under Chapter 7?
How much time does Janet have after filing the bankruptcy petition to submit the required sched-ules? What happens if Janet does not meet the deadline?
Rather than being allowed to file Chapter 7 bankruptcy petitions, individuals and couples should always be forced to make an effort to pay off their debts through Chapter 13.
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Bankruptcy
“Capitalism without
bankruptcy is like
Christianity without
hell.”
Many people and businesses in today’s economy are struggling
to pay their monthly bills. In the old days, debtors were punished and sometimes sent to jail for failing to pay their debts.
Today, the law provides debtors with numerous options,
including bankruptcy—a last resort in resolving debtorcreditor problems.
Frank Borman
As implied by the chapter-opening quotation, bankruptcy
1928–present
(U.S. astronaut and businessman)
is an essential aspect of our capitalistic society. Individuals and
businesses in our nation have great opportunities for financial success but may also encounter financial difficulties. For
instance, many retail chains (The Limited, Wet Seal, Gymboree) have filed for bankruptcy
in recent years, in part due to the increase in online shopping. (See this chapter’s Business
Web Log feature for further discussion.) Therefore, every businessperson should have some
understanding of the bankruptcy process.
26–1
The Bankruptcy Code
Bankruptcy relief is provided under federal law. Nevertheless, state laws on property, secured
transactions, liens, and judgments also play a role in federal bankruptcy proceedings.
Article I, Section 8, of the U.S. Constitution gave Congress the power to establish “uniform
laws on the subject of bankruptcies throughout the United States.” Federal bankruptcy
26
Learning Objectives
The four Learning Objectives below
are designed to help improve your
understanding. After reading this chapter,
you should be able to answer the following questions:
1. What are the two main goals
of bankruptcy?
2. In a Chapter 7 bankruptcy,
what happens if a court finds
that there was “substantial
abuse”? How is the means
test used?
3. In a Chapter 11 reorganization,
what is the role of the debtor
in possession?
4. How does a Chapter 13
bankruptcy differ from
bankruptcy under Chapter 7
and Chapter 11?
607
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UNIT THREE: Commercial Transactions
Online Retail Competition Causes Yet Another
Brick-and-Mortar Retailer to File for Bankruptcy
T
he online world did not significantly
affect consumers and brick-and-mortar
competitors for quite a few years after
the invention of the Internet. But as online
retailers become more aggressive and consumers become more comfortable ordering
online, the inevitable is finally happening.
More and more large retailers are filing for
bankruptcy. One of the latest is Toys R Us.
Toys R Us is just one of more than thirty-five
major retailers that have filed for either
Chapter 7 or Chapter 11 bankruptcy in recent
years. Others include Radio Shack, Payless
ShoeSource, and Vitamin World.
Toys R Us initially filed for Chapter 11
bankruptcy protection, indicating that it
wanted to come to terms with its debt
holders and other creditors. At issue was
$5 billion of debt. The company promised
consumers that its stores would stay open
for the 2017 Christmas holidays, which they
did, but its holiday sales were disappointing. Ultimately, the company’s enormous
debt and growing losses proved too much
to overcome with reorganization. Toys R Us
then announced that it was filing for
Chapter 7 liquidation and was closing (or
selling) all of its retail stores in the United
States.
Shopping malls throughout America
are struggling, too. Many of their anchor
stores, such as Nordstrom, are closing
money-losing locations. Others are filing
for bankruptcy. Retailers in malls are not
suffering because of cyclical downturns in
spending. The reality is that many younger
purchasers do not frequent shopping malls
and instead do their shopping primarily on
the Internet.
Although online competition has
affected department stores more than
any other retail sector, other retailers are
Business Web Log
feeling pressure as well, as shown by the
example of Toys R Us. As one commentator stated, “Virtually every sub-segment of
retail, other than auto retail and pharmacy,
is caught in the cross-hairs of Amazon’s
growing online presence.”
Key Point
We can expect to see brick-and-mortar
retailers forced into Chapter 11 reorganization for many years to come. Not only
is Amazon, the Internet’s biggest retailer,
expanding every year, but traditional retailers are shifting resources away from physical stores and learning how to increase
their online presence.
legislation was first enacted in 1898 and since then has undergone
several modifications, most recently in the Bankruptcy Reform Act.1
Federal bankruptcy laws are called the Bankruptcy Code or, more
simply, the Code.
QualityHD/Shutterstock.com
26–1a Goals of Bankruptcy Law
What are some factors that can cause large retail chains,
such as Toys R Us, to file for bankruptcy?
Learning Objective 1
What are the two main goals
of bankruptcy?
Bankruptcy law in the United States has two main goals:
1. To protect a debtor by giving him or her a fresh start without creditors’
claims.
2. To ensure equitable treatment of creditors who are competing for
a debtor’s assets.
Thus, the law attempts to balance the rights of the debtor and the
creditors.
Although the twin goals of bankruptcy remained the same, the
balance between them shifted somewhat after the reform legislation.
Because of its significance for creditors and debtors alike, we present the Bankruptcy Reform
Act as this chapter’s Landmark in the Law feature.
1. The full title of the act is the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, Pub. L. No. 109-8, 119 Stat. 23 (April 20, 2005).
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CHAPTER 26: Bankruptcy
The Bankruptcy Abuse Prevention
and Consumer Protection Act
W
hen Congress enacted the first
Bankruptcy Reform Act in 1978,
many claimed that the law made it too
easy for debtors to file for bankruptcy
protection. The 2005 Bankruptcy Abuse
Prevention and Consumer Protection Act
(BAPCPA) was passed, in part, in response
to businesses’ concerns about the rise in
personal bankruptcy filings.
From 1978 to 2005, personal bankruptcy
filings increased dramatically. Various
business groups—including credit-card
companies, retailers, and banks—claimed
that the bankruptcy process was being
abused and that reform was necessary.
More Repayment Plans, Fewer
Liquidation Bankruptcies One of
the major goals of the BAPCPA is to require
consumers to pay as many of their debts as
they possibly can instead of having those
debts fully discharged in bankruptcy. Before
the reforms, the vast majority of bankruptcies were filed under Chapter 7 of the Bankruptcy Code, which permits debtors, with
some exceptions, to have all of their debts
discharged in bankruptcy. Only about 20
percent of personal bankruptcies were filed
under Chapter 13 of the Bankruptcy Code.
As you will read later in this chapter,
Chapter 13 of the Bankruptcy Code requires
the debtor to establish a repayment plan
and pay off as many of his or her debts as
possible over a maximum period of five
years. Under the BAPCPA, more debtors
have to file for bankruptcy under Chapter 13.
Other Significant Provisions
of the Act The BAPCPA also made a
number of other changes. One important
provision involves the homestead exemption. Before the passage of the act, some
states allowed debtors petitioning for
bankruptcy to exempt all of the equity
(the market value minus the outstanding
mortgage owed) in their homes during
bankruptcy proceedings. The act leaves
these exemptions in place but puts some
limits on their use.
Another BAPCPA provision gives
child-support obligations priority over other
debts and allows enforcement agencies to
Landmark
in the Law
continue efforts to collect child-support
payments.
Application to Today’s World
Under the 2005 bankruptcy reforms, fewer
debtors are allowed to have their debts
discharged in Chapter 7 liquidation proceedings. At the same time, the act makes
it more difficult for debtors to obtain a
“fresh start” financially—one of the major
goals of bankruptcy law in the United
States. Today, more debtors are forced to
file under Chapter 13.
Additionally, the bankruptcy process
has become more time consuming and
costly because it requires more extensive documentation and certification.
These changes in the law have left many
Americans unable to obtain relief from
their debts.
26–1b Bankruptcy Courts
Bankruptcy proceedings are held in federal bankruptcy courts, which are under the authority
of U.S. district courts. Rulings by bankruptcy courts can be appealed to the district courts.
A bankruptcy court can conduct a jury trial if the appropriate district court has authorized
it and the parties to the bankruptcy consent. Bankruptcy courts follow the Federal Rules of
Bankruptcy Procedure rather than the Federal Rules of Civil Procedure. Bankruptcy court
judges are appointed for terms of fourteen years.
26–1c Types of Bankruptcy Relief
The Bankruptcy Code is contained in Title 11 of the United States Code (U.S.C.) and has
eight “chapters.” Chapters 1, 3, and 5 of the Code include general definitions and provisions
governing case administration and procedures, creditors, the debtor, and the estate. These
three chapters of the Code normally apply to all types of bankruptcies.
Four chapters of the Code set forth the most important types of relief that debtors
can seek.
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Know This
Congress regulates the
jurisdiction of the federal courts within the
limits set by the U.S.
Constitution. Congress
can expand or reduce the
number of federal courts
at any time.
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UNIT THREE: Commercial Transactions
1. Chapter 7 provides for liquidation proceedings—that is, the selling of all nonexempt assets and the distribution of the proceeds to the debtor’s creditors.
2. Chapter 11 governs reorganizations.
Design Pics Inc/Alamy
3. Chapter 12 (for family farmers and family fishermen) and Chapter 13 (for individuals) provide for adjustment of the debts of parties with regular income.2
Note that a debtor (except for a municipality) need not be insolvent3 to file for bankruptcy relief under the Bankruptcy Code. Anyone
obligated to a creditor can declare bankruptcy.
26–1d Special Treatment of Consumer-Debtors
A consumer-debtor is a debtor whose debts result primarily from the purchase of goods for personal, family, or household use. The Bankruptcy
Code requires that the clerk of the court give all consumer-debtors
written notice of the general purpose, benefits, and costs of each chapter
of bankruptcy under which they may proceed. In addition, the clerk
must provide consumer-debtors with information on the types of services available from credit
counseling agencies. Consumer-debtors are also required to confirm the accuracy of certain
information filed with the court (their attorney must do so if they are represented).
Under which chapter of the Code may family farmers seek
bankruptcy relief?
Consumer-Debtor One whose
debts result primarily from the purchase of goods for personal, family,
or household use.
26–2
Liquidation The sale of the non-
exempt assets of a debtor and the
distribution of the funds received to
creditors.
Bankruptcy Trustee A person
appointed by the court to manage the
debtor’s funds.
Discharge The termination of a
bankruptcy debtor’s obligation to pay
debts.
Petition in Bankruptcy The
document that is filed with a bankruptcy court to initiate bankruptcy
proceedings.
Chapter 7—Liquidation
Liquidation under Chapter 7 is the most familiar type of bankruptcy proceeding and is often
referred to as an ordinary, or straight, bankruptcy. Put simply, a debtor in a liquidation bankruptcy turns all assets over to a bankruptcy trustee, a person appointed by the court to manage
the debtor’s funds. The trustee sells the nonexempt assets and distributes the proceeds to
creditors. With certain exceptions, the remaining debts are then discharged (extinguished),
and the debtor is relieved of the obligation to pay the debts.
Any “person”—defined as including individuals, partnerships, and corporations4—may be
a debtor under Chapter 7. Railroads, insurance companies, banks, savings and loan associations, investment companies licensed by the U.S. Small Business Administration, and credit
unions cannot be Chapter 7 debtors. Other chapters of the Code or other federal or state statutes
apply to them. A husband and wife may file jointly for bankruptcy under a single petition.
A straight bankruptcy may be commenced by the filing of either a voluntary or an involuntary petition in bankruptcy—the document that is filed with a bankruptcy court to initiate
bankruptcy proceedings. If a debtor files the petition, then it is a voluntary bankruptcy. If one
or more creditors file a petition to force the debtor into bankruptcy, then it is an involuntary
bankruptcy.
26–2a Voluntary Bankruptcy
To bring a voluntary petition in bankruptcy, the debtor files official forms designated for
that purpose in the bankruptcy court. The law now requires that before debtors can file a
petition, they must receive credit counseling from an approved nonprofit agency. Debtors
2. There are no Chapters 2, 4, 6, 8, or 10 in Title 11. Such “gaps” are not uncommon in the United States Code. They occur because, when a
statute is enacted, chapter numbers (or other subdivisional unit numbers) are sometimes reserved for future use. (A gap may also appear if
a law has been repealed.)
3. The inability to pay debts as they come due is known as equitable insolvency. A balance-sheet insolvency, which exists when a debtor’s liabilities exceed assets, is not the test. Thus, it is possible for debtors to petition voluntarily for bankruptcy even though their assets far exceed their
liabilities. This situation may occur when a debtor’s cash-flow problems become severe.
4. The definition of corporation includes unincorporated companies and associations. It also covers labor unions.
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CHAPTER 26: Bankruptcy
filing a Chapter 7 petition must thus include a certificate proving that they have received
individual or group counseling from an approved agency within the last 180 days (roughly
six months).
A consumer-debtor who is filing a voluntary petition must confirm the accuracy of the
petition’s contents. The debtor must also state in the petition, at the time of filing, that he
or she understands the relief available under other chapters of the Code and has chosen to
proceed under Chapter 7.
Attorneys representing consumer-debtors must file an affidavit stating that they have
informed the debtors of the relief available under each chapter of the Code. In addition, the
attorneys must reasonably attempt to verify the accuracy of the consumer-debtors’ petitions
and schedules (described next). Failure to do so is considered perjury.
Chapter 7 Schedules The voluntary petition contains the following schedules:
1. A list of both secured and unsecured creditors, their addresses, and the amount of debt
owed to each.
2. A statement of the financial affairs of the debtor.
3. A list of all property owned by the debtor, including property claimed by the debtor to be exempt.
4. A list of current income and expenses.
5. A certificate of credit counseling (as mentioned previously).
6. Proof of payments received from employers within sixty days prior to the filing of the petition.
7. A statement of the amount of monthly income, itemized to show how the amount is calculated.
8. A copy of the debtor’s federal income tax return for the most recent year ending immediately before
the filing of the petition.
The official forms must be completed accurately, sworn to under oath, and signed by the
debtor. To conceal assets or knowingly supply false information on these schedules is a crime
under the bankruptcy laws.
With the exception of tax returns, failure to file the required schedules within forty-five
days after the filing of the petition (unless an extension is granted) will result in an automatic
dismissal of the petition. The debtor has up to seven days before the date of the first creditors’
meeting to provide a copy of the most recent tax returns to the trustee.
Tax Returns during Bankruptcy A debtor may be required to file a tax return at the end
of each tax year while the case is pending and to provide a copy to the court. A request for
a copy of the debtor’s tax return may be made by the court or the U.S. Trustee—a government
official who performs administrative tasks that a bankruptcy judge would otherwise have
to perform. In addition, any party in interest (a party, such as a creditor, who has a valid
interest in the outcome of the proceedings) may make this request. Debtors may also be
required to file tax returns during Chapter 11 and 13 bankruptcies.
Substantial Abuse and the Means Test A bankruptcy court can dismiss a Chapter 7
petition if the use of Chapter 7 constitutes a “substantial abuse” of bankruptcy law. The
revised Code provides a means test to determine a debtor’s eligibility for Chapter 7.
The purpose of the test is to keep higher-income people from abusing the bankruptcy
process, as was thought to have happened in the past. The test forces more people to file
for Chapter 13 bankruptcy rather than have their debts discharged under Chapter 7.
The Basic Formula. A debtor wishing to file for bankruptcy must complete the means test
to determine whether she or he qualifies for Chapter 7. The debtor’s average monthly income
in recent months is compared with the median income in the geographic area in which the person lives. (The U.S. Trustee Program provides these data at its website, www.justice.gov/ust.)
30301_ch26_hr_607-636.indd 611
U.S. Trustee A government official
who performs administrative tasks
that a bankruptcy judge would otherwise have to perform.
Learning Objective 2
In a Chapter 7 bankruptcy,
what happens if a court finds
that there was “substantial
abuse”? How is the means
test used?
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Order for Relief A court’s grant of
assistance to a debtor in bankruptcy
that relieves the debtor of the immediate obligation to pay debts.
UNIT THREE: Commercial Transactions
If the debtor’s income is below the median income, the debtor usually is allowed to file for
Chapter 7 bankruptcy, as there is no presumption of bankruptcy abuse.
Applying the Means Test to Future Disposable Income. If the debtor’s income is above
the median income, then further calculations must be made to determine the debtor’s future
disposable income. As a basis for the calculations, it is presumed that the debtor’s recent
monthly income will continue for the next sixty months. Disposable income is then calculated
by subtracting living expenses and interest payments on secured debt, such as mortgage
payments, from monthly income.
Living expenses are the amounts allowed under formulas used by the Internal Revenue
Service (IRS). The IRS allowances include modest allocations for food, clothing, housing,
utilities, transportation (including car payments), health care, and other necessities. (The
U.S. Trustee Program’s website also provides these amounts.) The allowances do not include
expenditures for items such as cell phones and cable television service.
Can the Debtor Afford to Pay Unsecured Debts? Once future disposable income has been
estimated, that amount is used to determine whether the person will have sufficient income
in the future to repay at least some of his or her unsecured debts. The court may also consider
the debtor’s bad faith or other circumstances indicating abuse.
Case Example 26.1 John and Sarah Buoy filed for Chapter 7 bankruptcy. For the past three
months, John’s gross monthly income was $4,900, and Sarah’s was $6,761. They had five
children. They owed secured debts of $34,321 on a Subaru Impreza and a BMW 328i, on
which they intended to continue making loan payments (this is called reaffirmation, as will
be discussed later). They owed $123,000 on a mortgage and $19,000 in student loans, and
their unsecured debts were $4,900.
An auditor for the U.S. Trustee Program reviewed the Buoys’ Chapter 7 schedule and
concluded that the family’s gross income figures were understated. Because of a mistake
in the math, the Buoys had miscalculated their biweekly income by approximately $800
a month (or nearly $650 after taxes). The debtors claimed that they had incurred additional expenses after the petition, including orthodontic braces and another car. Even
with those expenses, however, the court found that they would have an additional $400
a month in future disposable income and would receive sizeable tax refunds. The court
concluded that the Buoys could afford to pay their debts and dismissed the Chapter 7 petition for substantial abuse.5 ■
Blend Images/Alamy
Additional Grounds for Dismissal As noted, a debtor’s voluntary petition for Chapter 7 relief may be dismissed for substantial
abuse or for failure to provide the necessary documents (such as
schedules and tax returns) within the specified time. In addition,
a motion to dismiss a Chapter 7 filing may be granted in two other
situations.
How does family size affect the calculation and application
of the means test?
1. If the debtor has been convicted of a violent crime or a drug-trafficking
offense, the victim can file a motion to dismiss the voluntary petition.6
2. If the debtor fails to pay postpetition domestic-support obligations (which
include child and spousal support), the court may dismiss the petition.
Order for Relief If the voluntary petition for bankruptcy is found to
be proper, the filing of the petition will itself constitute an order for
relief. (An order for relief is the court’s grant of assistance to a debtor.)
5. In re Buoy, ___ Bankr. ___, 2017 WL 3194755 (N.D. Ohio 2017).
6. Note that the court may not dismiss a case on this ground if the debtor’s bankruptcy is necessary to satisfy a claim for a domestic-support obligation.
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CHAPTER 26: Bankruptcy
Once a consumer-debtor’s voluntary petition has been filed, the clerk of the court (or other
appointee) must give the trustee and creditors notice of the order for relief by mail not more
than twenty days after the entry of the order.
26–2b Involuntary Bankruptcy
An involuntary bankruptcy occurs when the debtor’s creditors force the debtor into bankruptcy proceedings. An involuntary petition cannot be filed against a charitable institution
or a farmer (an individual or business that receives more than 50 percent of its gross income
from farming operations).
An involuntary petition should not be used as an everyday debt-collection device. The
Code provides penalties for the filing of frivolous (unjustified) petitions against debtors.
If the court dismisses an involuntary petition, the petitioning creditors may be required to
pay the costs and attorneys’ fees incurred by the debtor in defending against the petition. If
the petition was filed in bad faith, damages can be awarded for injury to the debtor’s reputation. Punitive damages may also be awarded.
Requirements For an involuntary action to be filed, the following requirements must
be met:
1. If the debtor has twelve or more creditors, three or more of those creditors having unsecured claims
totaling at least $15,775 must join in the petition.
2. If the debtor has fewer than twelve creditors, one or more creditors having a claim of $15,775 or more
may file.7
Order for Relief If the debtor challenges the involuntary petition, a hearing will be held.
“I hope that after I die,
people will say of me:
‘That guy sure owed
me a lot of money.’”
Jack Handey
1949–present
(American humorist)
The bankruptcy court will enter an order for relief if it finds either of the following:
1. The debtor generally is not paying debts as they become due.
2. A general receiver, assignee, or custodian took possession of, or was appointed to take charge
of, substantially all of the debtor’s property within 120 days before the filing of the involuntary
petition.
If the court grants an order for relief, the debtor will be required to supply the same information in the bankruptcy schedules as in a voluntary bankruptcy.
26–2c Automatic Stay
The moment a petition, either voluntary or involuntary, is filed, an automatic stay, or suspension, of almost all actions by creditors against the debtor or the debtor’s property normally
goes into effect. Until the bankruptcy proceeding is closed or dismissed, the automatic stay
prohibits a creditor from taking any act to collect, assess, or recover a claim against the debtor
that arose before the filing of the petition.
If the debtor had two or more bankruptcy petitions dismissed during the prior year, the
Code presumes bad faith. In such a situation, the automatic stay does not go into effect until
the court determines that the petition was filed in good faith.
If a creditor knowingly violates the automatic stay (a willful violation), any injured party,
including the debtor, is entitled to recover actual damages, costs, and attorneys’ fees and may
be entitled to punitive damages as well. Example 26.2 Richard Anderson and his wife filed for
bankruptcy. One of the debts listed on their Chapter 7 schedule was a JCPenney credit card
with a balance of $630. Even after it is notified of the bankruptcy, Recovery Management
Automatic Stay In bankruptcy proceedings, the suspension of almost
all litigation and other actions by
creditors against the debtor or the
debtor’s property. The stay is effective
the moment the debtor files a petition
in bankruptcy.
7. 11 U.S.C. Section 303. The amounts stated in this chapter are in accordance with those computed on April 1, 2016. The dollar amounts are
adjusted every three years on April 1.
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UNIT THREE: Commercial Transactions
Systems Corporation (RMSC), a debt collection service, continues to send letters to Richard
Anderson in an attempt to collect the balance on the card. In this situation, RMSC is willfully
violating the automatic stay. The Andersons are entitled to seek actual damages, costs, attorneys’ fees, and even punitive damages for RMSC’s conduct. ■ (See this chapter’s Business
Law Analysis feature for further clarification.)
Adequate Protection Doctrine
A doctrine that protects secured
creditors from losing the value of
their security (because the collateral
depreciates, for instance) as a result
of an automatic stay in a bankruptcy
proceeding.
The Adequate Protection Doctrine Underlying the Code’s automatic-stay provision for
a secured creditor is a concept known as adequate protection. The adequate protection doctrine,
among other things, protects secured creditors from losing their security as a result of the
automatic stay. The bankruptcy court can provide adequate protection by requiring
the debtor or trustee to make periodic cash payments or a one-time cash payment. If the
stay may cause the value of the property to decrease, the court can also require the debtor
or trustee to provide additional collateral or replacement liens.
Exceptions to the Automatic Stay The Code provides the following exceptions to the
automatic stay:
1. Collection efforts can continue for domestic-support obligations, which include any debt owed to or
recoverable by a spouse, a former spouse, a child of the debtor, that child’s parent or guardian, or a
governmental unit.
2. Proceedings against the debtor related to divorce, child custody or visitation, domestic violence, and
support enforcement are not stayed.
3. Investigations by a securities regulatory agency can continue.
4. Certain statutory liens for property taxes are not stayed.
Requests for Relief from the Automatic Stay A secured creditor or other party in
interest can petition the bankruptcy court for relief from the automatic stay. If a creditor
Violations of the Automatic Stay
M
ichelle Gholston leased a Chevy
Impala from EZ Auto Van Rentals.
On November 8, Gholston filed for bankruptcy. On November 21, the bankruptcy
court notified EZ Auto of Gholston’s
bankruptcy and the imposition of an
automatic stay. Nevertheless, because
Gholston had fallen behind on her payments, EZ Auto repossessed the vehicle on
November 28.
Gholston’s attorney reminded EZ Auto
that it could not take this action because
of the automatic stay, but the company
failed to return the car. As a result of the
car’s repossession, Gholston suffered
damages that included emotional distress,
lost wages, attorneys’ fees, and car rental
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expenses. Can Gholston recover from
EZ Auto?
Analysis: A debtor may be entitled to
recover damages if a creditor knowingly
or willfully violates the automatic stay.
The test is whether EZ Auto knew about
Gholston’s bankruptcy at the time it repossessed her car. The bankruptcy court and
the debtor’s attorney had, in fact, notified
EZ Auto about the bankruptcy and the
automatic stay a week before the car was
repossessed.
Result and Reasoning: Gholston can
recover damages because EZ Auto willfully
violated the automatic stay. EZ Auto repossessed the car even though it received
Business Law
Analysis
notice of the automatic stay from the bankruptcy court. In addition, EZ Auto refused
to return the car even after Gholston’s
attorney had reminded it of the stay. Thus,
EZ Auto knew about the automatic stay
and violated it willfully. Because Gholston
suffered direct damages as a result, she
can recover from EZ Auto. She may also
be awarded punitive damages for EZ Auto’s
wrongful conduct.
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or other party requests relief from the stay, the stay will automatically terminate sixty days
after the request, unless the court grants an extension or the parties agree otherwise.
Secured Property The automatic stay on secured property terminates forty-five days after
the creditors’ meeting unless the debtor redeems or reaffirms certain debts. (Creditors’ meetings and reaffirmation will be discussed later in this chapter.) In other words, the debtor
cannot keep secured property (such as a financed automobile), even if she or he continues to
make payments on it, without reinstating the rights of the secured party to collect on the debt.
26–2d Estate in Bankruptcy
On the commencement of a liquidation proceeding under Chapter 7, an estate in bankruptcy
is created. The estate consists of all the debtor’s interests in property currently held, wherever
located. The estate in bankruptcy includes all of the following:
1. Community property (property jointly owned by a husband and wife in certain states).
2. Property transferred in a transaction voidable by the trustee.
Darren Brode/Shutterstock.com
CHAPTER 26: Bankruptcy
If a collection agency knowingly
repossesses a car when there is
an automatic stay in effect, what
can a debtor do?
Estate in Bankruptcy All of the
property owned by a person, including real estate and personal property.
3. Proceeds and profits from the property of the estate.
Certain after-acquired property to which a debtor becomes entitled within 180 days
after filing may also become part of the estate. Such after-acquired property includes gifts,
inheritances, property settlements (from divorce), and life insurance death proceeds.
Generally, though, the filing of a bankruptcy petition fixes a dividing line. Property acquired
prior to the filing of the petition becomes property of the estate, and property acquired after
the filing of the petition, except as just noted, remains the debtor’s.
26–2e The Bankruptcy Trustee
Promptly after the order for relief has been entered, a trustee is appointed. The basic duty
of the trustee is to collect the debtor’s available estate and reduce it to cash for distribution,
preserving the interests of both the debtor and the unsecured creditors. This requires that the
trustee be accountable for administering the debtor’s estate. To enable the trustee to accomplish this duty, the Code gives the trustee certain powers. These powers must be exercised
within two years after the order for relief has been entered.
Review for Substantial Abuse The trustee is required to review promptly all materials
filed by the debtor to determine if there is substantial abuse. Within ten days after the first
meeting of the creditors, the trustee must file a statement as to whether the case is presumed
to be an abuse under the means test. The trustee must provide all creditors with a copy of
this statement.
When there is a presumption of abuse, the trustee must either file a motion to dismiss
the petition (or convert it to a Chapter 13 proceeding) or file a statement explaining why a
motion would not be appropriate. If the debtor owes a domestic-support obligation (such as
child support), the trustee must provide written notice of the bankruptcy to the claim holder
(a former spouse, for instance).
Trustee’s Powers The trustee has the power to require persons holding the debtor’s
property at the time the petition is filed to deliver the property to the trustee.8 To enable
the trustee to implement this power, the Code provides that the trustee has rights equivalent
to those of certain other parties, such as a creditor who has a judicial lien. This power of a
trustee, which is equivalent to that of a lien creditor, is known as the strong-arm power.
8. Usually, the trustee takes constructive, rather than actual, possession of the debtor’s property. For instance, to obtain possession of a business’s
inventory, a trustee might change the locks on the doors and hire a security guard.
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In addition, the trustee has specific powers of avoidance. They enable the trustee to set
aside (avoid or cancel) a sale or other transfer of the debtor’s property and take the property
back for the debtor’s estate. These powers apply to voidable rights available to the debtor,
preferences, and fraudulent transfers by the debtor (as discussed in more detail next). The
trustee can also avoid certain statutory liens.
The debtor shares most of the trustee’s avoidance powers. Thus, if the trustee does not take
action to enforce one of these rights, the debtor in a liquidation bankruptcy can enforce it.
turtix/Shutterstock.com
Voidable Rights A trustee steps into the shoes of the debtor. Thus, any reason that a
debtor can use to obtain the return of his or her property can be used by the trustee as well.
The grounds for recovery include fraud, duress, incapacity, and mutual mistake.
Example 26.3 Ben sells his RV trailer to Inga. Inga gives Ben a check,
knowing that she has insufficient funds in her bank account to cover
the check. Inga has committed fraud. Ben has the right to avoid that
transfer and recover the RV trailer from Inga. If Ben files for bankruptcy relief under Chapter 7, the trustee can exercise the same right
to recover the RV trailer from Inga, and the RV trailer becomes part of
the debtor’s estate. ■
Preferences A debtor is not permitted to make a property transfer
or a payment that favors—or gives a preference to—one creditor over
others. The trustee is allowed to recover such payments whether they
were made voluntarily or involuntarily.
To have made a recoverable preferential payment, an insolvent
debtor generally must have transferred property for a preexisting debt
Just before filing Chapter 7 bankruptcy, a debtor sells
during the ninety days before the filing of the petition in bankruptcy.
his RV trailer, but the buyer’s check is no good. What, if
The transfer must have given the creditor more than the creditor would
anything, can the trustee do to recover the RV trailer on
have received as a result of the bankruptcy proceedings. The Code
the debtor’s estate’s behalf?
presumes that the debtor is insolvent during the ninety-day period
before filing a petition.
Preference In bankruptcy proceedIf a preferred creditor (one who has received a preferential transfer from the debtor) has
ings, a property transfer or payment
sold the property to an innocent third party, the trustee cannot recover the property from the
made by the debtor that favors one
innocent party. The trustee can generally force the preferred creditor to pay the value of
creditor over others.
the property, however.
Preferred Creditor In the context
Preferences to Insiders. Sometimes, a creditor receiving a preference is an insider. An
of bankruptcy, a creditor who has
insider is any individual (such as a relative or partner), partnership, or corporation with
received a preferential transfer from
a close relationship with the debtor. In this situation, the avoidance power of the trustee is
a debtor.
extended to transfers made within one year before filing. (If the transfer was fraudulent, as
will be discussed shortly, the trustee can avoid transfers made within two years before filing.)
Insider In bankruptcy proceedings,
any individual, partnership, or corpoHowever, the trustee must prove that the debtor was insolvent at the time the earlier transfer
ration with a close personal or busioccurred.
ness relation with the debtor.
Transfers That Do Not Constitute Preferences. Not all transfers are preferences. To be a
preference, the transfer must be made in exchange for something other than current consideration. Most courts do not consider a debtor’s payment for services rendered within fifteen
days prior to the payment to be a preference. If a creditor receives payment in the ordinary
course of business, such as payment of last month’s cell phone bill, the trustee in bankruptcy
cannot recover the payment. In contrast, a transfer for a preexisting debt, such as a year-old
landscaping bill, would be a recoverable preference.
Case Example 26.4 David Tidd operated a business performing small home repairs as well
as house-building projects. Tidd and his son regularly purchased supplies for his business
on credit from S.W. Collins. Eventually, Tidd filed for Chapter 7 bankruptcy. Within ninety
days preceding his petition, Tidd had made four payments for materials to S.W. Collins,
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totaling $46,000. The trustee filed a motion seeking to avoid this transfer as a preference.
The court, however, concluded that the transfer was a substantially contemporaneous
exchange of value (current consideration) and not a preference. The payments were made
in the ordinary course of business. Therefore, the court found in Tidd’s favor and denied the
trustee’s motion.9 ■
In addition, the Code permits a consumer-debtor to transfer any property to a creditor
up to a total value of $6,425 without the transfer constituting a preference. Payments of
domestic-support debts do not constitute a preference. Neither do payments required under
a plan created by an approved credit-counseling agency.
Know This
Usually, when property is
recovered as a preference,
the trustee sells it and
distributes the proceeds
to the debtor’s creditors.
Fraudulent Transfers A trustee can avoid fraudulent transfers or obligations if (1) they
were made within two years of the filing of the petition or (2) they were made with actual
intent to hinder, delay, or defraud a creditor. Case Example 26.5 David Dearmond was a real
estate developer who owned interests in two development companies—Briartowne, LLC,
and Hillside, LLC. He also owned one-third of Bluffs of Sevier County, LLC, which operated
Bluff’s Bar & Grill. When Briartowne defaulted on a $623,499 promissory note, SmartBank
filed an action against Briartowne, Dearmond, and others.
Five months later, Dearmond sold Boyds Creek Market and Garage, a property he had
paid $400,000 for the previous year, to his fiancée, Patricia Harper, for $90,000. Two days
after that, Dearmond created two irrevocable trust agreements and transferred all of his
interest in Hillside and Bluffs of Sevier County into those trusts. The trusts named Harper
as the primary beneficiary. Although SmartBank obtained a judgment against Dearmond
(and the other owners of Briartowne), it was unable to collect from these assets.
A year and a half later, Dearmond filed a petition for bankruptcy. The trustee filed a
motion seeking to avoid the fraudulent transfers made to benefit Harper. Harper claimed
that Dearmond had given her the interest in Hillside as a wedding present. The court concluded that the transfers should be set aside because they were made with actual intent to
hinder, delay, or defraud a creditor. Therefore, the trusts no longer owned the properties.
The court entered judgment for the trustee in an amount equivalent to the value of the
fraudulent transfers.10 ■
26–2f Exemptions
Federal Exemptions The Bankruptcy Code exempts the following
property up to a specified dollar amount that changes automatically
every three years:
1. A portion of equity in the debtor’s home (not to exceed $160,37511 under the
federal homestead exemption, even if state law would permit a higher
amount).
2. Motor vehicles, up to a certain value (usually just one vehicle).
3. Reasonably necessary clothing, household goods and furnishings, and household appliances (the aggregate value not to exceed a specified amount).
4. Jewelry, up to a specified value.
5. Tools of the debtor’s trade or profession, up to a specified value.
Jeff Greenberg/Universal Images Group/Getty Images
An individual debtor is entitled to exempt certain property from the
bankruptcy under federal or state exemption schemes.
During bankruptcy proceedings, when can a trustee claim
that the sale of a restaurant was a fraudulent transfer?
9. In re Tidd, ___ Bankr. ___, 2017 WL 4011014 (D.Me. 2017).
10. In re Dearmond, 2017 WL 4220396 (Bankr. E.D.Tenn. 2017).
11. The amounts stated in this chapter are in accordance with those computed from the Consumer Price Index as of April 1, 2016.
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6. A portion of unpaid but earned wages.
7. Pensions.
8. Public benefits, including public assistance (welfare), Social Security, and unemployment compensation, accumulated in a bank account.
9. Damages awarded for personal injury, up to a specified amount.
Property that is not exempt under federal law includes bank accounts, cash, family heirlooms, collections of stamps and coins, second cars, and vacation homes.
Limitations on the Homestead Exemption Probably the most familiar real property
exemption is the homestead exemption, the purpose of which is to ensure that the debtor will
retain some form of shelter. Each state permits the debtor to retain the family home, either
in its entirety or up to a specified dollar amount. The Bankruptcy Code limits
the amount that can be claimed in bankruptcy under the homestead exemption of any state, however. In general, if the debtor acquired the home within
three years and four months preceding the date of filing, the maximum equity
exempted is $160,375, even if state law would permit a higher amount.
In addition, the state homestead exemption is available only if the debtor has
lived in the state for two years before filing the petition. A debtor who has violated
securities law, been convicted of a felony, or engaged in certain other intentional
misconduct may not be permitted to claim the homestead exemption at all.
StanRohrer/Getty Images
Homestead Exemption A law permitting a debtor to retain the family
home, either in its entirety or up to
a specified dollar amount, free from
the claims of unsecured creditors or
trustees in bankruptcy.
State Exemptions Individual states have the power to pass legislation precluding debtors
from using the federal exemptions within the state. A majority of the states have done this.
In those states, debtors may use only state, not federal, exemptions. In the rest of the states,
an individual debtor (or a husband and wife filing jointly) may choose either the exemptions provided under state law or the federal exemptions.
26–2g Creditors’ Meeting and Claims
How does the homestead exemption help debtors
who go into bankruptcy?
Within a reasonable time after the order of relief has been granted (not more
than forty days), the trustee must call a meeting of the creditors listed in the
schedules filed by the debtor. The bankruptcy judge does not attend this
meeting, but the debtor must attend and submit to an examination under oath. At the meeting, the trustee ensures that the debtor is aware of the potential consequences of bankruptcy
and the possibility of filing under a different chapter of the Code.
To be entitled to receive a portion of the debtor’s estate, each creditor normally files a proof
of claim with the bankruptcy court clerk within ninety days of the creditors’ meeting. The
proof of claim lists the creditor’s name and address, as well as the amount that the creditor
asserts is owed to the creditor by the debtor.
When the debtor has no assets—called a “no-asset case”—creditors are notified of the debtor’s petition for bankruptcy but are instructed not to file a claim. In no-asset cases, the unsecured creditors will receive no payment, and most, if not all, of these debts will be discharged.
26–2h Distribution of Property
The Code provides specific rules for the distribution of the debtor’s property to secured and
unsecured creditors. If any amount remains after the priority classes of creditors have been
satisfied, it is turned over to the debtor.
Distribution to Secured Creditors Secured creditors have priority. The Code requires
that consumer-debtors file a statement of intention with respect to the secured collateral.
They can choose to pay off the debt and redeem the collateral, claim that it is exempt, reaffirm the debt and continue making payments, or surrender the property to the secured party.
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619
If the collateral is surrendered to the secured party, the secured creditor can either (1) accept
the collateral in full satisfaction of the debt or (2) sell the collateral and use the proceeds to
pay off the debt. Thus, the secured party has priority over unsecured parties as to the proceeds
from the disposition of the collateral. Should the collateral be insufficient to cover the secured
debt owed, the secured creditor becomes an unsecured creditor for the difference.
There are limited exceptions to these rules. For instance, certain unsecured creditors can
sometimes step into the shoes of secured tax creditors in Chapter 7 liquidation proceedings.
In such situations, when the collateral securing the tax claims is sold, the unsecured creditors
are paid first. This exception does not include holders of unsecured claims for administrative
expenses incurred in Chapter 11 cases that are converted to Chapter 7 liquidations. In the
following case, the plaintiff argued that it should.
Case 26.1
In re Anderson
United States Court of Appeals, Fourth Circuit, 811 F.3d 166 (2016).
Background and Facts Henry Anderson filed a voluntary
petition in a federal bankruptcy court for relief under Chapter 11 of
the Bankruptcy Code (which governs reorganizations of the debtor’s
estate). The Internal Revenue Service (IRS) filed a proof of claim
against the bankruptcy estate for unpaid taxes of nearly $1 million.
This claim was secured by Anderson’s property. Stubbs & Perdue,
P.A., served as Anderson’s counsel. The court approved compensation of $200,000 to Stubbs for its services. These fees constituted
an unsecured claim against the estate for administrative expenses.
Later, Anderson’s case was converted to a Chapter 7 liquidation.
The trustee accumulated more than $700,000 for distribution to
the estate’s creditors—but this was not enough to pay the claims
of both the IRS and Stubbs. The trustee excluded Stubbs’s claim.
Stubbs objected. The court dismissed Stubbs’s objection. A federal
district court upheld the exclusion. Stubbs appealed, arguing that
the IRS’s claim should be subordinated to Stubbs’s claim for fees.
In the Words of the Court
Pamela HARRIS, Circuit Judge:
****
* * * Before any of the events at issue here, Section 724(b)(2)
* * * provided all holders of administrative expense claims, like
Stubbs, with the right to subordinate secured tax creditors in
Chapter 7 liquidations. But that statutory scheme was criticized
on the ground that it created perverse incentives, encouraging
Chapter 11 debtors and their representatives to incur administrative expenses even where there was no real hope for a successful
reorganization, to the detriment of secured tax creditors when
Chapter 7 liquidation ultimately proved necessary.
* * * Congress responded with a fix * * * to limit the class
of administrative expenses covered by Section 724(b)(2) * * *.
In order to provide greater protection for holders of tax liens
* * *, unsecured Chapter 11 administrative expense claims
would no longer take priority over secured tax claims in Chapter 7
liquidations. [Emphasis added.]
****
* * * The Bankruptcy Technical Corrections Act [BTCA] * * *
clarified that Chapter 11 administrative expense claimants do not
hold subordination rights under Section 724(b)(2).
* * * Eleven months later, the Debtor’s bankruptcy case converted from Chapter 11 to Chapter 7, implicating Section 724(b)
(2) for the first time.
****
* * * As a general rule, a court is to apply the law in effect at
the time it renders its decision. [Emphasis added.]
****
Stubbs argues, however, that it would be unjust to apply the
BTCA version of Section 724(b)(2) * * * to disallow payment on
its unsecured claim for Chapter 11 fees. Prior to the BTCA, Stubbs
contends, it was entitled to subordinate the IRS’s secured claim.
The problem with Stubbs’s argument is its premise: that Stubbs
held subordination rights under Section 724(b)(2) before the BTCA
was enacted * * * . Before the BTCA was enacted, Section 724(b)
(2) had no application to the Debtor’s case at all. It afforded Stubbs
no entitlement to subordinate the IRS’s secured tax claim for the
threshold reason that it simply did not apply in the Chapter 11
proceedings that began in this case * * * and did not end until
* * * eleven months after the BTCA’s passage. The pre-BTCA
(Continues)
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version of Section 724(b)(2) that Stubbs invokes, in other words,
never controlled this case.
Decision and Remedy The U.S. Court of Appeals for the
Fourth Circuit affirmed the dismissal of Stubbs’s claim. Under
Section 724(b)(2), “it is clear that Stubbs is not entitled to subordinate the IRS’s secured tax claim in favor of its unsecured claim
to Chapter 11 administrative expenses.”
Critical Thinking
tLegal Environment Why, as a general rule, should a court apply
the law that is in effect at the time the court renders its decision?
tEthical If Anderson had filed his initial bankruptcy petition
under Chapter 7, not under Chapter 11, the result would have been
different—Stubbs would have been able to subordinate the IRS
claim. Is this fair?
Distribution to Unsecured Creditors Bankruptcy law establishes an order of priority for
classes of debts owed to unsecured creditors, and they are paid in the order of their priority.
Each class must be fully paid before the next class is entitled to any of the remaining proceeds.
If there is any balance remaining after all the creditors are paid, it is returned to the debtor.
In almost all Chapter 7 bankruptcies, the funds will be insufficient to pay all creditors.
If there are insufficient proceeds to pay the full amount to all the creditors in a class, the
proceeds are distributed proportionately to the creditors in that class. Creditors in classes
lower in priority receive nothing. Claims for domestic-support obligations, such as child
support and alimony, have the highest priority among unsecured claims, so these debts
must be paid first. In almost all Chapter 7 bankruptcies, the funds will be insufficient to
pay all creditors. Exhibit 26–1 illustrates the collection and distribution of property in most
voluntary bankruptcies.
26–2i Discharge
From the debtor’s point of view, the primary purpose of liquidation is to obtain a fresh
start through the discharge of debts. A discharge voids, or sets aside, any judgment on a
discharged debt and prevents any action to collect it. Certain debts, however, are not dischargeable in bankruptcy. Also, certain debtors may not qualify to have all debts discharged
in bankruptcy. These situations are discussed next.
Exhibit 26–1 Collection and Distribution of Property in Most Voluntary Bankruptcies
Secured Creditors
Debtor’s
Nonexempt Property
Property Transferred in
Transactions Voidable
by the Trustee
Certain After-Acquired
Property
Proceeds and Profits
from All of the Above
Property of the Estate
Collected and
Distributed by the Trustee
Unsecured Creditors
t Domestic-Support Obligations
t Administrative Expenses
t Ordinary Business Expenses
t Wages and Salaries
t Employee Benefit Plans
t Certain Farmers and Fishermen
t Consumer Deposits
t Taxes and Fines
t Claims Resulting from Driving while Intoxicated
t General Creditors
Debtor
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CHAPTER 26: Bankruptcy
Debts That Are Not Dischargeable The most important claims that are not dischargeable under Chapter 7 include the following:
1. Claims for back taxes accruing within two years prior to bankruptcy.
2. Claims for amounts borrowed by the debtor to pay federal taxes or any nondischargeable taxes.
3. Claims against property or funds obtained by the debtor under false pretenses or by false
misrepresentations.
4. Claims by creditors who were not notified of the bankruptcy. These claims did not appear on the
schedules the debtor was required to file.
Know This
Often, a discharge in
bankruptcy—even under
Chapter 7—does not free
a debtor of all of her or
his debts.
5. Claims based on fraud or misuse of funds by the debtor or claims involving the debtor’s embezzlement or larceny.
6. Domestic-support obligations and property settlements.
7. Claims for amounts due on a retirement loan account.
8. Claims based on willful or malicious conduct by the debtor toward another or toward the property of
another.
9. Certain government fines and penalties.
10. Student loans, unless payment of the loans causes an undue hardship for the debtor and the
debtor’s dependents (when paying the loan would leave the debtor unable to maintain a minimal
standard of living, for instance).
Case Example 26.6 Anthony Mickletz owned a pizza restaurant that
employed John Carmello. One night after Carmello had finished his
shift, Mickletz called him back into the restaurant and accused him of
stealing. An argument ensued, and Mickletz shoved Carmello, causing him to fall and injure his back. Because Mickletz did not provide
workers’ compensation coverage as required by law, the state prosecuted him criminally. He was ordered to pay more than $45,000 in
restitution to Carmello for his injuries.
Carmello also filed a civil suit against Mickletz, which the parties
agreed to settle for $175,000. Later, Mickletz filed a petition for bankruptcy. Carmello argued that these debts were nondischargeable, and
the court agreed. The exceptions from discharge include any debts for
willful (deliberate or intentional) injury, and Mickletz’s actions were
deliberate.12 ■
stockyimages/Shutterstock.com
11. Consumer debts of more than $675 for luxury goods or services owed to a
single creditor incurred within ninety days of the order for relief.
A pizza restaurant owner intentionally injures one of his
employees, who then sues and is awarded damages by a
civil court. If the owner files for Chapter 7 bankruptcy, can his
debt to the injured worker be discharged? Why or why not?
12. In re Mickletz, 544 Bankr. 804 (E.D. Pa. 2016).
Ethical Issue
Should there be more relief for student loan defaults?
Outstanding student loan balances total $1.4 trillion nationally
and are growing by approximately $3,000 per second. About 20 percent of these loans are ninety
or more days’ delinquent or are in default. That is the highest delinquency rate among all forms of
debt, including credit cards, automobile loans, and mortgages. The average student loan debt is
more than $35,000. Any student borrower who has not made regular payments for nine months
is in default. The U.S. Department of Education can keep the debtor’s tax refund or garnish his
(Continues)
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or her paychecks or other federal benefits (such as disability benefits) without obtaining a court
order. The government can also sue to collect a judgment from the debtor’s bank accounts or place
a lien on real property.
Politicians and society are increasingly discussing student loan debt and the costs of higher education. Some are suggesting reducing the interest rates that can be charged and imposing student
loan debt forgiveness after a certain period of time, such as twenty years. Others advocate making
college education free or at least reducing the costs charged to certain students. Another proposal
is to prohibit the federal government from profiting from student loan debt (the government brings
in more than $41 billion a year from student loans). In addition, some are asking Congress to allow
federal student loans to be discharged in most bankruptcy proceedings, rather than only in cases
of undue hardship.
Reasons That a Court Can Deny a Discharge A bankruptcy court may also deny
the discharge based on the debtor’s conduct. Grounds for denial of discharge of the debtor
include the following:
1. The debtor’s concealment or destruction of property with the intent to hinder, delay, or defraud a creditor.
2. The debtor’s fraudulent concealment or destruction of financial records.
3. The granting of a discharge to the debtor within eight years prior to the filing of the petition.
4. The debtor’s failure to complete the required consumer education course.
5. Proceedings in which the debtor could be found guilty of a felony. (Basically, a court may not
discharge any debt until the completion of the felony proceedings against the debtor.)
When a discharge is denied under any of these circumstances, the debtor’s assets are still
distributed to the creditors. After the bankruptcy proceeding, however, the debtor remains
liable for the unpaid portions of all claims.
A discharge may be revoked (taken back) within one year if it is discovered that the debtor
acted fraudulently or dishonestly during the bankruptcy proceeding. If that occurs, a creditor
whose claim was not satisfied in the distribution of the debtor’s property can proceed with
his or her claim against the debtor.
Whether a bankruptcy court properly denied a discharge based on the debtors’ conduct
was the issue in the following case.
Case 26.2
In re Cummings
United States Court of Appeals, Ninth Circuit, 595 Fed.Appx. 707 (2015).
Pamela Cummings filed a petition for a Chapter
7 bankruptcy in a federal bankruptcy court.
After the debtors filed two amended versions
of the required schedules, the trustee asked
for additional time to investigate. The court
granted the request. The debtors then filed a
third amended schedule. In it, they disclosed
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Carterdayne/Getty Images
Background and Facts Clarence and
What constitutes a false oath in
Chapter 7 proceedings?
for the first time the existence of First Beacon
Management Company, a corporation that they
planned to use as part of their postbankruptcy
“fresh start.” The trustee then claimed that the
Cummingses’ failure to disclose their interest
in First Beacon as debtor property was a “false
oath relating to a material fact made knowingly
and fraudulently” in violation of the Bankruptcy
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CHAPTER 26: Bankruptcy
Code. The court agreed and denied the debtors a discharge. The
Bankruptcy Appellate Panel (BAP) affirmed the court’s decision.
The Cummingses appealed.
In the Words of the Court
MEMORANDUM.
****
Chapter 7 debtors Clarence Thomas Cummings and Pamela
K. Cummings appeal the judgment of the Bankruptcy Appellate
Panel (“BAP”) affirming * * * the bankruptcy court’s order denying
discharge on the ground that the debtors made false oaths * * * .
The bankruptcy court rejected the explanatory testimony of Mr.
Cummings as “not credible” and “beyond not credible” and the
BAP found that “there is ample evidence to support the bankruptcy
court’s findings.
****
* * * Debtors claim that the bankruptcy court failed to consider
other “voluminous independent and undisputed documentary
evidence” introduced at trial that, they assert, “completely
obliterated any suggestion of fraudulent intent.”
* * * These materials do not advance debtors’ claim of inadvertence [lack of intent] or otherwise suggest bankruptcy court error.
To the contrary, the documents corroborate the obviousness of
debtors’ fraud and the objective it advanced, [namely], to insulate
First Beacon Management Co., * * * the new corporate anchor
623
of their post-petition fresh start, from the stigma of bankruptcy.
[Emphasis added.]
****
Debtors’ eventual disclosure of their interest in First Beacon on
their third amended Schedule * * * does not negate their initial
fraud. To the contrary, the sequence of debtors’ filings substantiates the presence of fraud: they elected, twice, to amend their
Schedule * * * without adding First Beacon, and disclosed First
Beacon only after the issuance of an order granting the Trustee
additional time to investigate.
****
The Trustee fully carried its burden of proving by a preponderance of the evidence * * * that under the circumstances, debtors’
failure to disclose their interest in First Beacon as debtor property
was a “false oath” relating to a material fact made knowingly
and fraudulently.
Decision and Remedy The U.S. Court of Appeals for the
Ninth Circuit affirmed the ruling of the BAP. “The sequence of
debtors’ filings substantiates the presence of fraud.” Thus, the
debtors’ Chapter 7 petition was denied.
Critical Thinking
tEconomic Why would a debtor risk the denial of a discharge
to conceal assets? Discuss.
26–2j Reaffirmation of Debt
An agreement to pay a debt dischargeable in bankruptcy is called a reaffirmation agreement.
A debtor may wish to pay a debt—for instance, a debt owed to a family member, physician,
bank, or some other creditor—even though the debt could be discharged in bankruptcy. Also,
as noted previously, a debtor cannot retain secured property while continuing to make payments on the underlying debt without entering into a reaffirmation agreement.
Reaffirmation Agreement An
agreement between a debtor and a
creditor in which the debtor voluntarily agrees to pay a debt dischargeable in bankruptcy.
Procedures To be enforceable, the reaffirmation agreement must be made before the
debtor is granted a discharge. The agreement must be signed and filed with the court (along
with disclosure documents, as described next). Court approval is required when the debtor
is not represented by an attorney. Even when the debtor is represented by an attorney, court
approval may be required if it appears that the reaffirmation will result in undue hardship
to the debtor.
When court approval is required, a separate hearing will take place. The court will approve
the reaffirmation only if it finds that the agreement is consistent with the debtor’s best interests and will not result in undue hardship.
Required Disclosures To discourage creditors from engaging in abusive reaffirmation
practices, the law provides specific language for disclosures that must be given to debtors
entering reaffirmation agreements. Among other things, these disclosures explain that the
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debtor is not required to reaffirm any debt, but that liens on secured property, such as mortgages and cars, will remain in effect even if the debt is not reaffirmed.
The reaffirmation agreement must disclose the amount of the debt reaffirmed, the rate of
interest, the date payments begin, and the right to rescind. The disclosures also caution the
debtor: “Only agree to reaffirm a debt if it is in your best interest. Be sure you can afford
the payments you agree to make.”
The original disclosure documents must be signed by the debtor, certified by the debtor’s
attorney, and filed with the court at the same time as the reaffirmation agreement. A reaffirmation agreement that is not accompanied by the original signed disclosures will not be effective.
Case Example 26.7 The owner of a seafood import business, Howard Lapides, signed a
secured promissory note for $400,000 with Venture Bank for a revolving line-of-credit loan.
Part of the collateral for that loan was a third mortgage on the Lapideses’ home (two other
banks held prior mortgages). Eventually, Howard and his wife filed for Chapter 7 bankruptcy
protection, and their personal debts were discharged.
Afterward, Venture Bank convinced the Lapideses to sign a reaffirmation agreement by telling
them that it would refinance all three mortgages so that they could keep their house. The
Lapideses made twelve $3,500 payments to Venture Bank, but the bank did not refinance
the other mortgages, so they stopped making payments. Venture Bank filed suit, but a court
refused to enforce the reaffirmation agreement because it violated the Bankruptcy Code. The
agreement had never been signed by Lapideses’ attorney or filed with the bankruptcy court.13 ■
26–3
Chapter 11—Reorganization
The type of bankruptcy proceeding used most commonly by corporate debtors is the
Chapter 11 reorganization. In a reorganization, the creditors and the debtor formulate a plan
under which the debtor pays a portion of its debts and the rest of the debts are discharged.
The debtor is allowed to continue in business. Although this type of bankruptcy is generally
a corporate reorganization, any debtor (except a stockbroker or commodities broker) who
is eligible for Chapter 7 relief is normally eligible for relief under Chapter 11. Railroads are
also eligible.
Congress has established a “fast-track” Chapter 11 procedure for small-business debtors
whose liabilities do not exceed $2.56 million and who do not own or manage real estate.
The fast track enables a debtor to avoid the appointment of a creditors’ committee and also
shortens the filing periods and relaxes certain other requirements. Because the process is
shorter and simpler, it is less costly. (See the Linking Business Law to Corporate Management
feature for suggestions on how small businesses can prepare for Chapter 11.)
The same principles that govern the filing of a liquidation (Chapter 7) petition apply to
reorganization (Chapter 11) proceedings. The case may be brought either voluntarily or
involuntarily. The automatic-stay provision and its exceptions apply in reorganizations as
well, as do the provisions regarding substantial abuse and additional grounds for dismissal
(or conversion) of bankruptcy petitions.
26–3a Workouts
Workout An agreement outlining
the respective rights and responsibilities of a borrower and a lender
as they try to resolve the borrower’s
default.
In some instances, to avoid bankruptcy proceedings, creditors may prefer private, negotiated
adjustments of creditor-debtor relations, known as workouts. Often, these out-of-court agreements are much more flexible and thus conducive to a speedy settlement. Speed is critical
because delay is one of the most costly elements in any bankruptcy proceeding. Another
advantage of workout agreements is that they avoid the various administrative costs of bankruptcy proceedings.
13. Venture Bank v. Lapides, 800 F.3d 442 (8th Cir. 2015).
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What Can You Do to Prepare for
Chapter 11 of the Bankruptcy Code
expresses the broad public policy
a Chapter 11 Reorganization?
of encouraging commerce. To this
end, Chapter 11 allows a financially troubled business firm to petition for reorganization in bankruptcy while it is still solvent so that the firm’s business can continue. Small businesses, however, do
not fare very well under Chapter 11. Although some corporations that enter into Chapter 11 emerge
as functioning entities, only a small number of companies survive the process.
Linking
Business Law
To Corporate
Management
If you ever are a small-business owner contemplating Chapter 11 reorganization, you can improve
your chances of being among the survivors by planning ahead. To ensure the greatest possibility of
success, you should take action before, not after, entering bankruptcy proceedings. Discuss your
financial troubles openly and cooperatively with creditors to see if you can agree on a workout or
some other arrangement.
If you appear to have no choice but to file for Chapter 11 protection, try to persuade a lender
to loan you funds to see you through the bankruptcy. If your business is a small corporation,
you might try to negotiate a favorable deal with a major investor. For instance, a small business
could offer to transfer ownership of stock to the investor in return for a loan to pay the costs
of the bankruptcy proceedings and an option to repurchase the stock when the firm becomes
profitable again.
Consult with Creditors
Most important, you should form a Chapter 11 plan before entering bankruptcy proceedings. Consult
with creditors in advance to see what kind of plan would be acceptable to them, and prepare your
plan accordingly. Having an acceptable plan prepared before you file will expedite the proceedings
and thus save substantially on costs.
Blend Images/Alamy
Plan Ahead
What are some strategies a
small-business debtor can use to
prepare for Chapter 11?
Critical Thinking
Filing for bankruptcy under Chapter 11 may involve a time-consuming process. How might this affect
the likelihood that a firm will be able to negotiate some type of agreement with its creditors?
26–3b Best Interests of the Creditors
Once a petition for Chapter 11 has been filed, a bankruptcy court can dismiss or suspend
all proceedings in a case at any time if dismissal or suspension would better serve the interests of the creditors. Before taking such an action, the court must give notice and conduct a
hearing. The Code also allows a court, after notice and a hearing, to dismiss a reorganization
case “for cause” when there is no reasonable likelihood that the business can successfully
remain in operation. Similarly, a court can dismiss a Chapter 11 petition when the debtor’s
reorganization plan cannot be effected or when an unreasonable delay by the debtor may
harm the interests of creditors. A debtor whose petition is dismissed for these reasons can
file another Chapter 11 petition in the future.14
14. See 11 U.S.C. Section 1112(b).
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UNIT THREE: Commercial Transactions
26–3c Debtor in Possession
Debtor in Possession (DIP) In
Chapter 11 bankruptcy proceedings,
a debtor who is allowed to continue
in possession of the business and to
continue business operations.
Learning Objective 3
In a Chapter 11 reorganization, what is the role of the
debtor in possession?
On entry of the order for relief, the debtor in Chapter 11 generally continues to operate the
business as a debtor in possession (DIP). The court, however, may appoint a trustee (often
referred to as a receiver) to operate the debtor’s business if gross mismanagement of the
business is shown or if appointing a trustee is in the best interests of the estate.
The DIP’s role is similar to that of a trustee in a liquidation. The DIP is entitled to avoid
preferential payments made to creditors and fraudulent transfers of assets. The DIP can
also exercise a trustee’s strong-arm powers. The DIP has the power to decide whether to
cancel or assume prepetition executory contracts (contracts not yet performed) or unexpired leases.
Cancellation of executory contracts or unexpired leases can be of substantial benefit to
a Chapter 11 debtor. Example 26.8 Five years ago, APT Corporation leased an office building
for a twenty-year term. Now, APT can no longer pay the rent due under the lease and has
filed for Chapter 11 reorganization. In this situation, the debtor in possession can cancel
the lease so that APT will not be required to continue paying the substantial rent due for
fifteen more years. ■
26–3d Creditors’ Committees
As soon as practicable after the entry of the order for relief, a committee of unsecured creditors is appointed.15 The business’s supplier may serve on the committee. The committee can
consult with the trustee or the debtor concerning the administration of the case or the formulation of the plan. Additional creditors’ committees may be appointed to represent special
interest creditors. Generally, no orders affecting the estate will be entered without the consent
of the committee or a hearing in which the judge is informed of the position of the
committee.
As mentioned earlier, businesses with debts of less than $2.56 million that do not own or
manage real estate can avoid creditors’ committees. In these fast-track proceedings, orders
can be entered without a committee’s consent.
Know This
26–3e The Reorganization Plan
Chapter 11 proceedings
are typically prolonged
and costly. Whether a
firm survives depends
on its size and its ability
to attract new investors
despite its Chapter 11
status.
A reorganization plan is established to conserve and administer the debtor’s assets in the
hope of an eventual return to successful operation and solvency. The plan must be fair and
equitable and must do the following:
1. Designate classes of claims and interests.
2. Specify the treatment to be afforded the classes. (The plan must provide the same treatment for all
claims in a particular class.)
3. Provide an adequate means for execution. (Individual debtors must utilize postpetition assets as
necessary to execute the plan.)
4. Provide for payment of tax claims over a five-year period.
The plan need not provide for full repayment to unsecured creditors. Instead, creditors
receive a percentage of each dollar owed to them by the debtor.
Filing the Plan Only the debtor may file a plan within the first 120 days after the date
of the order for relief. This period may be extended, but not beyond eighteen months from
the date of the order for relief. If the debtor does not meet the 120-day deadline or obtain
an extension, or if the debtor fails to obtain the required creditor consent (discussed next)
15. If the debtor has filed a plan accepted by the creditors, the trustee may decide not to call a meeting of the creditors.
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within 180 days, any party may propose a plan. If a small-business
debtor chooses to avoid a creditors’ committee, the time for the debtor’s filing is 180 days.
Acceptance and Confirmation of the Plan Once the plan has
zimmytws/iStock/Getty Images
been developed, it is submitted to each class of creditors for acceptance. For the plan to be adopted, each class must accept it. A class
has accepted the plan when a majority of the creditors, representing
two-thirds of the amount of the total claim, vote to approve it.
Even when all classes of creditors accept the plan, the court may
refuse to confirm it if it is not “in the best interests of the creditors.”
In addition, confirmation is conditioned on the debtor’s certifying
What are some basic criteria a bankruptcy court uses to
that all postpetition domestic-support obligations have been paid in
confirm a Chapter 11 reorganization plan?
full. For small-business debtors, if the plan meets the listed requirements, the court must confirm the plan within forty-five days (unless
this period is extended).
The plan can also be modified upon the request of the debtor, DIP, trustee, U.S. trustee,
or holder of an unsecured claim. If an unsecured creditor objects to the plan, specific rules
apply to the value of property to be distributed under the plan. Tax claims must be paid over
a five-year period.
Even if only one class of creditors has accepted the plan, the court may still confirm the
plan under the Code’s so-called cram-down provision. In other words, the court may confirm Cram-Down Provision A provision
the plan over the objections of a class of creditors. Before the court can exercise this right of of the Bankruptcy Code that allows a
court to confirm a debtor’s Chapter 11
cram-down confirmation, it must be demonstrated that the plan is fair and equitable.
Discharge The plan is binding on confirmation. Nevertheless, the law provides that
confirmation of a plan does not discharge an individual debtor. For individual debtors, the
plan must be completed before discharge will be granted, unless the court orders otherwise.
For all other debtors, the court may order discharge at any time after the plan is confirmed.
On completion of the plan, the debtor is given a reorganization discharge from all claims
not protected under the plan. This discharge does not apply to any claims that would be
denied discharge under liquidation.
26–4
reorganization plan even though
only one class of creditors has
accepted it.
Bankruptcy Relief under
Chapter 13 and Chapter 12
In addition to bankruptcy relief through liquidation (Chapter 7) and reorganization
(Chapter 11), the Code also provides for individuals’ repayment plans (Chapter 13) and
family-farmer and family-fisherman debt adjustments (Chapter 12).
26–4a Individuals’ Repayment Plan—Chapter 13
Chapter 13 of the bankruptcy code provides for the “adjustment of debts of an individual
with regular income.” Individuals (not partnerships or corporations) with regular income
who owe fixed unsecured debts of less than $394,725 or fixed secured debts of less than
$1,184,200 may take advantage of bankruptcy repayment plans.
Among those eligible are salaried employees and sole proprietors, as well as individuals
who live on welfare, Social Security, fixed pensions, or investment income. Many smallbusiness debtors have a choice of filing under either Chapter 11 or Chapter 13. Repayment
plans offer some advantages because they are typically less expensive and less complicated
than reorganization or liquidation proceedings.
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Learning Objective 4
How does a Chapter 13
bankruptcy differ from
bankruptcy under Chapter 7
and Chapter 11?
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UNIT THREE: Commercial Transactions
Filing the Petition A Chapter 13 repayment plan case can be initiated only by the debtor’s
filing of a voluntary petition or by court conversion of a Chapter 7 petition (because of a
finding of substantial abuse, for instance). Certain liquidation and reorganization cases may
be converted to Chapter 13 with the consent of the debtor.16
A trustee, who will make payments under the plan, must be appointed. On the filing of
a repayment plan petition, an automatic stay takes effect. Although the stay applies to all or
part of the debtor’s consumer debt, it does not apply to any business debt incurred by the
debtor or to any domestic-support obligations.
Good Faith Requirement The Bankruptcy Code imposes the requirement of good faith
on a debtor in both the filing of the petition and the filing of the plan. The Code does not
define good faith, but if the circumstances as a whole indicate bad faith (such as when
a debtor lies about available assets), a court can dismiss a debtor’s Chapter 13 petition.
FuzzMartin/E+/Getty Images
The Repayment Plan A plan of rehabilitation by repayment must provide for the
How does good faith
play a role in Chapter 13
reorganization plans?
Know This
Courts, trustees, and
creditors carefully monitor Chapter 13 debtors. If
payments are not made, a
court can require that the
debtor explain why and
may allow a creditor to
take back the property.
following:
1. The turning over to the trustee of future earnings or income of the debtor as necessary for execution
of the plan.
2. Full payment through deferred cash payments of all claims entitled to priority, such as taxes.17
3. Identical treatment of all claims within a particular class. (The Code permits the debtor to list
co-debtors, such as guarantors or sureties, as a separate class.)
The repayment plan may provide either for payment of all obligations in full or for
payment of a lesser amount. The debtor applies the means test to determine the amount of
disposable income that is available to repay creditors. The debtor is allowed to deduct certain
expenses from monthly income to arrive at this amount.
The debtor must begin making payments under the proposed plan within thirty days after
the plan has been filed and must continue to make “timely” payments. If the debtor fails to
make timely payments or does not commence payments within the thirty-day period, the
court can convert the case to a liquidation bankruptcy or dismiss the petition.
The Length of the Plan. The length of the payment plan can be three or five years, depending on the debtor’s family income. If the debtor’s family income is greater than the median
family income in the relevant geographic area under the means test, the term of the proposed
plan must be three years.18 The term may not exceed five years.
Confirmation of the Plan. After the plan is filed, the court holds a confirmation hearing, at
which interested parties (such as creditors) may object to the plan. The hearing must be held
at least twenty days, but no more than forty-five days, after the meeting of the creditors. The
debtor must have filed all prepetition tax returns and paid all postpetition domestic-support
obligations before a court will confirm the plan.
The court will confirm a plan with respect to each claim of a secured creditor under any
of the following circumstances:
1. If the secured creditors have accepted the plan.
2. If the plan provides that secured creditors retain their liens until there is payment in full or until the
debtor receives a discharge.
3. If the debtor surrenders the property securing the claims to the creditors.
In addition, for a motor vehicle purchased within 910 days before the petition is filed, the
plan must provide that a creditor with a purchase-money security interest (PMSI) retains its
16. A Chapter 13 repayment plan may be converted to a Chapter 7 liquidation either at the request of the debtor or, under certain circumstances,
“for cause” by a creditor. A Chapter 13 petition may be converted to a Chapter 11 reorganization after a hearing.
17. As with a Chapter 11 reorganization plan, full repayment of all claims is not always required.
18. See 11 U.S.C. Section 1322(d) for details on when a court will find that the Chapter 13 plan should extend to a five-year period.
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CHAPTER 26: Bankruptcy
lien until the entire debt is paid. For PMSIs on other personal property, the payment plan
must cover debts incurred within a one-year period preceding the filing.
Discharge After the debtor has completed all payments, the court grants a discharge of
all debts provided for by the repayment plan. Generally, all debts are dischargeable except
the following:
1. Allowed claims not provided for by the plan.
2. Certain long-term debts provided for by the plan.
3. Certain tax claims and payments on retirement accounts.
4. Claims for domestic-support obligations.
5. Debts related to injury or property damage caused while driving under the influence of alcohol or drugs.
An order granting discharge is final as to the debts listed in the repayment plan. A creditor
that willfully continues to attempt to collect on a debt that a court has ordered discharged
under Chapter 13 is in violation of the law and can be sanctioned.19
In the following case, a Chapter 13 debtor’s domestic-support obligations were at issue.
Under the Bankruptcy Code, a debt constitutes a domestic-support obligation if it is “in the
nature of alimony, maintenance, or support.” Did a parent’s promise to pay his children’s
college expenses meet this requirement?
19. See, for example, In re Vanamann, 561 Bankr. 106 (D.Nev. 2017).
Case 26.3
In re Chamberlain
United States Court of Appeals, Tenth Circuit, 721 Fed.Appx. 826 (2018).
Background and Facts When Stephen and Judith
Chamberlain were divorced, their marital settlement agreement
included a “College Education” provision. Stephen promised to
“pay the costs of tuition, room and board, books, registration fees,
and reasonable application fees incident to . . . an undergraduate
college education” for each of their three children, Sarah, Kate,
and John. Stephen did not meet this obligation.
Judith obtained an order in a Maryland state court to enforce the
agreement and initiated an effort to collect. Stephen filed a petition
for bankruptcy under Chapter 13. Judith filed a creditor’s claim with
the bankruptcy court, contending that the college expenses were
domestic-support obligations and thus created priority claims that
had to be fully paid. The court agreed. Stephen appealed.
In the Words of the Court
Robert E. BACHARACH, Circuit Judge
****
* * * Stephen argued that his obligation to pay his children’s
college expenses did not constitute a domestic support obligation
because it was not “in the nature of * * * support.”
* * * The court properly conducted a dual inquiry to determine
whether these obligations involved support, looking first to the
intent of the parties at the time they entered into their agreement,
and then to the substance of the obligation.
* * * With respect to the initial issue of intent, the court appropriately considered [1] the language and structure of the college
expense obligation in the marital settlement agreement and [2] the
parties’ testimony regarding surrounding circumstances, including
the disparity in Stephen and Judith’s financial circumstances
at the time of the divorce.
The bankruptcy court found that the parties had intended
Stephen’s college expense obligation to constitute support
because [of the following:]
t the evidence established that Stephen and Judith had viewed
a college education as an important part of their children’s
upbringing,
t the couple had long intended to provide for the children’s
education, and
t this intent could not be carried out at the time of the divorce,
given the couple’s relative financial capabilities, without
Stephen assuming this obligation.
****
(Continues )
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UNIT THREE: Commercial Transactions
* * * In determining whether Stephen’s obligation involved
support, the bankruptcy court also considered the substance of
Stephen’s obligation. The critical question in determining whether
the obligation is, in substance, support is the function served
by the obligation at the time of the divorce. In turn, the function
of the obligation is affected by the parties’ relative financial
circumstances at the time of the divorce. [Emphasis added.]
Here, the bankruptcy court reasonably determined that Stephen
was the only parent financially able to pay for the children’s
college education. Thus, the court was justified in regarding
Stephen’s obligation, in substance, as support.
Decision and Remedy The U.S. Court of Appeals for the
Tenth Circuit affirmed the judgment of the bankruptcy court.
“Stephen’s college expense obligation was ‘in the nature of
support’ as required for a domestic support obligation under the
Bankruptcy Code.”
Critical Thinking
tLegal Environment Maryland law arguably does not
include postsecondary education expenses in the definition of
“child support.” Should this state law have governed the court’s
conclusion in the Chamberlain case? Why or why not?
tWhat If the Facts Were Different? Suppose that
the marital settlement agreement had obligated Stephen to
assume the mortgage debt on the family home. If all other facts
were the same, would the result have been different?
26–4b Family Farmers and Fishermen—Chapter 12
John Wollwerth/Shutterstock.com
To help relieve economic pressure on small farmers, Congress created Chapter 12 of the
Bankruptcy Code. In 2005, Congress extended this protection to family fishermen, modified
its provisions somewhat, and made it a permanent chapter in the Bankruptcy Code (previously, it had to be periodically renewed by Congress).
For purposes of Chapter 12, a family farmer is one whose gross income is at least 50 percent
farm dependent and whose debts are at least 50 percent farm related. The total debt must not
exceed $4,153,150. A partnership or a close corporation that is at least 50 percent owned by
the farm family can also qualify as a family farmer.20
A family fisherman is one whose gross income is at least 50 percent dependent on commercial fishing operations and whose debts are at least 80 percent related to commercial fishing.
The total debt for a family fisherman must not exceed $1,924,550. As with family farmers,
a partnership or close corporation can also qualify.
Under Chapter 12, what is the definition of a “family
fisherman”?
Filing the Petition The procedure for filing a family-farmer or familyfisherman bankruptcy plan is similar to the procedure for filing a repayment plan under Chapter 13. The debtor must file a plan not later than
ninety days after the order for relief has been entered. The filing of the
petition acts as an automatic stay against creditors’ and co-obligors’
actions against the estate.
A farmer or fisherman who has already filed a reorganization or
repayment plan may convert the plan to a Chapter 12 plan. The debtor
may also convert a Chapter 12 plan to a liquidation plan.
Content and Confirmation of the Plan The content of a plan under
Chapter 12 is basically the same as that of a Chapter 13 repayment plan.
Generally, the plan must be confirmed or denied within forty-five days
of filing. The plan must provide for payment of secured debts at the
20. Note that for a corporation or partnership to qualify for bankruptcy under Chapter 12, at least 80 percent of the value of the firm’s assets must
consist of assets related to the farming operation.
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CHAPTER 26: Bankruptcy
631
value of the collateral. If the secured debt exceeds the value of the collateral, the remaining
debt is unsecured.
For unsecured debtors, the plan must be confirmed if either (1) the value of the property
to be distributed under the plan equals the amount of the claim or (2) the plan provides
that all of the debtor’s disposable income to be received in a three-year period (or longer,
by court approval) will be applied to making payments. Completion of payments under the
plan discharges all debts provided for by the plan.
Practice and Review
Three months ago, Janet Hart’s husband of twenty years died of cancer. Although he had medical
insurance, he left Janet with outstanding medical bills of more than $50,000. Janet has worked
at the local library for the past ten years, earning $1,500 per month. Since her husband’s death,
Janet also has received $1,500 in Social Security benefits and $1,100 in life insurance proceeds
every month, giving her a monthly income of $4,100. After she pays the mortgage payment of
$1,500 and the amounts due on other debts each month, Janet barely has enough left over to buy
groceries for her family (she has two teenage daughters at home). She decides to file for Chapter 7
bankruptcy, hoping for a fresh start. Using the information provided in the chapter, answer the
following questions.
1. Under the Bankruptcy Code after the reform act, what must Janet do before filing a petition for
relief under Chapter 7?
2. How much time does Janet have after filing the bankruptcy petition to submit the required schedules? What happens if Janet does not meet the deadline?
3. Assume that Janet files a petition under Chapter 7. Further assume that the median family income
in the state in which Janet lives is $49,300. What steps would a court take to determine whether
Janet’s petition is presumed to be substantial abuse under the means test?
4. Suppose the court determines that no presumption of substantial abuse applies in Janet’s case.
Nevertheless, the court finds that Janet does have the ability to pay at least a portion of the medical
bills out of her disposable income. What would the court likely order in that situation?
Debate This
Rather than being allowed to file Chapter 7 bankruptcy petitions, individuals and couples should
always be forced to make an effort to pay off their debts through Chapter 13.
Key Terms
adequate protection doctrine 614
automatic stay 613
bankruptcy trustee 610
consumer-debtor 610
cram-down provision 627
debtor in possession (DIP) 626
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discharge 610
estate in bankruptcy 615
homestead exemption 618
insider 616
liquidation 610
order for relief 612
petition in bankruptcy 610
preference 616
preferred creditor 616
reaffirmation agreement 623
U.S. Trustee 611
workout 624
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UNIT THREE: Commercial Transactions
Chapter Summary: Bankruptcy
The Bankruptcy
Code
1. Goals of bankruptcy law—The law attempts to balance the rights of the debtor and the creditors by giving the
debtor a fresh start and ensuring equitable treatment of creditors.
2. Bankruptcy courts—Bankruptcy proceedings are held in federal bankruptcy courts (under the authority of
U.S. district courts). They follow the Federal Rules of Bankruptcy Procedure. Bankruptcy court judges are
appointed for fourteen-year terms.
3. Types of bankruptcy relief—Chapter 7 provides for liquidation proceedings, Chapter 11 governs reorganizations, and Chapter 13 (for individuals) and Chapter 12 (for family farmers and family fishermen) provide for
adjustment of debts of parties with regular income.
4. Special treatment of consumer-debtors—The Bankruptcy Code requires that all consumer-debtors receive
written notice of the purpose, benefits, and costs of each chapter of bankruptcy, as well as information on
the types of services available from credit counseling agencies.
Issue
Chapter 7
Chapter 11
Chapters 12 and 13
Who Can Petition
Debtor (voluntary) or creditors
(involuntary).
Debtor (voluntary) or creditors
(involuntary).
Debtor (voluntary) only.
Who Can Be a
Debtor
Any “person” (including partnerships and corporations)
except railroads, insurance
companies, banks, savings and
loan institutions, investment
companies licensed by the U.S.
Small Business Administration,
and credit unions. Farmers and
charitable institutions cannot be
involuntarily petitioned.
Any debtor eligible for Chapter 7
relief; railroads are also eligible.
Chapter 12—Any family farmer (one
whose gross income is at least 50 percent
farm dependent and whose debts are at
least 50 percent farm related) or family
fisherman (one whose gross income is at
least 50 percent dependent on and whose
debts are at least 80 percent related to
commercial fishing) or any partnership or
close corporation at least 50 percent owned
by a family farmer or fisherman, when total
debt does not exceed a specified amount
($4,153,150 for farmers and $1,924,550 for
fishermen).
BANKRUPTCY—A COMPARISON OF CHAPTERS 7, 11, 12, AND 13
Chapter 13—Any individual (not partnerships or corporations) with regular income
who owes fixed (liquidated) unsecured
debts of less than $394,175 or fixed secured
debts of less than $1,184,200.
Procedure Leading Nonexempt property is sold
to Discharge
with proceeds to be distributed
(in order) to priority groups.
Dischargeable debts are
terminated.
Advantages
30301_ch26_hr_607-636.indd 632
On liquidation and distribution,
most debts are discharged, and
the debtor has an opportunity for
a fresh start.
Plan is submitted. If it is
approved and followed, debts
are discharged.
Plan is submitted and must be approved if
the value of the property to be distributed
equals the amount of the claims or if the
debtor turns over disposable income for a
three-year or five-year period. If the plan
is followed, debts are discharged.
Debtor continues in business.
Creditors can either accept the
plan, or it can be “crammed
down” on them. The plan allows
for the reorganization and
liquidation of debts over the plan
period.
Debtor continues in business or
possession of assets. If the plan is
approved, most debts are discharged
after the specified period.
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633
Issue Spotters
1. After graduating from college, Tina works briefly as a salesperson and then files for bankruptcy. As part of her petition, Tina reveals
that her only debts are student loans, taxes accruing within the last year, and a claim against her based on her misuse of funds during
her employment. Are these debts dischargeable in bankruptcy? Explain. (See Chapter 7—Liquidation.)
2. Ogden is a vice president of Plumbing Service, Inc. (PSI). On May 1, Ogden loans PSI $10,000. On June 1, the firm repays the loan. On
July 1, PSI files for bankruptcy. Quentin is appointed trustee. Can Quentin recover the $10,000 paid to Ogden on June 1? Why or why
not? (See Chapter 7—Liquidation.)
—Check your answers to the Issue Spotters against the answers provided in Appendix D at the end of this text.
Business Scenarios and Case Problems
26–1. Voluntary versus Involuntary Bankruptcy. Burke
has been a rancher all her life, raising cattle and crops. Her
ranch is valued at $500,000, almost all of which is exempt under
state law. Burke has eight creditors and a total indebtedness of
$70,000. Two of her largest creditors are Oman ($30,000 owed)
and Sneed ($25,000 owed). The other six creditors have claims
of less than $5,000 each. A drought has ruined all of Burke’s
crops and forced her to sell many of her cattle at a loss. She
cannot pay off her creditors. (See Chapter 7—Liquidation.)
1. Under the Bankruptcy Code, can Burke, with a $500,000
ranch, voluntarily petition herself into bankruptcy? Explain.
2. Could either Oman or Sneed force Burke into involuntary
bankruptcy? Explain.
26–2. Distribution of Property. Montoro petitioned himself into
voluntary bankruptcy. There were three major claims against his
estate. One was made by Carlton, a friend who held Montoro’s
negotiable promissory note for $2,500. Another was made by
Elmer, Montoro’s employee, who claimed that Montoro owed
him three months’ back wages of $4,500. The last major claim
was made by the United Bank of the Rockies on an unsecured
loan of $5,000. In addition, Dietrich, an accountant retained by
the trustee, was owed $500, and property taxes of $1,000 were
owed to Rock County. Montoro’s nonexempt property was liquidated, with proceeds of $5,000. Discuss fully what amount each
party will receive, and why. (See Chapter 7—Liquidation.)
26–3. Discharge in Bankruptcy. Like many students, Barbara
Hann financed her education partially through l…
