Bankruptcy

As the middle class continues to erode, advertisements for filing bankruptcy will continue to increase. In this article, I aim to give the reader an insight as to what bankruptcy is and how bankruptcy relates to your real property.

Bankruptcy is a valid means by which a debtor may obtain a financial fresh start. I emphasize the word valid because most adds nowadays focus on jamming a debtor's mind with guilt or fear at the prospect of filing for bankruptcy protection. This is clearly wrong. The credit companies love this tactic, as it keeps the money flowing into their pockets.

Title XI of the United States Code (U.S.C.) contains the relevant provisions of bankruptcy law. This is a creature all its own.

Now, most people are vaguely familiar with Chapters 7, 11, and 13 of the bankruptcy code. Chapter 7 is a pure liquidation proceeding. Chapter 11 is usually confined to reorganizations of business entities and individuals with vast wealth. Chapter 13 is a normal wage earner individual reorganization. A business entity may not file under Chapter 13. Please understand that Chapters 11 and 13 are designed for reorganization. In these chapters, the individual or entity is attempting to hold onto its assets, while reorganizing its financial relationships with its creditors. Today I will discuss Chapter 7 only.

Chapter 7 is a liquidation proceeding. Chapter 7 is usually sought by individuals with few to no assets. Similarly, Chapter 7 is usually sought by business entities that wish to dissolve, which is synonymous with going out of business. The debtor in a Chapter 7 case will throw all its assets upon the bankruptcy trustee, save for relevant exemptions, and let the trustee sell and distribute the dividends to all creditors. This is what liquidation is. The trustee liquidates, or converts, assets to cash money.

Procedure: The normal procedures regarding Chapter 7 are as follows:

1) The debtor files a petition for relief under Chapter 7 with the bankruptcy court. This filing includes a comprehensive schedule of the debtor's assets, as well as a schedule of the debtor's proposed exemptions.
2) At the moment the petition is filed, an automatic stay is immediately invoked as to all existing creditors. This stay is effective upon the filing, not upon the creditor receiving notice.
3) A trustee is appointed to represent the estate of the debtor.
4) All relevant creditors and parties are notified.
5) A meeting of the creditors, otherwise known as the 341 meeting is scheduled.
6) The debtor's non-exempt assets, if any, are sold and the proceeds are divided amongst all creditors.
7) The debtor receives a discharge. Only individuals receive a discharge, business entities do not.
8) After all proceedings are completed, the trustee gives a reviewable accounting of all events and the case is closed.
9) The debtor goes forward, free from all previously unsecured debt.

Of great importance to the debtor is the benefit of the automatic stay, found in Section 362. The automatic stay is fairly simple: it prevents a creditor from further collection activity against the debtor. The stay does not forever prevent the creditor from collecting, it simply prevents the creditor from collection activities during the administration of the bankruptcy estate. The debtor in a garden variety Chapter 7 will typically have no assets to offer the bankruptcy trustee. This is referred to as a "no asset" filing.

The automatic stay will remain in effect throughout the administration of the debtor's estate. The emphasis for enacting the automatic stay should strike the reader as obvious. The automatic stay offers two practical benefits: 1) it keeps creditors from tearing the debtor apart at the seems (usually with nonstop phone calls), and 2) it allows the bankruptcy judge an opportunity to sort through the debtor's financial situation.

Along with the petition, the debtor files a schedule of assets, which must include full disclosure of all assets. It is the debtor's nondisclosure that usually brings about challenges to the Chapter 7 estate. The debtor also files a schedule of claimed exemptions. Some of these exemptions are common sense, such as the family automobile, or clothing. The thrust behind exemption law is to allow the debtor to maintain a reasonable life, post discharge. Bankruptcy is not designed to destroy a debtor.

The court will appoint a trustee to represent the estate. The trustee, in reality, works for the creditors. As discussed, the trustee marshalls all non-exempt assets for liquidation. The trustee represents the debtor's Chapter 7 estate.

After the petition is filed, and a trustee has been appointed, the trustee will notify all creditors as to the time and location of the 341 meeting. It is called the 341 meeting as this corresponds to its section in the bankruptcy code. Clever huh? At the 341 meeting, the court may hear any creditor complaints. These complaints can be anything from the amount of money a particular creditor is receiving, to nondisclosure of assets. Most times, in a typical individual Chapter 7 filing, the trustee will notify the creditor that the creditor need not attend the 341 meeting, as the debtor will have no assets to distribute.

At some point following the 341 meeting, assuming no creditor objections, the individual debtor will be granted a discharge. This discharge is what constitutes the "fresh start". The debtor will now be free of its previously unsecured debt.

Now, how is real estate affected by the Chapter 7 filing? Well, for simplicity, let us assume that the debtor's homestead is encumbered by a mortgage, as most are. This mortgage, as discussed in a previous article, constitutes a secured transaction. The bank has a security interest in the land pursuant to its loan to the debtor. As a general rule, secured debt is nondischargeable in bankruptcy. So, a debtor cannot file bankruptcy in order to avoid a valid mortgage. The Chapter 7 trustee will perform a simple analysis regarding the debtor's real property. The trustee will look for the debt to equity ratio. Example: If the debtor's property is valued at $100,000.00 and the property is subject to a mortgage for $120,000.00, the trustee will conclude very quickly that the debtor has no equity in the home. As a result, the home will be of no value to existing creditors. What will the trustee do in this situation? The trustee will abandon the interest of the bankruptcy estate, as to that property.

Conversely, what happens if the home is not subject to a mortgage or if the debtor has equity in the home? Answer: The home will be sold by the trustee and the proceeds will be distributed amongst the various creditors.

From a title insurance perspective, I envision a bankruptcy estate as a fishbowl. There are numerous fish in the bowl, each fish representing a particular asset. If title insurance is sought regarding the debtor's home, I ask the following initial question: how can I remove that one fish, which represents the home, from the fishbowl? When I have answered that question, the home will no longer be subject to the bankruptcy estate and it can now be safely insured. If the homeowner himself is attempting to sell, I ask for the affidavit of abandonment from the bankruptcy trustee, demonstrating that the trustee does not consider the home to be part of the bankruptcy estate. It is additionally safe to secure an order from the bankruptcy judge approving such abandonment. That is a case by case decision for an underwriter. Conversely, if the bankruptcy estate is attempting to sell, it would be the trustee herself that I would require sign the deed. I would also require an order confirming sale to be signed by the bankruptcy judge. Either way, once a debtor files bankruptcy, his home falls within the confines of the bankruptcy estate fishbowl. No further action can or should be taken without direction from a proper representative of the bankruptcy estate.

It is extremely important to understand that not all debt or obligations are dischargeable in bankruptcy. A bankruptcy attorney will pinpoint your nondischargeable claims. The attorney may advise you that bankruptcy is not for you, if the majority of your financial difficulties fall within the nondischargeable category. For example, some of the nondischargeable items are: 1) student loans, 2) secured debt, 3) federal tax liens, and 4) property taxes. So, for discussion sake, if your debt is in the form of a defaulted student loan, or numerous federal tax liens, bankruptcy will not provide a discharge from these obligations. A bankruptcy attorney will discuss all these issues with the debtor.

Author opinion: There are a myriad of situations which may land a debtor in financial straights. Job layoffs and lack of unaffordable health insurance are the typical culprits that club a debtor over the head and beat them into financial submission. Once there, no matter how good of a person the debtor may be, the sledding will be awful difficult. Depression, suicide, and divorce are very real results that often face a troubled debtor. The debtor faces these emotional problems because the debtor is not getting what they expected out of life and out of themselves. It is as simple as that.

Most adults remember, to some degree, the great depression. I personally fear that we may be heading for another great depression. Not an economic recession, but a full blown melt down. 80 years ago, the work ethic of Americans was very strong. People were frugal and knew how to live off the land. Americans today do not share that same work ethic. Can you imagine our credit starved, give it to me right now society having to tear bed sheets in half to make shirts for our children? It is an extremely scary prospect.

I say forget the 700 billion dollar bail out. We, the people, must stop buying debt. Curving our credit driven society and buying what an individual can pay for, in cash, would be a concrete solution. Forget the wall street bailout that will end up costing us greatly in the end run. I am an idealist, which means I like to view things the way they should be. I have made my share of financial mistakes, of which I am still paying for. My opinions are not based on magazine articles or hype, they are based on my own personal experiences. I hope to pass some of my experiences to others in an effort to help them avoid certain turmoils.

The debtor-creditor relationship can take many turns during the existence of the debt. Most debtors acquire their financial difficulties through uncontrolled use of credit cards. The high interest rates, coupled with the compound interest monster, often renders the debtor unable to make its monthly payments, let alone pay the account in full. The debtor can get into trouble in the blink of an eye.

There exists responsibilities on both sides of the debtor-creditor marriage. Let us not forget: it is the debtor that seeks the credit card. As such, the debtor has the responsibility of managing his account and making the required monthly payments. On the other hand, the credit company should have the responsibility of extending credit only to those who are properly qualified. In example: why extend a $10,000.00 line of credit to a debtor who earns $30,000.00 annually? In this example, the chances of default are almost certain.

Now, it is my opinion that bankruptcy should only be sought by individuals serious about changing their future financial condition. Bankruptcy can truly offer these individuals a fresh start. Historically, bankruptcy has been abused. It has been abused by debtors who simply wish to dump their current debt. These debtors have no real intentions of changing their spending habits or lifestyle. In response, Congress has made an attempt to cut down on the availability of Chapter 7 to such debtors. These changes were enacted via the Bankruptcy Reform Act of 2005 (The Act). The Act makes Chapter 7 unavailable to certain debtors. Generally, in order for a debtor to enter Chapter 7, she must pass a "means" test, which is based on her income to debt ratio. If her income to debt ratio is not significant enough, her Chapter 7 petition will be dismissed. Additionally, if she passes the means test, and is qualified for Chapter 7, she must also complete a course on debt management before the case can move forward toward discharge.

So, theoretically, this trimming of the availability of Chapter 7 will drive many debtors into Chapters 11 & 13, where a creditor may receive some or all of the money they are owed. I feel this is a questionable theory, as most reorganizations, especially under Chapter 13, fail. The failure rate of a basic Chapter 13 case is approximately 70%!! That means that only 3 out of 10 debtors will successfully complete their Chapter 13 plan. It is quite possible that many debtors denied Chapter 7 availability will file Chapter 13 instead. Once there, a debtor may be struck by the ever changing financial landscape. For instance, what if the debtor in a Chapter 13 case completes the first two years of a five year plan, and then is laid off? Well, in this case, the debtor may attempt to convert from Chapter 13 to Chapter 7. A big mess. So, on one hand you have Congress foreclosing the availability of Chapter 7 to certain debtors. At first blush, this looks great: after all, the debtor earns enough money to pay its creditors over time via Chapter 13. On the other hand, we have an economy that is falling apart. It is very possible that most of the debtors Congress is shoveling toward Chapter 13 will ultimately end up in Chapter 7 by way of conversion. What a complete and confusing circle. It probably would have been advisable to change the bankruptcy laws during a strong economy. Maybe?

In concluding, bankruptcy may be a valid option when your financial condition becomes too oppressive. Do not let the credit companies confuse you on this. My advice is to consult with a bankruptcy attorney regarding your options. The attorney can help guide you into the appropriate chapter, as well as handle the filing with the court and dealings with the bankruptcy trustee, if one is appointed.

My next article will concern Chapter 13, the wage earner reorganization.

Adios,
dave