The Bankruptcy Code offers different types of relief under different “chapters” in the Code. Regardless of the chapter, there are some principles that govern every bankruptcy case. Before discussing chapter 11 cases in particular, it is helpful to understand how these principles play out an a chapter 7 case.
Estate, Trustee and Creditors
The filing of a bankruptcy petition creates an “estate,” which may be roughly defined as “whatever the debtor owned at the time of filing.” A bankruptcy “trustee” is appointed to liquidate the estate and disburse the proceeds to creditors. Proceeds of property given as collateral go to the secured creditor first, and the remainder goes into the pool to pay unsecured creditors. Unsecured creditors are generally paid on a pro rata basis, though Congress has given some unsecured claims “priority” over others.
To get a share of the proceeds, a “creditor” is required to file a proof of claim. Since paying an invalid claim would reduce the amount owed to legitimate creditors, the trustee reviews these claims and files objections where a ground to object is apparent. Debtors and others may also object to claims, as the trustee may not be familiar enough with a claim to recognize defects.
The Stay, Exemptions and Avoiding Powers
When a case is filed, an “automatic stay” is triggered. A stay is an injunction preventing creditors from collecting from the debtor or from the estate and, as the name implies, is automatic (no separate court order is required). The stay provides the trustee with the sole right to control and liquidate estate assets, without worrying about seizures by other creditors.
A creditor who wishes to foreclose on property of the estate may do so only with the approval of the bankruptcy court. The process is initiated by filing a motion requesting “relief” from the automatic stay. A motion may be granted if, for example, the property is collateral for a loan with a balance higher than the collateral’s value. The basic idea in that case is that the secured creditor would get the entire value of the property even if the trustee sold it, so it does no good to keep it under the control of the trustee.
An individual debtor may also wish to exempt property from the liquidation process. Recognizing that individuals may need to keep a home, a car, furnishings and other property to get a “fresh start,” Congress allows individuals to claim certain property as “exempt” from the liquidation process. Exemptions vary by state. Note that all assets of the debtor are listed, even if exempt. Instead, the debtor files a list of exempt property, and the trustee has time to file objections to the exemption claims before they are deemed final.
Trustees can also “avoid” certain transactions to increase the size of the estate, and therefore to increase the payout to creditors. For example, a creditor which repossessed a vehicle within 90 days before the bankruptcy petition was filed may be required to turn it over to the trustee. Similarly, if a debtor transferred a vehicle to a family member (or to an affiliate), the trustee would demand it back, or at least investigate whether the debtor received adequate consideration or was trying to protect the asset from creditors.
Corporations and other artificial entities do not receive a discharge, but it is the primary objective of most individual debtors. As long as an individual debtor plays by the rules (including listing all assets and debts honestly), the debtor will receive a discharge of debts. A “discharge” means that creditors are barred from collecting their debts from the debtor (though secured creditors can often pursued foreclosure or repossession against collateral). Dishonesty during the bankruptcy case, or certain kinds of misconduct before the bankruptcy, will prevent a discharge. Since the primary objective of most individual debtors is to receive a discharge of their debts, it is very important to avoid conduct that would disqualify a debtor from being discharged.
Even for debtors who play by the bankruptcy rules, certain debts are “excepted” from discharge. Debts excepted from discharge include child support, certain taxes, and debts incurred by fraud.
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