Bankruptcy Basics: The Chapters of Bankruptcy in a Nutshell

Filing for bankruptcy is more than merely filing a petition in court; the Bankruptcy Code provides for five different chapters under which a debtor can file. Much work has to be done before filing to select the appropriate chapter for the client as each chapter has its own unique rules and restrictions as well as pros and cons. Selecting the proper chapter, at times, can be more art than science. The purpose of this post is to introduce the various chapters of bankruptcy and some of the issues that go into deciding which chapter to file.

Who Can Be a Debtor?

Bankruptcy is not available to everyone. Certain entities, such as railroads, banks and insurance companies, are barred from filing for bankruptcy. Additionally, even if a person or entity can file for bankruptcy does not mean that every chapter is available. Only individuals can file under Chapter 12 and 13; Chapter 9 cases are exclusively for municipal government. Who or what can file bankruptcy and under which chapter is another topic for another time but it is worth mentioning early on.

Chapter 7

Chapter 7 is the “liquidation” chapter of bankruptcy[1]. When a debtor files for Chapter 7, his or her assets, at the date of filing, become part of a bankruptcy “estate.” The trustee, who is the person appointed to administer the case, will sort the debtor’s assets into exempt and non-exempt categories. This distinction is important for liquidation purposes as exempt assets are protected from the claims of creditors. As a quick example of an exemption, under Maine law a debtor can exempt $5,000 in equity in one car. Non-exempt assets, on the other hand, are collected by the trustee and sold, with the funds being distributed to creditors in full or partial payment of their claims. Exempt assets are released back to the debtor at the end of the case, when the debtor receives a discharge. More often than not Chapter 7 cases are “no-asset cases”, meaning that the debtor’s exemptions cover all of his or her property, leaving nothing for creditors[2]. A common misconception about bankruptcy is that debtors will lose all of their assets when filing under Chapter 7 but often that is not the case because of the exemptions.

This ability to protect most, if not all, of a debtor’s assets while getting an immediate discharge of any debts is what makes Chapter 7 the most attractive chapter to file but there is a one little hitch: the “means test”. The means test is designed to prevent certain debtors from filing Chapter 7, those have mostly consumer debts and who make more than the median income[3]. The ostensible purpose of Congress was to force those consumer debtors who have sufficient income to pay something back to creditors. Much ink has been spilled poking holes in the reasoning behind the means test (or in pointing out how the test can be gamed, rendering it useless for its purpose) but for now it is an impediment to anyone who wants to file Chapter 7.

Chapter 9

Chapter 9 covers municipal bankruptcies and thus unlikely to be of interest to the casual reader. This area of bankruptcy law has seen a great deal of activity in recent years with the bankruptcy filing by Detroit and San Bernadino.

Chapter 11

Chapter 11 is a “reorganization” chapter. Rather than liquidate all of the debtor’s non-exempt assets, in Chapter 11, the debtor proposes a plan to creditors on how creditors will be paid back, whether in whole or part. The plan can be a mixture of a payment plan or funded through the sale of assets, all of which is handled through the “confirmation process.” Confirmation is the actual means by which a plan is proposed to the creditors and approved. Failure to have a plan approved usually means the debtor will have to dismiss the case or convert to Chapter 7. Filing a Chapter 11 case is an expensive proposition and requires a great deal of expertise, so the typical Chapter 11 debtor tends to be a large corporation or an individual with significant income, who does not otherwise qualify for Chapter 7, 12 or 13.

Chapter 12 and 13

Also reorganization chapters, Chapters 12 and 13 are much less complicated than Chapter 11, though both are much more complicated than Chapter 7. Both chapters share similar procedures but they differ in which debtors can file for relief under each chapter. Chapter 12 is restricted to individuals who are farmers or fishermen while Chapter 13 is reserved for individuals who have regular income (meaning that the individual has a consistent source of income) and whose liabilities do not exceed certain debt limits: $383,175 in unsecured debts, like credit cards, and $1,149,525, in secured debts, like mortgages.

Like Chapter 11, the debtor will propose a plan and seek to have it confirmed (in Chapters 12 and 13, however, only the debtor can propose a plan). Once confirmed, the debtor contributes his or her disposable income, earned over the term of the plan, to the trustee to be paid to creditors; if during the plan’s term, the debtor receives an inheritance or other assets then this may have to be turned over to the trustee for payment to creditors. Plans under Chapter 12 can last up to 10 years while Chapter 13 plans by law cannot last more 5 years.

Structuring a plan in Chapter 12 and 13, even using the simplified procedures allowed to debtors, is still a complicated and time-consuming process which makes these chapter more expensive to handle than a Chapter 7 (though 10 times easier and cheaper than Chapter 11). As you can imagine, much can happen over the plan term and very often a debtor loses a job, gets divorced or gets hurt which makes regular plan payments impossible. I have been told the success rate for debtors completing their Chapter 13 plan is hovering just above 60%.

In spite of the difficulties in proposing and maintaining a plan in Chapter 12 and 13, there are many advantages for the debtor who can complete the plan. Here are just a few: first, the debtor can keep non-exempt assets, rather than surrendering them to the trustee, by paying the value of the asset into the plan; second, mortgage arrears can be paid, or “cured”, through the plan, without interest; third, any c0-debtors (someone who is liable along with the debtor) is protected by the automatic stay – meaning no collection action can be taken against them while the debtor is in bankruptcy. There are other benefits to filing Chapter 13 but these are some of the better ones. In my experience, though, most debtors prefer Chapter 7 over 13 and will resist filing Chapter 13. I believe this is due to the uncertainty with what can happen over a number of years that most turns people off. Still there are times when Chapter 13 (and Chapter 12, if you qualify) can be a great tool for obtaining debt relief.

Conclusion

Much more can be written about each chapter but this quick summary  explain some of the basics. In future posts, I intend to add more detail about Chapter 7 and 13 cases, as both of those chapters are the most common encountered for individuals debtors, my core clientele. Once you understand the basics of each chapter then you can see how bankruptcy can be used to help debtors get a fresh start.

[1] And the chapter most frequently used by debtors. In Maine, Chapter 7 cases make up the majority of filings in bankruptcy court. In 2015, 1,551 out of 1,867 cases were filed in the District of Maine were Chapter 7 cases, which comes out to 83% of the case filings. It is my understanding that across the states Chapter 7 cases far exceed other cases. Here is a link to the Bankruptcy Court for the District of Maine’s website: http://www.meb.uscourts.gov/meb/pdf/web_stats_2015.pdf

[2] Exemptions will be discussed in more detail in a later blog post.

[3] Exceeding the median income is not an immediate disqualification from filing Chapter 7 but it does make it much harder. I will be posting a much more in-depth discussion in the near future. You can find the median income for your state here: http://www.justice.gov/ust/eo/bapcpa/20151101/bci_data/median_income_table.htm