Bankruptcy in the United States

Encyclopedia : B : BA : BAN : Bankruptcy in the United States

Bankruptcy in the United States is a matter placed under Federal jurisdiction by the United States Constitution (in Article 1, Section 8), which allows Congress to enact "uniform Laws on the subject of Bankruptcies throughout the United States […]". Its implementation, however, is found in statute law. Much of the relevant statutes are incorporated within the Bankruptcy Code, located at title 11 of the United States Code, and amplified by state law in the many places where federal law either is absent or expressly defers to state law. Other bankruptcy statutes are found in titles 18 (crimes), 26 (internal revenue code) and 28 (judicial procedure) of the United States Code.

While bankruptcy cases are always filed in United States bankruptcy court (which are units of the United States district courts), bankruptcy cases, particularly regarding the validity of claims and exemptions, are often highly dependent on state law. State law therefore plays a major role in many bankruptcy cases, and it is often unwise to generalize bankruptcy issues across state lines.

Contents

Chapters of the bankruptcy code

There are several types of proceedings that fit under the general category of bankruptcy. Title 11 has multiple chapters, some of which provide different procedures available for debt resolution.

Chapter 7: Liquidation

Liquidation under a Chapter 7 filing is the most common form of bankruptcy. Liquidation involves the appointment of a trustee who collects the non-exempt property of the debtor, sells it and distributes the proceeds to the creditors.

Chapter 9: Reorganization for municipalities

A Chapter 9 bankruptcy is available only to municipalities. Chapter 9 is a form of reorganization, not liquidation. A famous example of a municipal bankruptcy was in Orange County, California.

Chapters 11, 12, and 13: Reorganization

Main articles: Chapter 11, Title 11, United States Code, Chapter 12, Title 11, United States Code and Chapter 13, Title 11, United States Code

Bankruptcy under Chapter 11, Chapter 12, or Chapter 13 is more complex reorganization and involves allowing the debtor to keep some or all of her property and to use future earnings to pay off creditors. Consumers usually file chapter 7 or chapter 13. Chapter 11 filings by individuals are allowed, but are rare.

Chapter 12: Reorganization for Family farmers / fishers

Chapter 12 is similar to Chapter 13 but is available only to "family farmers" and "family fisherman" in certain situations. As recently as mid-2004 Chapter 12 was scheduled to expire, but in late 2004 it was renewed and made permanent.

Chapter 15: Cross-border insolvency

The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 added Chapter 15 (as a replacement for section 304) and deals with cross-border insolvency: foreign companies with U.S. debts.

Features of U.S. bankruptcy law

The estate

Commencement of a bankruptcy case creates an "estate." The estate consists of all property interests of the debtor at the time of case commencement, subject to certain exclusions and exemptions (see generally #redirect ). In the case of a married person in a community property state, the estate may include certain community property interests of the debtor's spouse even if the spouse has not filed bankruptcy (see generally #redirect ). The estate may also include other items, including but not limited to property acquired by will or inheritance within 180 days after case commencement (see #redirect ).

For federal income tax purposes, the bankruptcy estate of an individual in a Chapter 7 or 11 case is a separate taxable entity from the debtor (see generally #redirect ). The bankruptcy estate of a corporation, partnership, or other collective entity, or the estate of an individual in Chapters 12 or 13, is not a separate taxable entity from the debtor (see generally #redirect ).

Bankruptcy court

In Northern Pipeline Co. v. Marathon Pipe Line Co., 458 U.S. 50 (1982), the United States Supreme Court ruled unconstitutional certain provisions of the law relating to bankruptcy judges (who are not life-tenured "Article III" judges). Congress responded in 1984 with changes in the statutes to remedy the constitutional defects. Under the revised law the bankruptcy judges in each judicial district in regular active service, as the United States bankruptcy court, constitute a "unit" of the applicable United States district court (see #redirect ). The judge is appointed for a term of fourteen years by the United States Court of Appeals for the circuit in which the applicable district is located (see #redirect ).

Formally, the United States District Courts have subject-matter jurisdiction over bankruptcy matters (see #redirect ). However, each such district court may, by order, "refer" bankruptcy matters to the Bankruptcy Court (see #redirect ). As a practical matter, most district courts have a standing "reference" order to that effect, so that all bankruptcy cases in that district are handled, at least initially, by the Bankruptcy Court. In unusual circumstances, a district court may in a particular case "withdraw the reference" (i.e., take the case or a particular proceeding within the case away from the Bankruptcy Court) and decide the matter itself under #redirect .

Decisions of the bankruptcy court are generally appealable to the District Court (see #redirect ), and then to the Court of Appeals. However, in a few jurisdictions a separate court called a bankruptcy appellate panel (composed of bankruptcy judges) hears certain appeals from bankruptcy courts (see #redirect ).

United States Trustee

The United States Attorney General appoints a separate United States Trustee for each of twenty-one geographical regions for a five year term. Each Trustee is removable from office by and works under the general supervision of the Attorney General (see #redirect and #redirect ). Each United Trustee, an officer of the U.S. Department of Justice, is responsible for maintaining and supervising a panel of private trustees for chapter 7 bankruptcy cases (see #redirect ). The Trustee has other duties including the administration of most bankruptcy cases and trustees (see generally #redirect ).

The automatic stay

Without the bankruptcy protection of the automatic stay creditors might race to the courthouse to improve their positions against a debtor. If the debtor's business were facing a temporary crunch, but were nevertheless viable in the long term, it might not survive a "run" by creditors. A run could also result in waste and unfairness among similarly situated creditors. Bankruptcy Code § 362 (see #redirect ) imposes the automatic stay at the moment a bankruptcy petition is filed. The automatic stay generally prohibits the commencement or enforcement of actions, judicial or administrative, against a debtor for the collection of a claim that arose prior to the commencement of the case. The stay also prohibits collection actions aimed at property of the estate itself. A secured creditor may, however, be allowed to take the applicable collateral if the creditor first obtains permission from the court. Permission is requested by a creditor by filing a motion for relief from the automatic stay.

The creditors

Secured creditors whose security interests survive the commencement of the case may look to the property that is the subject of their security interests, after obtaining permission from the court (in the form of relief from the automatic stay). Security interests, created by what are called secured transactions, are liens on the property of a debtor.

Unsecured creditors are generally divided into two classes: unsecured priority creditors and general unsecured creditors. Unsecured priority creditors are further subdivided into classes as described in the law. In some cases the assets of the estate are insufficient to pay all priority unsecured creditors in full; in such cases the general unsecured creditors receive nothing.

Because of the priority and rank ordering feature of bankruptcy law, debtors sometimes improperly collude with others (who may be related to the debtor) to prefer them, by for example granting them a security interest in otherwised unpledged assets. For this reason, the bankruptcy trustee is permitted to reverse certain transactions of the debtor within period of time prior to the date of bankruptcy filing. The time period varies depending on the relationship of the parties to the debtor and the nature of the transaction.

Also, the Bankruptcy Trustee may reject certain executory contracts and unexpired leases (see #redirect ). For bankruptcy purposes, a contract is generally considered "executory" where both parties to the contract have not yet fully performed a material obligation.

If the Trustee (or debtor in possession, in many chapter 11 cases) rejects a contract, the debtor's bankruptcy estate is subject for ordinary contract law damages; but the damage obligation is generally treated as an unsecured claim.

Exempt property

Although in theory all property of the debtor that is not excluded from the estate under the Bankruptcy Code becomes property of the estate (i.e., is automatically transferred from the debtor to the estate) at the time of commencement of a case, an individual debtor (not a partnership, corporation, etc.) may claim certain items of property as "exempt" and thereby keep those items (subject, however, to any valid liens or other encumbrances). Generally, the individual debtor is allowed to choose between a "Federal" list of exemptions and the list of exemptions provided by the law of the state. However, Federal law allows each state to specify by law, if the legislature of that state so desires, that only the state exemptions are available in that state. In states where the debtor is allowed to choose between the Federal and state exemptions, the debtor has the opportunity to choose the rules that most fully benefit him or her.

The exemption laws vary greatly from state to state. In some states, exempt property includes equity in a home or car, tools of the trade, and some amount of personal effects. In other states an asset class such as tools of trade will not be exempt by virtue of its class except to the extent it is claimed under a more general exemption for personal property.

One major purpose of bankruptcy is to ensure orderly and reasonable management of debt. Thus, exemptions for personal effects are thought to prevent punitive seizures of items of little or no economic value (personal effects, personal care items, ordinary clothing), since this does not promote any desirable economic result. Similarly, tools of the trade may, depending on the available exemptions, be a permitted exemption as their continued possession allows the insolvent debtor to move forward into productive work as soon as possible.

The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 placed pension plans not subject to the Employee Retirement Income Security Act of 1974 (ERISA), like 457 and 403(b) plans in the same status as ERISA qualified plans with respect to having exemption status akin to spendthrift trusts. However, SEP-IRAs and SIMPLEs still are outside federal protection and must rely on state law.

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Spendthrift trusts

Most states have property laws that allow a trust agreement to contain a legally enforceable restriction on the transfer of a beneficial interest in the trust (sometimes known as an "anti-alienation provision"). The anti-alienation provision generally prevents creditors of a beneficiary from acquiring the beneficiary's share of the trust. Such a trust is sometimes called a spendthrift trust. To prevent fraud, most states allow this protection only to the extent that the beneficiary did not transfer property to the trust. Also, such provisions do not protect cash or other property once it has been transferred from the trust to the beneficiary. Under the U.S. Bankruptcy Code, an anti-alienation provision in a spendthrift trust is recognized. This means that the beneficiary's share of the trust generally does not become property of the bankruptcy estate. See e.g., Texas Property Code section 112.035 and #redirect . [link]

Redemption

In a Chapter 7 liquidation case, an individual debtor may redeem certain "tangible personal property intended primarily for personal, family, or household use" that is encumbered by a lien. To qualify, the property generally either (A) must be exempt under section 522 of the Bankruptcy Code, or (B) must have been abandoned by the trustee under section 554 of the Bankruptcy Code. To redeem the property, the debtor must pay the lienholder the full amount of the applicable allowed secured claim against the property. See #redirect .

Debtor's discharge

Key concepts in bankruptcy include the debtor's discharge and the related "fresh start." Discharge is available in some but not all cases. For example, in a Chapter 7 case only an individual debtor (not a corporation, partnership, etc.) can receive a discharge (see #redirect ).

The effect of a bankruptcy discharge is to eliminate only the debtor's personal liability (#redirect ), not the "in rem" liability for a secured debt to the extent of the value of collateral. The term "in rem" essentially means "with respect to the thing itself" (i.e., the collateral). For example, if a debt in the amount of $100,000 is secured by property having a value of only $80,000, the $20,000 deficiency is treated, in bankruptcy, as an unsecured claim (even though it's part of a "secured" debt). The $80,000 portion of the debt is treated as a secured claim. Assuming a discharge is granted and none of the $20,000 deficiency is paid (e.g., due to insufficiency of funds), the $20,000 deficiency -- the debtor's personal liability -- is discharged (assuming the debt is not non-dischargeable under another Bankruptcy Code provision). The $80,000 portion of the debt is the in rem liability, and it is not discharged by the court's discharge order. This liability can presumably be satisfied by the creditor taking the asset itself. An essential concept is that when commentators say that a debt is "dischargeable," they are referring only to the debtor's personal liability on the debt. To the extent that a liability is covered by the value of collateral, the debt is not discharged.

This analysis assumes, however, that the collateral does not increase in value after commencement of the case. If the collateral increases in value and the debtor (rather than the estate) keeps the collateral (e.g., where the asset is exempt or is abandoned by the trustee back to the debtor), the amount of the creditor's security interest may or may not increase. In situations where the debtor (rather than the creditor) is allowed to benefit from the increase in collateral value, the effect is called "lien stripping" or "pairing down." Lien stripping is allowed only in certain cases depending on the kind of collateral and the particular chapter of the Code under which the discharge is granted.

The discharge also does not eliminate certain rights of a creditor to setoff (or "offset") certain mutual debts owed by the creditor to the debtor against certain claims of that creditor against the debtor, where both the debt owed by the creditor and the claim against the debtor arose prior to the commencement of the case (see #redirect ).

Not every debt may be discharged under every chapter of the Code. Certain taxes owed to Federal, state or local government, government guaranteed student loans, and child support obligations are not dischargeable. (Guaranteed student loans are potentially dischargeable, however, should the debtor prevail in a difficult-to-win adversary proceeding brought in the nature of a complaint to determine dischargeability brought against the lender. Also, the debtor can petition the court for a "financial hardship" discharge, but the grant of such discharges is rare.) The debtor's liability on a secured debt, such as a mortgage or mechanic's lien on a home, may be discharged, but the effects of the mortgage or mechanic's lien cannot be discharged in most cases if it affixed prior to filing, so if the debtor wishes to retain the property, the debt must usually be paid for as agreed. (See also lien avoidance, reaffirmation agreement) (Note: there may be additional flexiblity available in Chapter 13 for debtors dealing with oversecured collateral such as a financed auto, so long as the oversecured property is not the debtor's primary residence.)

Any debt tainted by one of a variety of wrongful acts recognized by the Bankruptcy code, including defalcation, or consumer purchases or cash advances above a certain amount incurred a short time before filing, cannot be discharged. However, certain kinds of debt, such as debts incurred by way of fraud, may be dischargeable through the Chapter 13 super discharge. All in all, as of 2005, there are 19 general categories of debt that cannot be discharged in a Chapter 7 bankruptcy, and fewer debts that cannot be discharged under Chapter 13.

Entities that cannot be debtors

The section of the Bankruptcy code that governs which entities are permitted to file a bankruptcy petition is 11 U.S.C. [§ 109]. Banks and other deposit institutions, insurance companies, railroads, and certain other financial institutions and entities regulated by the federal and state governments cannot be a debtor under the Bankruptcy Code; instead, there are special state and federal laws which govern the liquidation or reorganization of these companies. Thus, in the U.S. context at least, it is incorrect to refer to a bank or insurer as being "bankrupt": the terms "insolvent", "in liquidation", or "in receivership" would be appropriate under some circumstances.

Pension Plan Debt and the PBGC

Current law places employer's debt for pension plans in certain circumstances into the hands of the Pension Benefit Guaranty Corporation (PBGC).

Bankruptcy crimes

In the United States, criminal provisions relating to bankruptcy fraud and other bankruptcy crimes are found in sections 151 through 158 of Title 18 of the United States Code.

Bankruptcy fraud includes filing a bankruptcy petition or any other document in a bankruptcy case for the purpose of attempting to execute or conceal a scheme or artifice to defraud. Bankruptcy fraud also includes making a false or fraudulent representation, claim or promise in connection with a bankruptcy case, either before or after the commencement of the case, for the purpose of attempting to execute or conceal a scheme or artifice to defraud. Bankruptcy fraud is punishable by a fine, or by up to five years in prison, or both. See generally #redirect .

Knowingly and fraudulently concealing property of the estate from a custodian, trustee, marshal, or other court officer is a separate offense, and may also be punishable by a fine, or by up to five years in prison, or both. The same penalty may be imposed for knowingly and fraudulently concealing, destroying, mutilating, falsifying, or making a false entry in any books, documents, records, papers, or other recorded information relating to the property or financial affairs of the debtor after a case has been filed. See #redirect .

Certain offenses regarding fraud in connection with a bankruptcy case may also be classified as "racketeering activity" for purposes of the Racketeer Influenced and Corrupt Organizations Act (RICO), #redirect through #redirect . Any person who receives income directly or indirectly derived from a "pattern" of such racketeering activity (generally, two or more offensive acts within a ten year period) and who uses or invests any part of that income in the acquisition, establishment, or operation of any enterprise engaged in (or affecting) interstate or foreign commerce may be punished by up to twenty years in prison. See generally #redirect and #redirect .

Bankruptcy crimes are prosecuted by the United States Attorney, typically after a reference from the United States Trustee, the case trustee, or a bankruptcy judge.

Bankruptcy fraud can also sometimes lead to criminal prosecution in state courts, under the charge of theft of the goods or services obtained by the debtor for which payment, in whole or in part, was evaded by the fraudulent bankruptcy filing.

Bankruptcy and Federalism

On January 23, 2006, the Supreme Court, in Central Virginia Community College v. Katz, declined to apply state sovereign immunity from Seminole Tribe v. Florida, 517 U.S. 44 (1996), to defeat a trustee's action under #redirect to recover preferential transfers made by a debtor to a state agency. The Court ruled that Article I, section 8, clause 4 of the U.S. Constitution (empowering Congress to establish uniform laws on the subject of bankruptcy) abrogates the state's sovereign immunity in suits to recover preferential payments. []

History

The current Bankruptcy Code was enacted in 1978 by § 101 of the Bankruptcy Reform Act of 1978, Pub. L. No. 95-598, 92 Stat. 2549 (Nov. 6, 1978), and generally became effective on October 1, 1979. The current Code completely replaced the former Bankruptcy Act, sometimes called the "Nelson Act" (Act of July 1, 1898, ch. 541, 30 Stat. 544), which initially entered into force in 1898. The current Code has been amended numerous times since 1978. See also the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005.

Bibliography

Born Losers: A History of Failure in America, by Scott A. Sandage (Harvard University Press, 2005).

External links

[United States Bankruptcy Courts] via uscourts.gov
[Title 11 of the U.S. Code] (including links to forms) via gpo.gov
[Title 11 of the U.S. Code] via cornell.edu
[Bankrutpcy Reform 2005 Resources] via bestcase.com
[Bankruptcy Reform Page] via uscourts.gov

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