BANKRUPTCY

In 2005 the U.S. Congress enacted profound changes to the Bankruptcy Reform Act of 1978. Known as the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, the amendments were designed to correct perceived abuses by debtors who allegedly took advantage of the pro-debtor tone and provisions of the 1978 statute. The emphasis has been shifted from a pro-debtor enactment to one favoring creditors.

The basic premise for enabling debtors to file for bankruptcy is to have a "fresh start" by permitting them to end their overwhelming debt and begin anew to rebuild their credit and engage in day-to-day activities without fear of creditors seizing their assets and imposing liens on their salaries. Congress had concluded that a sizable percentage of debtors had taken advantage of liberal Bankruptcy Code provisions and grossly abused their credit access. Thus, Congress imposed a number of roadblocks to the discharge of indebtedness while refraining from limiting creditors' persistent inundation of offers of credit to consumers—especially by credit card companies.

The Bankruptcy Code contains a number of chapters, including preliminary sections concerning procedural and administrative requirements and substantive chapters that detail requirements for debtors regarding liquidation, reorganization, or adjustment of debts. The most relevant chapters are 7, 11, and 13.

CHAPTER 7 LIQUIDATION PROVISIONS

The most significant change to the 1978 statute concerns consumer bankruptcy under the Chapter 7 liquidation provisions. Previously, debtors had the choice of filing for liquidation—which means that debtors are completely discharged from all indebtedness except for certain nondischargeable debts, after their assets have been reduced to cash and distributed to creditors—or filing a plan under Chapter 13 with the court for the payment of all or part of the indebtedness.

The act continues the choice but now requires consumer debtors electing to file under the act to initially secure credit counseling within 180 days preceding the filing and to provide a certificate from an approved non-profit budget and credit counseling agency concerning services provided to the debtors, including a copy of the repayment plan, if any. The act also continues to permit debtors to have their debts discharged, after compliance with the statute, and to possess a not-insignificant amount of assets upon termination of the proceeding.

Exemptions

Contrary to what many persons believe, the debtor being discharged in bankruptcy is able to retain a substantial amount of property (which would be double the sum if there is a joint filing). This is a further inducement to seek bankruptcy protection before being reduced to an impoverished condition. The assets that a bankrupt person may retain are:

Interest in property held jointly or as tenants by the entirety if the tenant is exempt from the process under nonbankruptcy law
Retirement funds pursuant to statute
Debtor's aggregate interest up to $18,450 in value in real or personal property used as a residence, cooperative, or burial plot
Debtor's interest in one motor vehicle up to $2,950 in value
Debtor's interest up to $475 in any particular item or $9,850 in total value in household furnishings and goods, and various personal items, such as clothing
__BODY__,225 in value for jewelry for personal, family, or dependent use
Any property up to $975 plus up to $9,250 of any unused amount of exemption
__BODY__,850 in any implements, professional books, tools of trade
Unmatured life insurance
Prescribed health aids
Various other benefits and payments, such as Social security

Priority of Distributions

Not all creditors are treated alike with respect to the distribution of net assets that remain after the deduction of costs, expenses, and other indebtedness. The order of distribution of assets remaining is as follows:

Secured creditors to the extent of their security on specific property (e.g., mortgage interest on real property)
Unsecured domestic support obligations
Administrative expenses
Claims up to $10,000 earned by the creditor within 180 days of filing or cessation of business for wages, sales, or commissions
Contributions to an employee benefit plan arising within 180 days of filing or cessation of business up to $10,000 per employee
Claims of persons engaged in farming or fishing up to $4,925 each
Other claims for rental, sale, or use of property or services rendered up to $2,225
Certain claims by governmental entities including income and property taxes
Claims for death or personal injuries arising from use of an automobile or vessel while debtor was intoxicated
All other indebtedness

Nondischargeable Debts

The act provides that certain debts may not be discharged since Congress has determined that bankrupt persons should continue to be responsible for such debts even if they cannot currently make payment. The reasons for the nondischargability of such debts include: the nature of the debt, policy reasons to protect the creditors (e.g., support obligations for one's family), and debts arising because of the debtor's misconduct. They are as follows:

Taxes, including state and local taxes, and customs duty
Money or other financial benefit received by reason of false pretenses
Consumer debts incurred within ninety days before filing totaling more than $500 owed to a single creditor for luxury goods and services; cash advances of $750 from a single creditor within seventy days of filing
Debts not listed
Debt for fraud, embezzlement, and larceny
Domestic support obligation
Willful or malicious injury to another person or property
Fines, penalties, forfeitures payable to a governmental entity, including for state and local taxes, that is not compensation for actual money loss, other than a tax penalty imposed before three years before date of filing of petition
Educational benefit funded by government unless undue hardship; also, student loans payable to for-profit and nongovernmental entities
For death or injury by auto, vessel, or an aircraft while intoxicated from drugs, alcohol, or other substance
To a spouse or former spouse
Fee or assessment due to condominium or coop
Fee imposed on a prisoner
Debts owed to a pension, profit-sharing, or stock bonus plan
Violation of the federal securities laws

Dismissal of Petition for Abuse—The Means Test

The revised act mandates the dismissal of a Chapter 7 filing if the grant of relief would constitute an "abuse" of the act by individual consumer debtors. The tests that may be used by the Bankruptcy Court in dismissing a petition for abuse include a median income test and a means test. If the debtor's current monthly income exceeds the state's medium income for a family of equivalent size or if the debtor's monthly income less allowable expenses exceeds an amount allowed under the act for a family of equivalent size, then there is a presumption of abuse; otherwise, no such presumption may be inferred.

The court may also use noneconomic factors in determining if abuse does exist. The formulas presented are quite complex and may necessitate the services of professionals. Thus, the act seeks to require debtors able to pay their debts over time to adopt the provisions of Chapter 13 and pay all or a portion of the debt over a period of years rather than expeditiously having a clean slate to start anew. The debtor thus has extensive filing requirements, including the credit counseling certificate, pay stubs, and statements of pre- and postpetition income and expenses.

A previous source of abuse was that debtors could use either the act's exemptions or the exemptions provided in the state in which they resided, whichever was greater. Thus, certain states had homestead exemptions that permitted multimillion-dollar homes to be exempt from claims of creditors. The act now limits the exemption to $125,000 if there is an abuse in the filing or other defined bases.

The revised statute makes use of attorneys potentially very costly or otherwise inaccessible. The signature by an attorney on the bankruptcy petition is a certification that he or she has no knowledge, after a diligent inquiry, that the information on the schedules is incorrect. The effect of this provision is that an attorney has to make a detailed investigation of the debtor's finances and be ready to be subject to expenses of a trustee in making a motion to dismiss as well as to incur potential fines. Thus, many attorneys may refrain from representing debtors or significantly increase the fees they charge for services rendered because of the additional time required in assisting debtors, as well as the heightened potential liability for the attorneys.

Discharge

After the assets are distributed, then the unpaid claims are discharged. Partnerships and corporations must liquidate under state law before or on completion of the proceeding. The debtor cannot file another Chapter 7 proceeding until the expiration of eight (formerly six) years.

Other Liquidation Provisions

There are separate liquidation provisions for stockbrokers, commodity brokers, and clearing bank liquidations. Also, municipal governmental bankruptcies are treated under Chapter 9 of the act.

CHAPTER 11 REORGANIZATION

The Bankruptcy Code recognizes that liquidating a company may entail the loss of jobs as well as other disruptive events. Accordingly, Chapter 11 seeks to permit companies to become solvent again by reorganizing themselves in such a way as to permit them to continue functioning as viable entities. Chapter 11 applies to individuals, partnerships, corporations, unincorporated associations, and railroads, although corporations are almost always the petitioners. It does not apply to companies that are regulated by other statutes, such as banks, savings and loan associations, unions, insurance companies, and brokerage firms.

The advantage to a Chapter 11 filing is that the debtor is permitted to remain in possession of the entity, which is especially important in business filings since the debtor may continue to operate the business. If the court believes there may be adverse circumstances, such as possible fraud or other dishonesty or gross mismanagement, then it may appoint a trustee or examiner to review the debtor's finances.

Once an order of relief is granted, the court will appoint a creditors' committee, which generally consists of the seven largest unsecured creditors. Their function includes appearances at court hearings, participation in the plan of reorganization, and asserting possible objections to the plan. As in Chapter 7, there is an automatic stay that prevents creditors from pursuing other judicial proceedings or collecting debts.

Chapter 11 permits the debtor to accept or reject executory contracts (contracts whose completion is to be accomplished in the future). The plan of reorganization is to be filed within 120 days after date of the order of relief. The plan sets forth the debtor's proposed new capital structure, designates the different classes of claims and interests, and proposes possible alteration of the rights of creditors, conversion of unsecured creditors to equity holders, sale of assets, and other items. The creditors are to receive a disclosure statement containing necessary information concerning the plan of reorganization. The creditors and interests are to accept or reject the plan before confirmation by the court. Confirmation requires that the plan be in the best interests of each class of claims and interests, and be feasible. If creditors object, the court is empowered to compel acceptance and participation.

CHAPTER 13 CONSUMER DEBT ADJUSTMENT

Chapter 13 applies to natural persons and is intended to allow the debtors to file a petition with the Bankruptcy Court in an endeavor to permit the debtors to become solvent by either extending the time to pay their debts or by a composition that permits the debtors to pay a sum less than the full amount to each of the creditors. Eligible persons are natural persons who have regular income and who possess noncontingent, liquidated, unsecured debts of less than $250,000 and secured debts of less than $750,000.

The plan of payment must be filed within fifteen days after the filing of the Chapter 13 petition. The plan must recite the debtors' finances, estimated income, and expenses with a payout over a three-year period (5 years if approved by the court). The advantages to debtors include continuation of possession of their property. The planned installment, which is made to the trustee, is to commence within thirty days of filing. The trustee is responsible for paying the creditors.

Objections to the plan may be filed by the creditors, which are then determined at a hearing. The court examines whether the plan was made in good faith, whether it is feasible (if the debtor will be able to make the proposed payments), and be in the interests of the creditors, that is, the creditors must receive at least what they would have received under a Chapter 7 liquidation proceeding.