The Bankruptcy Courts administer the Bankruptcy Code, Title 11 of the United States Code (not to be confused with "Chapter 11.")
Kinds of Bankruptcies
There are 5 kinds of bankruptcy in the United States.
- Chapter 7 - Liquidation.
- Chapter 9 - Municipal reorganization
- Chapter 11 - Reorganization
- Chapter 12 - Family Farm Reorganization
- Chapter 13 - Personal Reorganization
All bankruptcies are also categories as business or individual, and Chapter 7 cases are classified either as "no asset" cases, or "asset" cases. Generally, bankruptcy cases are commenced voluntarily by the debtor, but in rare cases a group of creditors can collectively force a debtor into a "involuntary" Chapter 7 bankruptcy.
The vast majority of cases are either individual, "no asset" cases, or individual, Chapter 13 cases. Chapter 12 is a temporary Chapter of the bankruptcy code that is periodically renewed.
Bankruptcy Case Statistics
About 95%+ of all Chapter 7 cases, and two-thirds of all bankruptcy cases, are "no asset" cases where there is no distribution to creditors of any kind. Most of the remaining cases are Chapter 13 cases where the debtor owns a home and a car or two with little equity in any of them, and retains the home and car and perhaps some self-employment related assets in exchange for making up the amounts in default on the debts secured by those assets over several years, while making minimal payments on other debts. A large percentage of Chapter 13 plans are never completed, because the debtor is unable to make the payments agreed to in the Chapter 13 plan, and as a result eventually convert into Chapter 7 liquidations.
In 2002, for example, 69% of cases were non-business Chapter 7 cases (of which "asset" cases make up 3% or less of the total docket, while "no asset" cases make up 66% or more of the total docket, a handful (on the order of 0.1% of Chapter 7 cases) are "involuntary" cases), 29% were non-business Chapter 13 cases, and 2.5% were business cases. There were also 967 non-business Chapter 11 cases (0.06% of all cases and 8.2% of Chapter 11 cases). Of business cases 58% were Chapter 7 liquidations, 27% were Chapter 11 reorganizations, 14% were Chapter 13 reorganizations, and a little under 1% were Chapter 12 farm reorganizations. There were 8 municipal bankruptcies in 2002 nationwide. There were also 76 "Section 304" proceedings (extensions of foreign bankruptcy cases) nationwide in 2002. See Court Statistics.
Bankruptcy rates for individuals tend to closely follow per capita personal debt burdens. Bankruptcy rates for businesses tend to follow the business cycle. Municipal reorganizations are extremely rare, typically a handful each year.
The vast majority of bankruptcy cases are largely uncontested, simply going through mandatory hoops, like an interviews with the bankruptcy trustee and filing the proper paperwork, without any adversary litigation. About 3% of bankruptcy cases do involve adversary litigation, however. Adversary cases come overwhelmingly from business cases (particularly reorganizations), "asset" Chapter 7 cases, and non-business Chapter 11 cases. Moreover, Chapter 11 cases are an order of magnitude more involved than any other type of bankruptcy case. Publicly held companies that are unable to meet their obligations almost always file for bankruptcy under Chapter 11.
Basic Concepts in Bankruptcy Law
Different Kinds of Debts
Bankruptcy law treats different debts differently. The most fundamental divide is between secured and unsecured debts.
A secured debt is a debt whose collectability is enhanced by a right to seize a particular piece of property before any other creditors of the debtor can do so. Secured debts on real estate are typically called "mortgages" or "deeds of trust" or "liens" or "encumbrances." Secured debts in personal property are legally called "security interests" or "liens," although a variety of names such as "chattle mortgage" were used before this area of law was standardized by the Uniform Commercial Code, a model state law adopted in all 50 states. The most common kinds of personal property security interests are car loans, boat loans, airplane loans, and to the extent of a security deposit, deposits on leased real estate. Most other personal property security interests involve business loans secured by business assets. The property that helps a creditor collect a secured debt is called the collateral. A secured creditor's debts must be satisfied out of the collateral before any of the proceeds from the sale of the collateral can go to unsecured debtors.
If the value of the collateral is less than the value of the debt, the debt is broken into two debts for bankruptcy purposes, a secured and an unsecured part.
When a debtor and a creditor have mutual debts (i.e. each owes something to the other) the results are in many circumstances set off against each other, so that only the "net debt" is considered an "unsecured debt".
A debt that is not a secured debt is called an "unsecured debt". Alimony, child support, credit card debt, corporate bonds, unpaid bills (to the extent not secured by a security deposit), student loans, court judgments and tax debts (to the extent not converted into liens on property), and criminal fines are all unsecured debts.
Unsecured debts, in turn, are classified into two main types: Priority and non-priority debts. If there are assets to be distributed to unsecured creditors in a bankrupty, priority debts get paid first.
The priority debts are set forth in Section 507 of the bankruptcy code. They include: debts related to the administration of the bankruptcy itself (administrative expenses), a small amount of debts for unpaid employee compensation and payments to farmers and fishermen, security deposits owed to customers and tenants, alimony and child support, certain tax debts, certain debts to the FDIC and related bodies, and certain claims in involuntary bankruptcies.
Typical non-priority debts include credit card debts, corporate bonds, and unpaid bills.
As will be discussed later, unsecured debts are also classified as "discharageable" meaning that they can be eliminated in bankruptcy, and "non-dischargable" meaning that they can not be elminated in bankruptcy. Many, but not all, priority debts are also non-dischargable. Many, but not all, non-dischargable debts are also priority debts.
Assets, Property Rights and Contract Rights
The term "asset" is defined broadly in bankruptcy to include an economic benefit which may be owed to an individual. Accounts receivable, security deposits, and contract rights can all be assets in a bankruptcy.
Bankruptcy makes a distinction between property rights and contract rights. Generally, the property rights of people other than the debtor are not effected by a bankruptcy. For example, if Molly and Joe are co-owners of a house, and Joe goes bankrupt, his creditors can seize his interest in the house, but cannot disturb Molly's co-ownership.
Secured debts are consider "property rights" in the particular property, to the extent of a debt, and thus can't be eliminated in bankruptcy. Bankruptcy simply adjudicates the disposition of secured debts without eliminating them. In contrast, bankruptcy can completely eliminate or "discharge" contract rights which basically consist of all "unsecured debts", to the extent permitted by the bankruptcy code.
Outside bankruptcy the distinction between property rights and contract rights is also important. Taking someone's property is considered theft and can put you in jail. Breaking a contract is a "civil matter" for which you can be sued, but is not something that will land you in jail.
Each state has a list of property which creditors are not allowed to seize to collect their debts outside of bankruptcy. In some states this is more generous, in some states, this is stingy. Some of the items protected from seizure are quaint (e.g. one season's supply of seed corn). There is also a federal exempt property list which sometimes applies in bankruptcy is the debtor is able to make a valid election to have them rather than state exemptions apply to the case. The federal list is found at section 522 of the bankruptcy code.
The exemptions are typically broken up into a collection of exemptions for personal property, and a "homestead exemption". The personal property exemption typically covers basic household goods of minimal value, wedding rings, tools of the trade and medical aids. The homestead exemption is usually limited to a dollar amount of equity, which varies widely from state to state, although a few states (Florida and Texas are most well known for this) bar creditors from any effort to collect a debt from equity in a personal residence.
The Automatic Stay
The filing of a bankruptcy automatically causes the "automatic stay" (bankruptcy code section 362) to take effect, before any judge even looks at the case. This makes it illegal to take any collection effort of any kind against the debtor outside the bankruptcy court. The effect can be quite dramatic. Court cases can be stopped in mid-trial. Foreclosure sales can be stopped in the middle of an auction. Creditors aren't allowed to call or write letters to the debtor. Garnishments are set aside. All creditor activity must stop. All creditors than file "claims" with the bankruptcy court (except in "no asset" cases, where they are told not to bother to file a claim). Secured creditors and landlords may seek "relief from stay" in the bankruptcy court to get the property which partially belongs to them which the debtor is using for free back, if the property is not essential to the bankruptcy case.
Preferences and Avoidance Powers
Once a bankruptcy begins, part of the process is to maximize the assets available to creditors with claims. Two ways this is done are with the power to reclaim "preference payments" (section 547 of the bankruptcy code) and with the "avoidance power" (especially section 545 of the bankruptcy code).
A preference payment is an excess payment made to a creditor on a pre-existing debt. For example, suppose a debtor owed $10,000 to Visa and $10,000 to his brother. Both debts might have monthly payments of $400. If, on the eve of bankruptcy the debtor pays $8,000 to his brother and nothing to Visa, the bankruptcy court could make the brother return the $8,000 and would then divide the funds equally among all of the creditors in the estate. For third parties the "eve of bankruptcy" is defined to be 90 days, for insiders the "eve of bankruptcy" is defined to be one year.
The avoidance power invalidates any liens or security interest in real estate which would not hold up against a third party, even if the debtor himself would have been prevented from getting out of the lien. An avoidable lien is called an "unperfected security interest". The typical avoidable lien is a lien which the debtor agreed to in writing, but which was not recorded in the proper government office by the creditor. For example, a mortgage which the mortgage company forget to record with the clerk and recorder would be an avoidable lien.
Distributions of Non-Exempt Property
In a Chapter 7 bankruptcy, the secured creditors are paid first to the extent of their collateral, then exempt property is set aside for the debtor, then the priority creditors including administrative expenses (in order of priority) are paid, and anything left is distributed pro-rata (e.g. ten cents on the dollar) in proportion to the amount of the claim, to general unsecured creditors from remaining non-exempt property. Any debts that agreed in advance to be subordinated to other debts is paid last (few creditors so agree). In the unlikely event that unsecured creditors are paid in full (a "cash flow problem bankruptcy") then the remaining assets go back to the debtor.
In "no asset" cases, general unsecured creditors get nothing. Even in other kinds of cases, distributions of ten or twenty cents on the dollar are exceptionally high.
The distribution made in a Chapter 7 bankruptcy is used as a benchmark in Chapter 11 and Chapter 13 cases. Typically, if a creditor gets under a reorganization plan as much as he would have gotten in a Chapter 7 case, he is not allowed to object to that reorganization plan in Chapter 11 or Chapter 13.
Discharge and Exceptions To Discharge
When all the requirements for processing a case in Chapter 7 are completed, the debtor receives a "discharge" of all debts he doesn't have any assets to pay. Gross abuses of the bankruptcy process can result in the debt being denied any discharge of debts (see section 727 of the bankrupty code).
More commonly, all but a handful of a debtor's debts are elminated in bankruptcy by the discharge. Some debts require affirmative action by a creditor to be preserved, others are automatically preserved. The governing section of the bankruptcy code is section 523. But, many debts which can't be discharged in Chapter 7 or Chapter 11 can be discarged in Chapter 13 with what is called the "superdischarge" which encourages debtors to enter into a payment plan with creditors from future income (something not required in other kinds of bankruptcy).
The debts which cannot be discharged in bankruptcy in some circumstances include: certain tax debts, certain debts incurred by fraud, certain debts not identified in the bankruptcy process, alimony and child support, debts for willful injury to property, student loan debts, criminal fines, DUI related debts, certain FDIC related debts, certain other divorce related debts, and certain HOA dues.
The "superdischarge" in Chapter 13 of the bankruptcy code (section 1328(a) of the bankruptcy code) will generally elminate all debts except for debts affirmed as part of a Chapter 13 plan, criminal fines and restitution, alimony, child support, student loans and DUI debts. Thus, debtors with substantial non-exempt debts often choose a Chapter 13 bankruptcy.
One of the more graphic examples of how an exception to discharge can impact individuals is the position that Ohio has taken that even indigent defendants may be forced to pay court costs, notwithstanding a lack of clear statutory authorization for the costs. These debts cannot be discharged in bankruptcy.
The Economic Big Picture
Outside of bankruptcy, a creditor has several remedies which can generally be used for years after receiving a judgment (often 6-20 years depending on the state). The most common creditor remedies are "execution" and "garnishment". Garnishment is the right to seize wages up to the federally limited amount (typically 25% of compensation in excess of the minimum wage in non-domestic cases), plus bank accounts and other obligations third parties have to pay the debtor. Execution is the seizure of personal property or real estate owned by the debtor, typically preceded by imposition of a lien on the property in question. All states provide that some property is exempt from execution, but the states vary widely in their generosity.
Bankruptcy permits someone who otherwise would give up being productive because his or her situation is hopeless, sending most of the fruits of his or her labors to creditors to get a fresh start that makes working make sense again. It acts as a back stop to limit the harshness of unfair civil laws and economic arrangements. It is designed to make asset distributions of insolvent people more fair, and to salvage businesses that are fundamentally sound but over burdened with long term debt.
Outside of bankruptcy, debt collection works on a first come, first served basis. This is fine if the debtor has more assets than liabilities, and is simply unwilling to pay. But, if a debtor is insolvent and unable to pay everyone, then the first come, first served approach makes the ultimate distribution largely unrelated to how much each creditor was owed. Bankruptcy solves that problem. But, the small number of involuntary bankruptcies (which are largely begun to insure a more equitable distribution of assets) compared to voluntary bankruptcies, shows that the fresh start is much more important that relative fairness among creditors, in driving personal bankruptcies. People go bankrupt largely because it provides more protection from creditors than state law does.
Bankruptcy Law, Credit Markets and the Legal System
In many parts of bankruptcy law, there is room to be more or less generous towards the debtor. More or less property can be declared exempt. More or fewer debts can be excluded from the bankruptcy discharge. The automatic stay can have more or fewer exceptions which are easier or harder to take advantage of from the perspective of a creditor. In each of these debts the fundamental considerations are the ease with which a debtor can obtain a fresh start, the amount of return creditors receive from the change (i.e. how much of a difference it makes to them in getting their debts paid), and the impact the change has on the creditworthiness of people seeking credit given that they might go bankrupt later.
At one extreme, a bankruptcy law that made all assets exempt would discourage anyone from ever lending to anyone. All debts would become completely voluntary. Incidentally, this doesn't mean that lending would stop or that debtors would necessarily stop paying their creditors, and credit reporting would help creditors identify who was likely to pay them on a voluntary basis. At any given time probably 30-40% of the population has the ability to file for a no asset bankruptcy under Chapter 7, keep all of their assets, and discharge all of there debts, for just a few hundred dollars of total legal costs, yet the vast majority of those people do not file for bankruptcy even though many have thousands or tens of thousands of dollars of dischargable debts. But, the lack of creditworthiness of people in this situation also drives the legal loan sharking that results in payday loan operations charging triple digit annualized interest rates, rent to own operations and pawn shops on every corner in most poor neighborhoods in the United States, and at a more sophisticated level, a flourishing subprime mortgage market.
At the other extreme, a system in which creditors are allowed to seize the shirt off someone's back, even though it might only fetch a dollar or two at a yard sale held by a creditor who is owed hundreds of thousands of dollars, is simply punitive for no genuine economic purpose.
In between these extremes, a law that required people with more than median income to devote a portion of their income over the next three years to their creditors, for example, reduces the risk to creditors associated with lending to people with more than the median income, which, in theory, such cause credit to become available to those people on easier terms. For example, credit card interest rates to this class of people should, in theory, drop under that proposed set of bankruptcy laws.
The strictness of the bankruptcy law ripples through the entire civil legal system. When bankruptcy is easy to get, it doesn't make sense for an insolvent debtor to argue with a creditor in state court over whether he owes the creditor $10,000 or $100,000. The debtor is going to lose everything anyway, so it doesn't matter. On the other hand, if debts must be paid out of future income for decades (as they would have to be in the absence of a bankruptcy law), state court litigation over these issues could have a profound impact on the rest of the debtor's life. Thus, an overly loose bankruptcy system represents to some extent, a lack of faith in the accuracy of state court judgments, while an overly strict bankruptcy system may give undue importance to litigation results that may not really reflect the facts because the debtor's involvency made fighting over the merits to expensive to do properly.
This ripple effect is particular of concern in the area of Health Care. Medical providers routinely charge the uninsured far more than they do people with insurance, in hope of recovering the bad debts they incur. Right now, the impact of these unfairly high charges often doesn't matter much when they go unpaid, because many of the uninsured simply end up going bankrupt and discharging those debts in the end anyway. Indeed, the health care debts of the uninsured is one of the biggest factors driving a dramatic growth in personal bankruptcies. But, if bankruptcy laws are tightened, allowing medical providers to collect more of their fees from bankrupt debtors, then increasing attention needs to be given in the larger economic system to the fairness of the charges imposed by medical providers on the uninsured who typically do not engage in meaningful negotiation over price with medical cost before obtaining treatment.
Business bankruptcies for corporations have very different motivations than personal bankruptcies. It is not about protecting someone's personal dignity and giving them a fresh start. It is about forcing creditors to acknowledge a hopeless situation and allowing them to negotiate collectively to maximize value for them while keeping a business which would be viable, but for debt with some adjustments, alive, and thereby save jobs. Since senior management is among the group of people whose jobs are at stake, preserving those jobs is generally the primary motive to file for bankruptcy in the first place.
The risk in the business reorganization context is that keeping the business going may simply fritter away assets that could go to creditors on a business that will never be viable even without its debts, i.e. a fundamentally unprofitable venture. The smaller a business is, the less likely it is to succeed in a reorganization, as a general rule.
If a business will ultimately fail, it is in the interest of creditors to shut it down as soon as possible before there is any more bleading of assets. If a business will make it, the key point is to get the reorganization done right so as to maximize creditor value. Ideally, the bankruptcy system should quickly distinguish between businesses that merely have a cash flow problem, and businesses that are fundamentally unprofitable, and order the immediate liquidation of the later, while reorganizing the former.
Other key issues include balancing fairness to all creditors and a "what's done is done" attitude to fairness (particularly in the area of "preference" payments), how to regulate the compensation that goes to professional advisors in a bankruptcy, and how to avoid alienating creditors whose help will be needed in the future ("trade creditors"), while eliminating the burdens imposed by creditors who have already finished contributing to the business ("long term debt").
Issues and New Legislation
Several recent attempts have come very close to a major overhaul of the bankruptcy laws (even obtaining passage of similar bills in both houses of Congress) only to fail.
Some of the fundamental goals of all of these legislative attempts included:
- Requiring bankrupt Chapter 7 debtors with solid incomes to use their income as well as assets for a period of time to repay credits, at least if the payments would make a meaningful dent in the total amount owed. Most analysts predictions of the percentage of Chapter 7 cases which would be affected by these proposals in various forms are in the range of 2%-20% of Chapter 7 cases.
- Speeding up the ability of banks to repossess personal property and real estate subject to mortgages or other forms of secured credit in bankruptcy cases.
- Improving the ability of landlords to evict tenants who don't pay rent during a bankruptcy.
- Improving the ability of child support and alimony creditors to collect their debts.
- Narrowing the scope of the "superdischarge" for Chapter 13 debtors.
- Addressing a number of perceived abuses of the bankruptcy system such as serial bankruptcy filings, successive bankruptcy filings by multiple co-owners to prevent the foreclosure of a particular piece of real estate, and running up large credit card debts on the eve of bankruptcy.
- Increasing regulation of debtor's bankruptcy lawyers.
- Limiting the ability of debtors to move with a state with a generous homestead exemption and use assets to purchase an expensive home to thwart creditors.
- Increasing the efficiency with which small business reorganizations are handled.
- Overhauling bankruptcies for complex financial institutions, like hedge funds, which have many "net contracts" with other firms.
- Overhauling the foreign bankruptcy case rules.
Two major impediments to the passage of these bills were a deadlock over the treatment of judgments owed as a result of harm caused by abortion protestors who knowingly violated the law, and the treatment of creditors who engage in abusive practices. Senator Paul Wellstone of Minnesota, a major opponent of bankruptcy reform who broght some of these issues into the debate, died shortly before a pending election and so the Democratic caucus may have less of an organized opposition to bankruptcy reforms than it did in the past in the current Congress.
George W. Bush had stated the bankruptcy reforms will be an important part of his second term agenda. A Bush lead bankruptcy reform is likely to focus on making it harder for consumer debtors to receive discharges of their debts in bankruptcy, while leaving abuses such as the unlimited homestead exemptions found in Republican controlled Florida and Texas unaltered.
Progressive Outlooks on Bankruptcy Reform
Bankruptcy reform is not a simple issue, even when the goal is simply to carry out a progressive agenda (which, of course, is not the goal of bankruptcy reform under a conservative administration).
If bankruptcy provides too easy an escape from liability, than successful personal injury suits and other lawsuits such as those for civil rights violations and those involving consumer rights can become meaningless creating what commentators have described as a growing "Death of Liability".
On the other hand, bankruptcy laws which are too strict can impose needless hardship on working class debtors who are exploited by their lack of understanding of contractual relationships, frequently fail to fully protect their rights in State Courts because they can't afford lawyers, and are lured into taking out loans they are unable to pay with unreasonable loose credit standard of creditors who cater to them and often include draconian liabilities in the event of a default. Moreover, because working class debtors have generally precarious economic situations, the likelihood of a slight mishap forcing them into bankruptcy despite a lack of morally blameful conduct is significant.
Progressive Priorities in Consumer Bankruptcies
Generally speaking, progressives favor contraining generous homestead exemptions from creditors and other provisions of the bankruptcy code (such as unlimited exemptions for large pension plans) that allow even wealthy debtors to escape their debts.
Likewise, progressives tend to oppose provisions such a mandatory education programs, that can place significant economic hurdles in the way of the least affluent debtors, and provisions that push marginal bankrupts into homelessness or carlessness while in bankruptcy, which can often shift a bankrupt individual from a fresh sharp to an economic death spiral. Progressive are also wary of "luxury purchase" priorities intended to catch eve of bankruptcy spending splurges intended to defraud credit card companies which are sometimes defined so as to include legitimate and non-abusive debts as well.
Progressive also tend to favor changes in the bankruptcy law to disallow or give subordinate status to debts involving abusive or overreaching creditor practices, such as those involved with high interest payday and car title loans, pre-payment penalties, large residential lease termination liabilities, late fees, excessive default interest rate payments, debts of to creditors who engage in unfair consumer credit practices, or debts obtains with default judgments.
On the other hand, progressives don't necesarily oppose provisions that force individuals who have a substantial ability to pay to contribute to a bankruptcy estate out of their earnings, and generally support efforts to increas the ability of bankruptcy estates to recover funds from corporate insiders as preferences.
Progressive Priorities in Business Bankruptices
In the context of large Chapter 11 bankruptcies, progressives generally want ever effort to be made to preserve existing businesses and the jobs that come with them, but are also particularly concerned about the ability that Chapter 11 bankruptcies give companies to abrogate hard fought union labor agreements.
Progressives tend to favor efforts to prefer trade creditors, such as small suppliers for big businesses, and consumers and employees over long term debtors (such bond holders) who are ultimately wealthy individuals who took on the credit risks associated with the bonds much more knowingly than the non-financial creditors of a business.