Chapter III Some Bankruptcy Fundamentals

JurisdictionUnited States

III. Some Bankruptcy Fundamentals

A. Structure of the Code

You find bankruptcy law in the Bankruptcy Code, title 11 of the U.S. Code.3 There are nine chapters in the Bankruptcy Code, and six of them govern specific types of bankruptcy procedures. The most common of those six are:

• Chapter 7, for liquidation bankruptcy (typically used by individuals and small businesses). The debtor surrenders its assets,4 if it has any, and (usually) gets a discharge — in other words, it wipes out its unpaid debts. The trustee turns the assets into cash and distributes them among the debtor's creditors in accordance with the types of claims that the creditors have against the debtor or its assets.
• Chapter 13, for individual debtors with a regular income. The debtor gets to hold onto his assets. He pays some or all of his pre-bankruptcy debts out of post-bankruptcy earnings under a "plan" that lasts from three to five years. He will receive a discharge upon completion of the plan.
• Chapter 11, the chapter for "business reorganization" There is more to say about "reorganization" later, but for the moment, note that chapter 11 can encompass "big cases" like Enron, with millions, perhaps billions, in assets and claims, or it can encompass little cases like "Moe and his Backhoe," where the assets are Moe and the Backhoe, or sometimes just Moe alone. An individual may file for chapter 11 as well. Several entertainment figures, such as rapper 50 Cent, have done so.
• Three other chapters — 9, 12 and 15 — address more specialized problems, as mentioned mentioned briefly in the introduction.
• The last three chapters in this discussion — which are actually the first three in the Code — are chapters 1, 3 and 5, which set forth a basic framework and specify some rules for application in all chapters.

We will have more to say about particular chapters later, but here are some key bankruptcy concepts and some of the Code provisions that carry out those concepts:

• Eligibility (§ 109). There are different rules for each of the different chapters, and § 109 tells you who is eligible to file under each.
• The Automatic Stay (§ 362). The automatic stay goes into effect at the moment a bankruptcy petition is filed. It bars the creditor from doing just about anything the creditor would want to do to collect its claim. This might not seem fair to creditors who have taken an interest in some of the debtor's property as collateral for their loans. Those creditors may ask the court to grant relief from the stay.
• Discharge. A primary debtor goal in bankruptcy is to emerge from bankruptcy free of any liability for pre-bank-ruptcy debts. The mechanism that achieves this goal is the discharge. Section 727 authorizes the chapter 7 discharge. More importantly, it sets criteria for denying the discharge. In other words, if you flunk § 727, you do not get your discharge — and wanting the discharge is probably what brought you to bankruptcy in the first place. The result is that you lose your property and remain liable for pre-bank-ruptcy debts. There are also discharge rules in § 1328 (for chapter 13), § 1141 (for chapter 11), § 1228 (for chapter 12) and § 944 (for chapter 9).5
• Dischargeability. Section 523 itemizes some debts that are excepted from discharge. This section applies only to individuals. In other words, you may get the "general" discharge under § 727, but you will still have to pay some of your pre-bankruptcy debts, including spousal and child support, student loans and most back taxes.
• Priority. A basic rule of bankruptcy is that similarly situated creditors are treated equally. The Code deems some creditors more worthy than others, however. Several sections of the Code set forth the priority scheme. Section 726 sets forth the scale of priorities in a chapter 7 case. Within that scale is § 507, which establishes a ladder of priority for specific categories of claims. The § 507 priorities apply in chap-ters 11 and 13 as well as in chapter 7. Section 364 permits the court to allow "priming loans" ahead of the regular priorities, and § 510 gives the court the power to "subordinate" a claim (i.e., to push it further down the priority ladder).
• Plan Confirmation. A debtor in a chapter 11 or chapter 13 case must get the court to confirm its repayment plan in order to be discharged from pre-bankruptcy debts. Sections 1322 and 1325 tell you how to confirm a chapter 13 plan. Sections 1123 and 1129 tell you how to confirm a chapter 11 plan.

1. Chapter 7

a. In General

Chapter 7 — a.k.a. "straight bankruptcy" — is where a debtor goes just to get a discharge. The debtor must surrender its "nonexempt" property to the trustee, who will turn it into cash and use the proceeds to pay some or all of the pre-bankruptcy claims against the debtor. This is not quite as onerous a burden as it might appear, for two reasons.

First, the magic word is "nonexempt." All states have laws that allow individuals to keep some property as exempt from creditor execution. That means that a "general" creditor, or one that has not taken an interest in any of the debtor's property as collateral for its claim, cannot use the judicial process to seize and sell that property to satisfy its claim. The Bankruptcy Code also includes a list of exempt property, and debtors in a handful of states have a choice between bankruptcy and nonbankruptcy exemptions. By the time they get to bankruptcy, most of what many individual debtors have is exempt from the claims of general creditors.

Second, and more notable, the Code provides that under chapter 7, wages earned after the filing are not property of the estate [§ 541(a) (6)]. This rule is important because for most individual debtors, their capacity to earn is the most important piece of "property" they own.

Business entities may also file for chapter 7, but such an entity will do so only if it has given up any chance of continuing as a business. A business entity is not entitled to claim any property as exempt. Such an entity is also not entitled to a chapter 7 discharge, which is why an entity that files under chapter 7 ceases its existence under state law and goes out of business.

b. Eligibility: The 2005 Revolution

Until BAPCPA, filing for bankruptcy was a pretty straightforward matter. A debtor filled out the papers, filed them with the court and paid the fee, and that was that. There was a provision allowing dismissal for "substantial abuse," but in most districts, this was not a big deal, except perhaps to the extent that the court used it to bar high-income individual debtors from chapter 7.6

With BAPCPA, Congress changed all that by substantially ramping up the barriers to entry into chapter 7 for individuals. The precise purpose of the amendments is a matter of contention, but a possible outline goes something like this: Congress thought that lots of bankruptcy cases were being filed by individuals with substantial earnings in excess of their ordinary living expenses. The idea was to keep those debtors out of chapter 7 and to redirect them (as appropriate) into private workout programs or chapter 13.

The most visible (but probably not the most important) new barrier to entry is the "means test." The means test provides that a chapter 7 case should be dismissed if the debtor will have post-filing net income sufficient to pay some or all of her debts over the term of a five-year chapter 13 plan. Importantly, the means test applies only to individual debtors whose debts are primarily consumer debts. As set forth in § 707(b)(2) of the Code, the means test is mind-bog-glingly complex, but it is applied in several stages, and it is easier to understand if you understand those stages.

First, a debtor whose "current monthly income," multiplied by 12, is less than or equal to the median income for a family of comparable size in her state will pass the means test and will be permitted to file for chapter 7. This debtor is known as the "below-median" debtor. "Current monthly income" is a defined term in the Code and takes into account the debtor's average monthly income from all sources in the six-month period before she filed for bankruptcy. The median income for each state comes from the Census Bureau, and this number, as well as other numbers needed for the means test, can be found on the the U.S. Trustee Program's website.7 If the debtor is a "below-median" debtor, no additional calculations are needed, and the debtor can file for chapter 7.

If the debtor's current monthly income multiplied by 12 is greater than the median income for a family of comparable size in her state, she is an "above-median" debtor and additional calculations are needed to determine whether she can file for chapter 7. The debtor must calculate her net monthly income according to a formula provided by the Code. The Code tells a debtor what expenses may be deducted from her current monthly income, some of which are actual expenses, such as payments on secured debts like car loans and mortgages. Others are standard expenses based on Internal Revenue Service (IRS) guidelines. The standard expense numbers can be found on the U.S. Trustee Program's website.

Once you determine an above-median debtor's net monthly income, you then multiply that number by 60 to determine whether the debtor can file for chapter 7. If that amount is less than $7,700,8 she can stay in chapter 7 and get her discharge. If the net is more than $12,850,* she will not be permitted to stay in chapter 7. If the net is more than $7,700* but less than $12,850,* she can stay in chapter 7 if her net is less than 25 percent of all "nonpriority, unsecured" claims against the debtor. Nonpriority unsecured claims include things like credit card debt and debts for medical expenses.

There are many things to say about the means test, but one threshold question leaps to mind: Whatever possessed Congress to come up with a test so complicated? To answer this question, remember that a camel is a horse...

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