Most people have heard the term "bankruptcy" and understand that it has something to do with being broke. Below is an overview of bankruptcy, its types, and how can the process actually help you in various situations. See FindLaw's Bankruptcy Basics section for additional articles and resources.
Bankruptcy: Origins and Background
Several early attempts at creating universal bankruptcy rules, beginning in 1800, were amended and eventually repealed until passage of the so-called "Nelson Act" in 1898. Specifically, the Nelson Act gave companies the option of discharging debts but did extend those same protections to consumers.
In 1978, using the authority granted by Article I, Section 8 of the U.S. Constitution, Congress enacted the much broader "Bankruptcy Code." The Code has been amended numerous times since being enacted and governs all U.S. bankruptcy cases.
The Federal Rules of Bankruptcy Procedure (or simply "Bankruptcy Rules"), created by the U.S. Supreme Court, govern the processes of bankruptcy. Each bankruptcy court also has its own local rules.
How Bankruptcy Courts Work
While most court cases are heard in either civil or criminal court, bankruptcy has a dedicated system of courts throughout the country. Each judicial district in the U.S. has its own bankruptcy court, while each state has at least one district (90 districts total).
United States bankruptcy judges have the authority to make binding decisions in bankruptcy cases, such as eligibility issues or whether to grant a debt discharge. However, most aspects of the bankruptcy process are done outside of the court. For example, an appointed trustee carries out the administrative duties of Chapter 7, Chapter 13, and other types of bankruptcy cases.
The debtor actually has very little interaction with the bankruptcy judge. Most Chapter 7 applicants don't even set foot in court and only see the judge if there are objections to the bankruptcy plan. Chapter 13 debtors typically appear in court just once, at the bankruptcy plan confirmation hearing. The informal meeting of the creditors (also called a "341 meeting," based on Section 341 of the Code) is typically held at the trustee's office.
Bankruptcy's Main Goal
Federal bankruptcy laws are intended to allow debtors a way out of particularly heavy debts, giving consumers and businesses a fresh start where all other options have failed. A 1934 U.S. Supreme Court decision described bankruptcy's role as follows:
[I]t gives to the honest but unfortunate debtor a new opportunity in life and a clear field for future effort, unhampered by the pressure and discouragement of preexisting debt. Local Loan Co. v. Hunt, 292 U.S. 234, 244 (1934).
The bankruptcy discharge, a court order releasing the debtor from personal liability for certain debts, is the main way this is accomplished. The discharge also prohibits creditors or collections agencies from communicating with debtors.
Different Types of Bankruptcy
If you were to ask an attorney, "What is bankruptcy?" you would probably be asked whether you are a business or an individual, the status of your debts, and other questions to help narrow down the definition. Truth is, bankruptcy can mean different things to different debtors. There are several types of bankruptcy provided under the U.S. Bankruptcy Code, each with its own rules and procedures:
Chapter 7 Bankruptcy is titled "Liquidation" in the Code, since most of the debtor's assets are sold for cash (or "liquidated") and used to pay creditors. However, there are certain limits to which assets may be liquidated (see Bankruptcy Exemptions: Chapter 7 for more details). Chapter 7 filings where there is very little nonexempt property, if any, are called "no-asset cases." Creditors holding unsecured claims (such as credit card issuers) typically do not receive proceeds unless it is an asset case and the creditor has filed a proof of claim with the court.
Major changes to the Bankruptcy Code in 2005 included the requirement of a "means test" to determine eligibility for personal bankruptcy under Chapter 7. The test determines whether or not the debtor has too much income for this type of filing.
Chapter 13 Bankruptcy is titled "Adjustment of Debts of an Individual with Regular Income." Unlike Chapter 7, Chapter 13 is best suited to debtors with regular income. Those who file under Chapter 13 typically are able to hold onto valuable assets, such as a house and car. Instead of liquidating assets, Chapter 13 debtors work out a plan to repay creditors over a longer period of time, usually three to five years.
The court either approves or rejects the repayment plan at a confirmation hearing, based on whether it meets requirements established by the Code. The main difference, as opposed to Chapter 7, is that the Chapter 13 filer typically remains in possession of property and makes payments to creditors through the trustee. The plan is based on the debtor's projected income over the life of the bankruptcy plan. The debtor does not receive an immediate debt discharge upon approval, but must complete payments first.
While the plan is in effect, the debtor is shielded from wage garnishments, lawsuits, and other creditor or collections actions. Additionally, debtors may be able to eliminate more debts under the Chapter 13 discharges.
Titled "Reorganization," Chapter 11 Bankruptcy is most often used by businesses that would like to continue their operations while they repay creditors. Debtors in Chapter 11 have the right to file a reorganization plan for the first 120 after filing the case, which must include a disclosure statement to creditors with enough information to help them evaluate the plan.
Under Chapter 11, the debtor may trim its debts through a combination of repaying some debts and discharging others entirely. Additionally, the debtor may offload leases and contracts, while recovering certain assets and focusing its efforts on becoming profitable. The process normally involves a period of consolidation, which may include a reduction in work force.
The purpose of Chapter 12, titled "Adjustment of Debts of a Family Farmer or Fisherman with Regular Annual Income," is self-explanatory. The Chapter 12 process is quite similar to that of Chapter 13, in that the debtor devises a plan to repay his or her debts over a period of a few years. The plan may be for as long as three years for Chapter 12 filings, and up to five years with court approval. The trustee in Chapter 12 cases functions similarly to a trustee in Chapter 13.
The goal of this type of bankruptcy is to allow family farmers and fisherman to continue operations throughout the duration of the plan.
Chapter 9 is titled, "Adjustment of Debts of a Municipality" and allows cities, towns, counties, school districts, and other municipalities to declare bankruptcy. This is similar to a Chapter 11 reorganization, but applicable to a city or some other municipality instead of a business entity.