BASIC BANKRUPTCY CONCEPTS FOR NON-BANKRUPTCY LAWYERS

REMEMBER BANKRUPTCIES?  WELL, THEY’RE COMING BACK BASIC BANKRUPTCY CONCEPTS FOR NON-BANKRUPTCY LAWYERS

By: Philip Rudd and Jim Samuelson 

With bankruptcies on the rise, this article briefly covers three fundamental bankruptcy concepts that practitioners should be familiar with. Generally, the Bankruptcy Code, 11 U.S.C. §§ 101 et seq., serves three purposes: (1) temporary relief from creditors; (2) a mechanism for the equitable distribution of a debtor’s assets to its creditors; and (3) a “fresh start” to  “the honest but unfortunate” debtor. These fundamental purposes are reflected in the three most basic effects of a bankruptcy filing: (1) the imposition of the automatic stay; (2) the creation of the bankruptcy estate; and (3) the availability of a discharge from indebtedness.

Types of Bankruptcies

A bankruptcy case is commenced by the filing of a bankruptcy petition, either by the debtor itself (a voluntary bankruptcy) or its creditors (an involuntary bankruptcy). The most common bankruptcy proceedings are (1) the Chapter 7 liquidation, in which all of the debtor’s nonexempt assets are marshalled and liquidated by a court-appointed trustee who distributes the proceeds to creditors, pro rata, pursuant to the Code’s priority scheme; (2) the Chapter 11 reorganization, in which the debtor typically remains in control of its assets and formulates a plan of reorganization providing for, among other things, the payment of its debts (note: the Code was recently amended to allow “small business debtors” [i.e., generally, debtors with no more than approximately $3 million in debt] to more easily and cost effectively reorganize); and (3) the Chapter 13 “wage earners” reorganization which allows a consumer debtor to formulate a payment plan to creditors from nonexempt assets and future earnings.

The Automatic Stay

The filing of the bankruptcy petition triggers the imposition of an “automatic stay” which provides a breathing spell for the debtor. The stay operates as an affirmative injunction against the commencement, continuation or enforcement of any action against the debtor or the debtor’s property. The stay applies to any act to create, enforce, or perfect a lien against property of the debtor’s estate, or to take possession of property of the estate. Collection activities, foreclosures and repossessions may not be pursued while the stay is in effect. The stay does not apply, however, to certain limited proceedings, including criminal, paternity, domestic support and certain tax proceedings.

Generally, the stay remains in effect until the property at issue is no longer part of the bankruptcy estate and until the earliest of the time the case is closed, or dismissed, or a discharge is granted or denied. Under certain conditions, the stay may be terminated, annulled, modified or otherwise conditioned upon a creditor’s showing of either (a) cause, including the lack of “adequate protection,” or (b) as to an act against specific property, that the debtor does not have any equity in the property and the property is not necessary for an effective reorganization that is “in prospect.”

A knowing violation of the stay may result in severe sanctions and damages, including punitive damages. 

The Creation of the Bankruptcy Estate

The commencement of a bankruptcy case creates a bankruptcy “estate.”  Generally, the estate is comprised of all legal and equitable interests of the debtor in property, wherever located and by whomsoever held, as of the commencement of the case, as well as any proceeds, product, offspring, rents, profits and earnings from any such property. Although the definition of property of the estate is broad, individual debtors are entitled to exempt certain assets from the estate, pursuant to either the Code’s exemption provisions or applicable state law exemptions.  For example, in Arizona, individuals are currently entitled to a homestead exemption of  $425,200, a vehicle exemption of $16,000, funds in certain retirement accounts, $5,400 in a single bank account or cash, and a variety of other exemptions for money benefits, household goods and furnishings and personal property.

Asserting Claims against the Bankruptcy Estate

A debtor is required to file a list of creditors and a schedule of assets and liabilities with the Court. If the debtor incorrectly schedules the amount owed to a creditor, or asserts that the claim is disputed, contingent, or unliquidated, the creditor’s rights to a distribution from the bankruptcy estate may be detrimentally affected unless a proof of claim is filed. A properly filed proof of claim constitutes prima facie evidence of the amount and validity of the creditor’s claim.  Unless objected to and disallowed by the court, the filing of a proof of claim ensures that the creditor will participate in any distribution of bankruptcy estate. The penalties for filing a fraudulent proof of claim are severe, i.e., a $500,000 fine or up to five years in prison, or both.  Thus, it is imperative that the proof of claim be accurate and, typically, signed by the creditor, not the attorney.

Avoidance Powers

The trustee (or the debtor-in-possession in a Chapter 11 case) is required to maximize the value of the bankruptcy estate for the benefit of the estate’s creditors. The trustee has certain “avoidance” or strong-arm powers available to it in order to do so.  The most common of these powers allow the estate to avoid, or set aside, for the benefit of the estate, (a) fraudulent conveyances (i.e., either transfers made with the actual intent to hinder, delay or defraud creditors and/or transfers for which the debtor received less than reasonably equivalent value and were made when the debtor was insolvent or rendered the debtor insolvent) and (b) preferences (i.e., transfers of the debtor’s property, outside of the debtor’s ordinary course of business, to a creditor within 90 days (or within one year if made to an affiliate of the debtor) prior to the bankruptcy proceeding, and which allow the creditor to recover more than it would otherwise have received if the debtor had been liquidated. 

Discharge

The goal of providing a fresh start to the honest-but-unfortunate debtor is accomplished through the grant of a “discharge” to the debtor. Generally, the effect of the discharge is to void any judgment against the debtor and to impose an injunction precluding creditors from pursuing discharged claims against the debtor. Some claims in an individual’s case are not subject to discharge, including certain tax debts, certain alimony, spousal maintenance and child support debts, certain student loans, debts for personal injury or death caused by the debtor’s drunk or drug-induced driving, certain debts incurred by the debtor as a result of debtor’s fraud or defalcation, debts for malicious or willful injury by the debtor, and restitution or criminal fines resulting from a debtor’s conviction of a crime.

The denial of a discharge, however, is not always automatic. For example, a creditor objecting to a discharge on the grounds of fraud, fraud in a fiduciary capacity, and willful and malicious injury must file a complaint in the bankruptcy proceeding and prove the non-dischargeable nature of the debt.

Conclusion

Understanding these concepts will not make you an expert on bankruptcy law. But as bankruptcy filings rise, no matter what your practice area is, you will be better prepared when that bankruptcy issue lands on your desk.