The overall objective of bankruptcy law is
to allow honest insolvent debtors to surrender most of their assets and obtain release from
their debts. A secondary purpose is to give creditors fair opportunity to share in the
debtor’s limited assets in proportion to their claims. Bankruptcy questions normally
emphasize when involuntary and voluntary proceedings can be conducted, the federal exemptions,
and the role of the trustee in bankruptcy, preferential transfers, priorities of the
creditors, and, conditions under which debts may be discharged in bankruptcy.
Although bankruptcy under Chapter 7 is emphasized on the CPA examination, you should also be
familiar with the other portions of this review. For example, Chapter 11 on business reorganizations
has received some increased treatment. Bankruptcy in general, is based mostly on
federal law. Bankruptcy provides a method of protecting creditors’ rights and granting
the debtor relief from his or her indebtedness. Debtor is permitted to have a fresh start
free of previous debt. Creditors are treated more fairly according to the priorities stated
in bankruptcy laws to effect an equitable distribution of debtor’s property.
There are three types of bankruptcy. They are Chapter 7, Chapter 11 and, Chapter 13.
Chapter 7 deals with liquidation, which is turning the majority of the debtor’s assets
into cash to pay debts. Any debtor may file for Chapter 7 except: railroads, banking institutions
and insurance companies. Chapter 11 deals with reorganization of debts. Usually businesses
who do not want to liquidate choose Chapter 11. However, most debtors who qualify for
Chapter 7 bankruptcy qualify for Chapter 11. Railroads may however, file under Chapter
11. Note that stockbrokers and commodity brokers are not eligible for Chapter 11. Chapter 13
deals with reorganization of debts primarily for individuals. Chapter 13 is similar to
Chapter 11, but more streamlined. Note that bankruptcy rules involve a modified
insolvency in the “equity sense” which means, debtor is not paying debts as they
become due. However the Bankruptcy Act uses insolvency in the “bankruptcy sense” which
means, liabilities exceed fair market value of all nonexempt assets.
This audio will provide instances which are alternatives to Bankruptcy Proceedings. Alternative
to bankruptcy proceedings creditors may choose to do nothing. This alternative is used when
expenses of collection exceeds what creditors could recover. Creditors may also expect the
debtor to pull through and not opt for the bankruptcy proceeding. Other alternative is
where creditors rush to satisfy their claims individually through legal proceedings. Bankruptcy
proceedings may result anyway in a legal proceeding, especially if some creditors are dissatisfied.
Receiverships provides for general administration of debtor’s assets by a court appointee
for benefit of all parties. Agreements can also be used to avoid bankruptcy such as composition
agreements with creditors whereby, creditors agree to accept less. Creditors who do not
agree may force debtor into bankruptcy proceeding. Filing the bankruptcy petition stays most
other legal proceedings. Filing effectively stops creditors, current and future, from
pursuing claims against the debtor, except in bankruptcy court. A stay does not apply
to actions concerning paternity, alimony, or child support. This is because; these matters
may be pursued outside the bankruptcy court. Consumer filers must receive credit counseling
from an approved agency within 180 days prior to filing the petition. Failure to obtain
a certificate of completion from counseling agency will result in a dismissal of the bankruptcy
petition. However, the credit counseling does not apply to debtors who are incapacitated,
disabled, or on active duty in a military zone. Consumers seeking a discharge of their
debts, under either Chapter 7 or 13, must also attend an approved financial management
course or their discharge, will be denied. Voluntary bankruptcy petition under Chapter
7 is a formal request by debtor for an order of relief. There is no minimum number of creditors
required to file for voluntary bankruptcy petition under Chapter 7. Involuntary bankruptcy
petition may also be filed with bankruptcy court by creditors requesting an order for
relief. Exempt from involuntary bankruptcy are persons owing less than $15,325, farmers
and charitable organizations. Note that bankruptcy is not available for deceased person’s estate,
but once bankruptcy has begun, it is not stopped if the bankrupt dies.
Voluntary bankruptcy petition is filed with the court along with a list of debtor’s
assets and liabilities. Petition may be filed by husband and wife jointly. Debtor is automatically
given an order of relief upon fling of voluntary bankruptcy petition. The Bankruptcy Abuse
and Protection Act of 2005, imposes criteria that a consumer debtor must meet to prove
that the debtor is not abusing the Bankruptcy Code. In other words, the law is trying to
assure that debtors with the ability to repay their debts are not declaring bankruptcy.
If the consumer debtor’s income falls below the state’s median income, then the presumption
of abuse is removed and the debtor may continue under Chapter 7. If the debtor’s income
exceeds the state’s median income, then the law presumes abuse unless the debtor’s
monthly income falls below certain dollar limits. Note that the law does permit the
deduction of monthly living expenses when calculating monthly income. Other special
circumstances such as a medical conditions or service in the armed forces are also considered.
If the debtor’s income exceeds the statutory amount and the debtor is unable to remove
the presumption of abuse, the debtor may proceed under Chapter 13 instead of Chapter 7.
If there are fewer than twelve creditors, a single creditor may file the involuntary
bankruptcy petition as long as his or her claim aggregates $15,325 in excess of any
security he or she may hold. If necessary, more than one creditor may join together to
have combined debts of more than $15,325 of unsecured claims. Note that in involuntary
bankruptcy proceedings claims must be undisputed. If there are twelve or more creditors, then
at least three must sign the involuntary bankruptcy petition and they must have claims that aggregate
$15,325 in excess of any security held by them. In this case claims subject to bona
fide dispute are not counted in above $15,325 tests. Thus claims must be undisputed in this
case too. Creditors who file petition in bankruptcy
may need to post a bond, which indemnifies debtor for losses caused by contesting petition.
This is generally to avoid frivolous petitions. Bankruptcy court may award damages including
attorneys’ fees to debtor who successfully challenges involuntary bankruptcy petition.
If petition was made in bad faith, punitive damages may also be awarded.
In involuntary bankruptcy proceeding an order for relief will be granted if the requirements
for filing are met, and the petition is uncontested; or the petition is contested; and the debtor
is generally not paying his or her debts as they become due; or during the 120 days preceding
the fling of the petition, a custodian was appointed or, a custodian took possession
of substantially all of the property of the debtor.
In chapter 11, the Goal is to keep financially troubled firm in business. In general, chapter
11 allows debtor to keep assets of business. Petition under chapter 11 can be initiated
by debtor voluntary or by creditors which will be involuntary. Chapter 11 is available
to individuals, partnerships, or corporations including railroads. Other entities which
are ineligible to be debtors under Chapter 7 are ineligible under Chapter 11 too.
In chapter 11, creditor’s committee is appointed after the order for relief is entered. This
committee essentially functions as the bankruptcy trustee. Committee is made up of unsecured
creditors only. If debtor’s management is capable of continuing business, no trustee
is appointed. If debtor’s management is not considered capable of running business,
then trustee is appointed to conduct business. Trustee may also be appointed if it is in
the best interest of the creditors. The Committee will create a reorganization plan; however,
the debtor has an exclusive right to file its own plan within 120 days after the order
for relief is entered into. A reorganization plan allows for continued
operation of business unless court orders otherwise. It provides for payment of part
or, all of debts over an extended period. Payment to creditors primarily comes primarily
from the future income. A reorganization plan must divide claims into classes of similar
claims, and claims within a class must be treated equally. Plan may also provide for
some creditors to receive stock in place of debt. Preferred shareholders may be converted
to common shareholders. Common shareholders may be forfeited. Typically, the claimants
receive a reduced amount. The reorganization plan needs approval of
over half of creditors in each committee that owed at least two thirds of the total debt
in that class, and acceptance of stockholders holding at least two third in amount of the
stock. Complete reorganization plan can still be approved by court if court determines plan
is fair even if some committees fail to approve it; called “cram down” power.
After court confirms plan and issues final decree, debtor is discharged from debts that
arose before confirmation of plan, except those agreed to continue under the recognized
plan and those exempted by law. Court may convert Chapter 11 reorganization into Chapter
7 straight bankruptcy if fairer. In Chapter 13, debt adjustment plans, most
individuals are eligible if debtor has a regular income, and o we unsecured debts of less than
$383,175, and owe secured debts of less than $1,149,525.
Chapter 13 bankruptcy proceeding is initiated when debtor files voluntary petition in bankruptcy
court. Creditors may not file involuntary petition under Chapter 13. Filing of petition
stays all collection and straight bankruptcy proceedings against debtor. In chapter 13,
debtor has exclusive right to propose plan. If debtor does not file plan, creditors may
force debtor into involuntary proceeding under Chapter 7. Plan will be confirmed or denied
by court without approval of unsecured creditors. However, unsecured creditors must receive
as much as they would get under Chapter 7, and either be paid in full, or have all debtor’s
disposable income committed to plan, and plan may put claims in different classifications
but, may not discriminate unfairly against any of designated classes and, each claimant
within same classification must receive same treatment. If debts to unsecured creditors
are not paid in full, plan must commit to payments for three years. If debtor’s monthly
income exceeds the state’s average median annual income, plan must make payment for
five years. Court must appoint trustee in Chapter 13 cases.
Debtor who is engaged in business may continue to operate that business subject to limitations
imposed by court. Completion of plan discharges debtor from debts dischargeable by law.
This audio will provide brief description of Chapter 7 bankruptcy proceedings.
The proceedings take place under the federal law. An order of relief is sought. Court appoints
interim trustee. Filing petition automatically stays other legal proceedings, except lawsuits
involving “family law”, against debtor’s estate until bankruptcy case is over or until
court orders otherwise. Debtor may regain property in possession of interim trustee
by fling court approved bond. Debtor furnishes a schedule of assets, their locations, and
a list of creditors. Claims of debtors are deemed allowed unless objected to, in which
case the court will determine their validity. Claims must be filed within six months of
first creditors’ meeting. Contingent and unliquidated claims are estimated. Note that
any attorneys’ fees above those ruled reasonable by court are disallowed when objected to by
creditors. Trustee may be elected by creditors in Chapter 7 proceeding. If no election is
requested by creditors, interim trustee appointed by court continues in the office. Trustee
has right to receive compensation for services rendered based on value of those services.
Trustee’s duties are to collect, liquidate, and distribute the estate, keeping accurate
records of all transactions. Note that trustee represents estate of bankrupt which is the
debtor. Property of the estate includes property presently
owned by debtor as of the filing date. It also includes property owed to debtor by third
parties that can be recovered by trustee. Property acquired by the estate after the
filing date of the petition is generally not part of the estate. However property received
by debtor within 180 days after filing of petition by inheritance, life insurance, property
settlement with spouse, is included in the estate. Income from property owned by estate
after petition is filed is a part of the estate. Exempt property is property that does not
go to the estate. Any interest in joint tenancy property, if those interests are exempt under
other non-bankruptcy law is an exempt property. Note that debtor usually has option of choosing
either exemptions under state law or exemptions under the Bankruptcy Code.
In general, trustee’s duty is to liquidate and sell assets owned to pay creditors based
on priorities. Thus trustee acquires all legal assets owed to estate for equitable distribution
to creditors. Trustee makes interim reports and presents final accounting of the administration
of the estate to the court. A trustee may take any legal action necessary to carry out
duties. Trustee may utilize any defense available to the debtor against third parties. Trustee
may also continue or cease any legal action started by the debtor for the benefit of the
estate. Trustee, with court approval, may employ professionals to assist trustee in
carrying out duties that require professional expertise. Employed professional must not
hold any interest adverse to that of debtor. Employed professional has right to receive
compensation for reasonable value of services performed. Note that reasonable fee is based
on amount and complexity of services rendered, not on size of estate. Trustee, with court
approval, can also act in professional capacity if capable and, be compensated separately
for professional services rendered. Trustee must within sixty days of the order for relief
assume or reject any executory contract, including leases, made by the debtor. Any executory
contract not assumed by the trustee is deemed rejected. Trustee must perform all obligations
on lease of a nonresidential property until lease is either assumed or rejected. Note
that rejection of a contract is a breach of contract and injured party may become an unsecured
creditor. Trustee may also assign or retain leases if good for bankrupt’s estate and
if allowed, under the lease and the state law. Rejection or assumption of lease is subject
to the court approval. Trustee may set aside liens if lien becomes
effective when bankruptcy petition is filed or when debtor becomes insolvent, if lien
is not enforceable against a bona fide purchaser when the petition is filed, and in the case
of a security interest, if not perfected before filing of bankruptcy petition. Trustee may
set aside transfers made within one year prior to the filing of the bankruptcy petition if
the transfer was made with intent to hinder, delay, or defraud any creditor. The debtor
need not be insolvent at time of transfer. Trustee may set aside transfers made within
one year prior to the fling of the bankruptcy petition if, debtor received less than a reasonably
equivalent value in exchange for such transfer or obligation, and, the debtor was insolvent
at the time, or became insolvent as a result of the transfer. Trustee may also set aside
preferential transfers of nonexempt property to a creditor made within the previous ninety
days prior to the filing of the petition. Preferential transfers are those made for
preexisting debts that enable the creditor to receive more than he or she would have
otherwise, under a Chapter 7 liquidation proceeding. Note that a preferential transfer includes
a security interest given by debtor to secure antecedent debt. Preferential transfers made
to insiders within the previous twelve months may also be set aside. Insiders are close
blood relatives, officers, directors, controlling stockholders of corporations, or general partners
of partnerships. Trustee cannot set aside preferential transfers in case of a contemporaneous
exchange between creditor and debtor, whereby debtor receives new value. Transfer made in
the ordinary course of business is also not a voidable preference and cannot be set aside.
A perfected security interest that arises from an ordinary course of business filed
within forty-five days of creation of the debt cannot be set aside by the trustee. A
security interest given by debtor to acquire property, which is perfected within ten days
after the security interest attaches cannot be set aside by the trustee. Trustee cannot
set aside consumer debts less than $650 and business debts less than $6,225.
When the bankruptcy trustee sets aside a transaction, the trustee places the parties back in their
original positions. Thus, trustee may be sued, or sue, on behalf of the estate.
Where claimant has a property right; property is turned over to claimant, because it is
not considered part of debtor’s estate. Reclamation is a claim against specific property
by a person claiming it to be his or hers. Trust claim is made by beneficiary for trust
property when the trustee is bankrupt. Secured claim is one when creditor has a security
interest. Secured claim status may be achieved by subrogation.
All claims must be filed within six months after the first creditors’ meeting. Timely
claims are deemed allowed unless a creditor objects. Contingent and unliquidated claims
may be estimated. Certain claims are not allowed if objected. They include unenforceable claims,
unmatured interest as of date of fling bankruptcy petition, claims that may be offset, property
tax claim in excess of the property value, insider or attorney claims in excess of reasonable
value of services as determined by court, alimony, maintenance, and support claims for
amounts due after bankruptcy petition is filed, landlord’s damages for lease termination
in excess of specified amounts, damages for termination of an employment contract in excess
of one year’s wages and certain employment tax claims.
Secured creditors are not a part of the priorities because they never become part of the bankrupt
estate. Valid security interests though, perfected prior to the filing of the bankruptcy petition,
supersede the bankruptcy trustee’s interest. Therefore, these secured creditors’ claims
must be satisfied first to see if there are any assets left over for the bankruptcy estate.
If the value of the collateral is sufficient to pay off the secured party, then any excess
will go to junior secured parties. If there is any money left after all secured parties
are paid, then the trustee may use that money as part of the estate to pay the general creditors.
If the value of the collateral is insufficient to satisfy the claim of the secured party,
the secured party will receive the money from the collateral and the remaining debt that
the secured party is owed will be treated as a general obligation. The secured party
must have a security interest in the specific collateral or the secured party has no priority
to the collateral. Unsecured creditors’ claims are paid in
full at each level of priority before any lower level is paid. If there are insufficient
assets to pay any given level, then assets are prorated at that level and the next levels
receive nothing. A discharge is the release of a debtor from
all his or her debts not paid in bankruptcy. The debtor has no further obligation even
for the debts that were not paid at all, or are partially paid. Creditors not paid are
prohibited from any further debt collection on the discharged debts. There are, however,
some non-dischargeable debts. Debtor must be an individual to be discharged. Business
organizations do not receive a discharge because they no longer exist; all of their assets
have been liquidated. Conversely, individual debtors need to be discharged to get a fresh
start. Debtor must be adjudged an “honest debtor” to be discharged. Discharge will
only be granted once every 8 years. Acts that bar discharge of all debts include
improper actions during bankruptcy proceeding, failing to satisfactorily explain any loss
of assets, refusing to obey court orders, removing or destroying property within twelve
months prior to filing of petition with intent to hinder, delay, or defraud any creditor,
destroying, falsifying, concealing, or failing to keep books of account or records unless
such act is justified under the circumstances and, “Substantial abuse” of bankruptcy
by individual debtor with primarily towards consumer debts. A preferential transfer does
not bar a discharge but can be set aside. Improper actions during bankruptcy proceeding
includes making false claims against the estate, concealing property, transfer of property
after filing with intent to defeat the law, making any false entry in or on any document
of account relating to bankrupt’s affairs. Note that these acts are also punishable by
fines and imprisonment. Debts Not Discharged by Bankruptcy include
taxes within three years of fling bankruptcy petition, loans for payment of federal taxes,
unscheduled debts unless creditor had actual notice of proceedings, alimony, separate maintenance,
or child support and liability due to theft or embezzlement. Debts arising from debtor’s
fraud about his or her financial condition or fraud in connection with purchase or sale
of securities are not discharged. Willful and or malicious injuries to a person or property
of another including intentional tort is not dischargeable, whereas unintentional torts
and breaches of contract are dischargeable. Congress amended Bankruptcy Code making it
more difficult for student loans to be discharged in bankruptcy. This was prompted because many
students have had large student loans to pay for tuition and living expenses. Upon graduation
some students have few assets and may be inclined to file for bankruptcy trying to get student
loans discharged. Student loans are defined by bankruptcy code to include those loans
made or guaranteed by units of government. It also includes loans for students made by
nongovernmental commercial institutions such as banks. Included in student loan are stipends,
scholarships or benefits given by educational institutions. Bankruptcy Code provides that
student loans can be discharged in cases of “undue hardship” to debtor and any dependants.
“Undue hardship” is defined very strictly so, he or she needs to show that payment of
the loan would negate payment of basic necessities of food or shelter. Cosigners such as parents
who guarantee family member’s student loan must meet same “undue hardship” test to
discharge obligation. Other debts not dischargeable by bankruptcy
include governmental fines or penalties imposed within prior three years of filing bankruptcy,
those debt from a prior bankruptcy proceeding in which the debtor waived discharge or was
denied discharge, any liability incurred by operating any vehicle, vessel or aircraft
while legally intoxicated, any debt from violation of securities laws including those under Sarbanes-Oxley
Act, debts owed to pension plans, profit sharing plans or similar employee plans and homeowner
association fees, condo fees, or cooperative fees.
To avoid the practice of “loading up on luxury goods” before bankruptcy, there is
a presumption of non-discharge ability for consumer debts to a single debtor under specified
conditions for luxury goods or services made within 60 days of filing, and for certain
cash advances based on consumer credit taken within 60 days of filing.
Discharge may be revoked if bankrupt committed fraud during bankruptcy proceedings unknown
to creditors seeking revocation, bankrupt acquired rights or title to property of estate
and fraudulently failed to report this, and bankrupt refused to obey lawful court order,
or refused to testify when not in violation of his or her constitutional
right against self-incrimination. Debtor may also promise to pay a debt that
will be discharged. However, the Code makes it difficult to reaffirm dischargeable debt.
To be enforceable, reaffirmation of dischargeable debt must conditions including that the reaffirmation
must take place before discharge is granted, reaffirmation must be approved by bankruptcy
court, and debtor is allowed sixty days to rescind reaffirmation once agreed to. Debtor
must have received appropriate warnings from the court or attorney on effects of reaffirmation,
and if reaffirmation also involves consumer debt not secured by real property, court must
approve a new agreement as being in best interests of debtor and not imposing undue hardship
on debtor. The Bankruptcy Abuse Prevention and Consumer
Protection Act of 2005 Amends various parts of United States Bankruptcy Code including
consumer bankruptcies and business bankruptcies. Provisions under the Bankruptcy Abuse Prevention
and Consumer Protection Act of 2005 allow trade creditors to treat large portions, sometimes
most or even all of vendors’ claims as being administrative expenses, significantly increasing
their priority status. This Act creates a new Bankruptcy Code section that imposes,
limits on the payment of severance pay or retention bonuses to key employees as in a
Chapter 11 case. Retention bonuses are permitted only if key employees have good-faith offers
from other businesses at the same or greater compensation.
For consumer cases, the time between discharges has been increased by 2005 Act. So Bankruptcy
Code will deny discharge to a Chapter 7 debtor if that debtor received either a Chapter 7
or Chapter 11 discharge in a case filed within 8 years of filing of pending case. Note that
prior law said 6 years between such discharges under Chapter 7 or Chapter 11. Under the new
act, Chapter 13 debtors have a few different time limitations when combined with the various
chapters. The Bankruptcy Abuse Prevention and Consumer
Protection Act of 2005 created a new Chapter 15 of the United States Bankruptcy Code, on
cross-border insolvency cases. It is meant for to make bankruptcy proceedings across
international borders more functional. It favors and promotes cooperation and communication
with both foreign courts and foreign representatives.