Overview of the Bankruptcy Process

Bankruptcy is for everyone’s benefit

In economist Adam Smith’s book, Wealth of Nations, he uses the phrase “invisible hand” metaphorically to demonstrate how each person acting in his own interest combines to promote the good of the community. The same is true in bankruptcy proceedings.

For debtors, the bankruptcy process gives debtors a chance through the automatic stay to regroup and analyze how to handle financial problems.  A discharge under Chapter 7 or 13 (11 USC §727, § 1328), or a confirmed plan in a Chapter11 reorganization (11 USC §§ 1129, 1141) also offers a fresh start to the honest but unfortunate debtor.

For creditors, the bankruptcy process offers disclosure of the debtor’s actual financial situation, and an orderly liquidation or payment plan without the time, cost and uncertainty of costly traditional litigation, and it further stops the race between creditors to be first to grab dwindling assets of the debtor. In a successful Chapter 11 or 13 case, creditors stand to have a greater portion of the debt repaid than if the debtors’ nonexempt assets are just liquidated as occurs in out-of-bankruptcy enforcement of judgment procedures.

The US Trustee’s goal in bankruptcy is to ensure the debtor acts honestly and equitably toward the creditors. This may occur by reviewing the petition, past tax returns, or examining the debtor throughout the case to evaluate which, if any, type of bankruptcy is best for all concerned and if needs be, file a motion to convert a case to one under another chapter or seek to have it dismissed entirely.

The bankruptcy case trustee (different from the US Trustee’s office) has the goal of getting as many assets into and disbursed through bankruptcy estate, as the trustee makes a commission based on this throughput.

Overview

The Bankruptcy Code is found in Title 11 of the United States Code. It is divided into nine chapters, all but one of which is odd-numbered. Generally, Chapters 1, 3 and 5 apply to all bankruptcies (§103). Chapter 1 deals with global issues such as definitions (§101), the powers of the bankruptcy courts (§105), and limits on who may be a debtor in bankruptcy (§109). Chapter 3 addresses case administration for all bankruptcies such as how cases are commenced (§301, 303), who are the officers of the case, including the US Trustee (§307), the case trustee (§321), employment and compensation of professionals (§§327-330), the effect of the automatic stay and when it may be lifted or modified (§362), and how to deal with “executory contracts”, meaning those not fully performed save for payment of money (§365). Chapter 5 covers the claims process including allowance of claims, determination of secured status and the like (§§501-511), the debtor’s duties to list all assets and liabilities (§521), the definition of property of the estate (§541) and the trustee’s powers to compel turnover of estate property held by others or return of assets to the estate that had been disbursed to some creditors before the case was commenced (§§542-553).

The effect of the automatic stay

One of the effects of every type of bankruptcy (see below) is the “automatic stay” imposed by §362 of the Code. The automatic stay stops the vast majority of creditor actions against a debtor. It operates as an injunction to stop:

• the commencement, continuation of lawsuits, and administrative proceedings;
• efforts to enforce money judgments;
• garnishments and attachments in pre-judgment collection litigation
• any act to create, perfect or enforce most liens; and offset of debts owing to debtor.

It does not, however, stop:

• criminal proceedings;
• professional or drivers’ license revocation proceedings;
• paternity, domestic support obligations;
• marriage dissolution cases (except for division of property that is estate property);
• domestic violence proceedings;
• interception of tax refunds under the Social Security Act;
• tax audits or notices of deficiency from the IRS;
• eviction proceedings of non-residential real property where the lease has expired of its own terms;
• continued withholding from earnings (Chapters 11, 13);
• acts to enforce against property that was the subject of a successful relief motion within the previous 2 years in prior case;
• continued eviction of residential property if judgment was entered before the bankruptcy petition was filed;
• acts to perfect or continue perfection of lien that relates back (such mechanics’ liens).

What the bankruptcy estate is made of

The filing of a bankruptcy petition creates a bankruptcy estate. It generally is comprised of:

• all assets of the debtor, and of spouse’s interest in community property;
• all inheritances, bequests, devises, amounts received from divorce decrees or life insurance policies received within following 180 days;
• in a Chapter 13, the debtor’s earnings through the life of repayment plan;
• the proceeds, product, rents and profits of property of the estate
• all transfers avoided by the trustee such as fraudulent conveyances or preferential transfers;

minus

• exemptions allowed to be taken by individuals under applicable law once allowed.
• (§§541, 522, Cal. Civ. Proc. Code §703.010 et seq.; Fed. R. Bankr. Proc. 4003).

What are California’s exemptions?

Only individual debtors have exemptions. Corporate debtors do not. California has two sets of exemptions laws. One is permitted to be used by anyone and includes the statutory homestead exemption; the other is limited to bankruptcy debtors who elect to use the alternative “bankruptcy-like” exemptions (§522, Civ. Proc. Code §703.010 et seq.)

Generally speaking, for California bankruptcies, individual debtors may choose either the “standard” exemptions under the California Code of Civil Procedure, or “bankruptcy like” exemptions found in an alternate section Cal. Civ. Proc. Code § 703.140.

Different Types of Bankruptcies

Chapter 7 is known as a liquidation bankruptcy, and is the most common form of bankruptcy. According to the Northern District of California Bankruptcy Court, 21,941 Chapter 7 cases were filed in the Northern District of California in 2011, but that number had fallen to 4,527 filings in 2019. With the onslaught of layoffs and the current economic climate caused by COVID-19, these numbers are expected to jump dramatically by the third quarter of 2020. Business bankruptcies have already risen to levels not seen since 2009 and individual bankruptcies are expected to follow as unemployment claims rise and unemployment benefits are exhausted. In the San Francisco Bay Area alone, unemployment jumped by over 20,000 between February and March of 2020 and, as of October 2010  the Bureau of Labor Statistics reports that California’ unemployment rate now stands at 11.4%.

In a Chapter 7 case, an individual debtor gives up all non-exempt property to pay creditors and in return, receives a discharge from most debts.   Corporations do not have exemptions because they do not need to eat, clothe themselves or otherwise prepare for life after bankruptcy (§522, Cal. Civ. Proc. Code §703.020, §703.130 et seq.). Similarly, corporations do not receive a discharge under Chapter 7 because there is no need for the fresh start. The corporation is no longer engaged in business (§727).

The “Means Test”: Where the debtor is an individual or a couple with primarily consumer (as opposed to business) debts, they may be precluded from being Chapter 7 debtors by the “means test”, a mechanism found in §707 and intended to prohibit high wage earners without significant secured debt from obtaining a discharge when they can repay a substantial portion of their debt. If they fail the means test, the debtors must file under Chapter 13 or Chapter 11. As of May 1, 2020, the “median” income in California (the baseline in the means test for determining ability to repay some debt) is as follows:

• 1 person | $60,360
• 2 people | $79,271
• 3 people | $88,235
• 4 people | $101,315
• Each additional person | *$9,000 per additional person

This is a baseline number, and not a complete “means test” calculation. Among other things, the Means Test does not apply to certain debtors or certain types of debt. Speak with an attorney qualified in this area.

Chapter 13 is the next most common form of bankruptcy, accounting for nearly 40% of all bankruptcy filings in the Northern District of California in 2019. Only an individual or married person can be a debtor under Chapter 13, often dubbed the “wage earner plan” bankruptcy (§§109, 1301). In addition, to be a debtor under Chapter 13, the debtor must not have more than $1,257,850 in secured debt and $419,275 in unsecured debt. 11 USC § 109(e). Generally, the debtor who qualifies for and must file a Chapter 13 case due to excessive income in the months leading up to bankruptcy must file and have approved by the Court a repayment plan that commits to paying all of the debtor’s “monthly disposable income” for a five year period, at the end of which, the debtor will receive a discharge. The estate property includes these post-petition earnings in addition to the normal definition of “estate property” under §541 (§1306). The detriment of a Chapter 13 plan to a Chapter 7 liquidation is the time and cost.  The usual benefit to debtors is the ability to reinstate a loan on a primary residence that has fallen into default and where the home is on the verge of being foreclosed. The easiest way to describe a Chapter 13 case is to compare it to a Chapter 11 reorganization case. Chapter 13 is a streamlined and simplified reorganization and partial repayment of debts.  In a Chapter 13 case, the debtor applies to the Court for confirmation of a plan, whereas in a Chapter 11, the debtor must usually also obtain approval from creditors.

With the possible exception of a bankruptcy by a municipality under Chapter 9, a Chapter 11 bankruptcy is easily the most complicated and nuanced of the bankruptcies. Typically dubbed a “reorganization” case, it can take on many forms and outcomes. Under a Chapter 11 case, the debtor remains in possession of the estate property and is called a “debtor in possession” or “DIP”. If it is an ongoing business, the debtor is authorized to continue operating the business (§1107-1108) unless ousted by the appointment of a trustee under §1104, usually for misconduct or mismanagement by the DIP. In addition to scheduling all of the assets, liabilities and ongoing executory contracts (such as leases, financing agreements, collective bargaining agreements and the like) (§521, Fed. R. Bankr. Proc 1007), a DIP must both (1) seek approval of the Court for “out of the ordinary” expenses such as employing professionals like lawyers and accountants, and (2) regularly report to the Court by filing monthly operating and income and expense reports. Additionally, DIPs have a limited time to propose a plan of reorganization, create and get approved a “disclosure statement” and lobby creditors to accept the plan (§§1121-1126, §1129). Creditors’ committees are often appointed under §§1102-1103 to represent unsecured creditors at large and these committees often seek representation, also at the expense of the estate. This continuous oversight adds to the ongoing cost of running any business and can overtax it to such an extent that some Chapter 11 cases are doomed in the first several months. Many Chapter 11 cases end up being converted to Chapter 7 liquidations when no feasible plan of reorganization can be created or approved before this additional burden becomes overwhelming. One may ask why, then, anyone would file a Chapter 11 case. The debtor’s goals in filing for bankruptcy include getting an automatic stay in order to have some breathing room to reassess how to handle the situation. For businesses in bankruptcy, this also permits the debtor a chance to renegotiate leases, alter borrowing relationships with lenders (sometimes to a lower interest rate or principal reduction), or sometimes reject onerous agreements with labor unions. This higher level of negotiating and maneuvering often escapes the normal unsecured creditor’s notice.

What debts cannot be discharged?

A discharge generally operates to discharge the debtor from all debts arising before the petition was filed, except:

• most recent taxes due and unpaid;
• taxes due for fraudulent returns or unfiled returns;
• domestic support obligations;
• fines, penalties and forfeitures;
• student loans unless the court determines that requiring payment would impose and undue hardship;
• death, personal injury injuries caused by DUI or under illegal controlled substances;
• criminal restitution orders;
• divorce obligations ordered by family court;
• HOA fees or assessments due after the petition was filed;
• amounts owed under repayment to pension or profit sharing plans under ERISA;
• judgments for fraud or defalcation under securities laws;

If a creditor establishes the following in proceedings in the bankruptcy court:

• debt for money, property or services obtained by false pretenses ( for example credit card debts incurred just before the bankruptcy petition is filed);
• fraud while acting as a fiduciary; or
• willful and malicious injury,

these debts may be found non-dischargeable and may survive the bankruptcy process (§§523, 727, 1141, 1328).

Provisions to discourage multiple filings

Finally, there are provisions to discourage frequent resort to bankruptcy:

• A Chapter 7 debtor may not receive a discharge if one was received in a previous Chapter 7 case filed within the past 8 years;
• A Chapter 7 debtor may not receive a discharge if one was received in a previous Chapter 13 case filed within the past 6 years;
• A Chapter 13 debtor cannot receive a discharge if one was received in a Chapter 7 case filed within the past 4 years;
• A Chapter 13 debtor cannot receive a discharge if one was received in a previous Chapter 13 case filed within the past 2 years; and
• No natural person may be a debtor whose prior case has been dismissed within the previous 180 days for willful failure to prosecute the prior case.