Bankruptcy is the painful process of taking debt down to size. The process of bankruptcy has a long tradition in the Western world, and it has been part of the United States since its founding. When individuals and businesses file for bankruptcy, they are under the protection of federal bankruptcy court. Under this protection creditors are strictly prohibited from taking any actions related to collecting debts.
Debtors can repay some or all of their debts through this process. Bankruptcy is divided into two broad types: liquidation and reorganization. Each type is designed to accomplish a specific goal. Liquidation sells off all debtor assets that are legally sellable and uses the proceeds to repay creditors. Reorganization helps debtors restructure their businesses and debts so that they can create repayment plans and come out ahead.
Chapter 7 – Liquidation
Under Chapter 7, which lasts from three to six months, the debtor places himself in the hands of a court-appointed bankruptcy trustee. The trustee sells or liquidates some of the debtor’s property to repay creditors. Chapter 7 eliminates all debts that are unsecured and do not have collateral attached. The debtor gets to keep the property, which is usually personal, that is exempt under federal and state laws. The trustee cannot liquidate this property, which may include the debtor’s car, clothes and household furnishings.
Secured debts are handled differently under Chapter 7. While this type of bankruptcy cannot prevent lenders from foreclosing on a house, some kinds of secured debts can be eliminated under Chapter 7. The debtor has three choices. They can
– allow the lender to repossess the property
– continue making payments under the terms of the original contract or
– pay a lump sum equal to the current market replacement value of the property.
There is also the question of eligibility. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 changed the rules by which debtors filed for bankruptcy. The law added a means test and an income cut-off. Debtors with enough income to file for Chapter 13, which reorganizes their debts under a repayment plan, are required to do so by federal law. Chapter 7 is barred to them.
Chapter 11 – Reorganization
Debtors can reorganize and restructure their debts under Chapter 11. This type of bankruptcy is usually reserved for businesses who cannot cover their obligations. Restructuring their debts and reorganizing their business, companies typically emerge from Chapter 11 much stronger and poised for future growth.
Individuals can also file for Chapter 11, but it is very unusual. Individual debtors can only file for Chapter 11 if their debts exceed the limits of Chapter 13 or if they own large assets that are not exempt from liquidation. Substantial real estate holdings would qualify an individual debtor for Chapter 11.
Under current bankruptcy law, no debtor may file for bankruptcy unless they have received credit counseling from an approved credit counseling agency at least 180 days before filing. This rule applies to all chapters of the bankruptcy code including Chapter 11. This rule can be waived under certain circumstances, such as no approved agencies are available to the debtor.