When a business entity or person is unable to pay its debts, bankruptcy law provides avenues to resolve those debts. These remedies are available to individuals, partnerships, LLCs, and corporations. Bankruptcy law seeks to balance the claims of the creditors with the inability of the debtor to meet those obligations. 

A debtor is an individual or business entity that owes money to another entity. A creditor is an individual or business to which money is owed. As students familiar with good accounting practices, you recognize that assets (the value of the property owned) should exceed liabilities (what is owed). When an individual or business's liabilities exceed assets, insolvency occurs.

Insolvency may lead to default, the state in which a debtor fails to meet one or more financial obligations to a creditor. When default occurs, creditors seek to protect their interests by collecting from the debtor.

Bankruptcy law has two main goals. First, bankruptcy laws ensure that creditors competing for the debtor's assets are treated fairly. Second, it allows the debtor the ability to have a "fresh start" without the crippling insolvency that preceded the bankruptcy. 

Bankruptcy laws were not always so liberal in the United States. Until the American Revolutionary War, the Thirteen Colonies followed the British system governing insolvent creditors. This system frequently involved putting the debtor into debtors' prison where the individual would perform labor to cover the costs of both the incarceration and the underlying debt. Upon the ratification of the US Constitution in 1789, Congress was given the power to create bankruptcy law. These laws permitted a creditor to sell certain assets held by the debtor, with an amount retained by the debtor (to allow a fresh start) and the remainder allocated to the creditors.

Governed by federal and state law, the proceedings may have different results depending on the state of filing. However, in no state can a bankruptcy be filed in bad faith - that is, with the sole purpose to defraud a creditor. Moreover, it is illegal to knowingly lie, hide assets, or falsify reports when filing for bankruptcy. 

Bankruptcy Proceedings

Remember from our study of civil procedure (Chapter 3) that bankruptcy is subject to the exclusive jurisdiction of the federal courts. Therefore, those filing bankruptcy in Rexburg will do so at the federal court in Pocatello.

Most bankruptcy cases share a set of proceedings:

1. The filing of a petition for bankruptcy.
2. Once the petition is filed, the court grants an automatic stay for creditor actions against the debtor.
3. The court determines whether or not bankruptcy is appropriate.
4. The creditors meet with the debtor.
5. A payment plan may be created and approved by the court and the creditors to be implemented later.
6. Debts are usually discharged.

The Filing

Bankruptcy begins with the filing of the petition in bankruptcy with the court. Almost all bankruptcies are voluntary petitions, meaning that the individual or business entity files the petition on behalf of itself. However, in a small number of cases (about 1%), involuntary petitions may be filed by a creditor if a number of conditions are met.

The Automatic Stay

The petition acts as a stay against creditors taking any action against the debtor. Creditors may not attempt to recover the debts, enforce judgments, or place liens on property. In effect, the automatic stay creates a short respite from the worries of the debt and prohibits creditors from communicating with the debtor. All creditors must rely on the bankruptcy courts when seeking payment from a debtor that has filed bankruptcy. Violation of the automatic stay may result in all debts to that creditor being dismissed.

Meeting with the Creditors

Assuming that the bankruptcy is appropriate (more on this later), the creditors must meet within a reasonable amount of time. The debtor may be called to the meeting to make statements under oath. A trustee is appointed and will mediate this meeting in an attempt to distribute assets (if any) in a manner deemed appropriate to the creditors.

During this process, creditors must show that they have a valid right to payment, known as a claim. Before the trustee can distribute the debtor's assets to the creditors, the creditors must submit their claims within six months of the meeting. The trustee or creditor has the ability to dispute and eventually disallow any claim that is found not to be valid. 

Priority of Claims

The bankruptcy code establishes a priority among the creditors. Establishing priority is vital because it may determine which creditor(s) get paid and which do not. Remember that the debtor filed bankruptcy due to insolvency, an inability to pay the debts as they come due. As a result, at least one creditor is not going to be paid. To have the best chance of collecting the debts, it is important as a creditor to have higher priority. The next chapter discusses how to ensure this.

First, secured creditors get their security interests before others receive payment. Next priority claims can receive payment. Priority claims include (listed in order of preference):

1. Domestic support obligations. These are claims for support owed to the spouse, former spouse, or child.
2. Administrative expenses. We're primarily looking at the trustee and attorney fees here.
3. Employee wages. If the creditor owes money to employees, the courts will then grant the employees their wages up to about $11,000 for each worker.
4. Taxes.

This visual may help you see how the bankruptcy estate is created and distributed by the trustee:

Throughout this process, the debtor is required to be honest. Any violation of this duty may result in the denial of the bankruptcy discharge (the part where the debtor is discharged of his remaining debts). 

Debtor's Exemptions

The Bankruptcy Code anticipates debtors coming out of the process with something to live on. If this were not the case, or in other words, if debtors came out of bankruptcy with nothing, the entire purpose of the law would be frustrated. As a result, bankruptcy allows debtors to keep some limited assets (known as exceptions) so as to permit a fresh start. 

Unfortunately, the law is not uniform when dealing with exceptions. States have been permitted to create their own exemptions and they vary widely from state to state. To avoid debtors that "state shop" in order to use the state with the most generous exceptions, the law does require that a debtor live in a state for 2 years prior to filing bankruptcy to utilize that state's laws. Because some states have such generous exceptions and others do not, I'll limit the following to just the federal exemptions alongside the Idaho-specific exemptions:

The federal law also allows debtors to keep personal property up to $575 per item, including furnishings, clothing, animals, crops, and books, with an aggregate amount limited to $12,250. Idaho follows a similar rule and includes that debtors may also retain their food storage (yet another reason to get that started!), burial plots, water rights for up to 50 acres, and a firearm worth up to $500, because...Idaho. 

Post Bankruptcy

Once the debtor has received the discharge, the debtor is no longer legally required to pay any remaining dischargeable debts that arose before the bankruptcy filing. The debtor will retain the assets listed as exceptions and will move forward unencumbered by the previous debts. 

But life for the debtor is not all smiles and giggles. Some debts cannot be discharged in bankruptcy. The most common non-dischargeable debts include:

• Debts not listed in the bankruptcy filings
• Student loans...except in extreme cases...though this may be changing...
• Taxes
• Alimony and child support
• Debts incurred by fraud or embezzlement

A debtor may also decide to reaffirm a debt that was discharged in bankruptcy.

Chapter 07: Liquidation Proceedings

The most common type of bankruptcy filing is Chapter 7 (so named because the law around this type of bankruptcy is found in Chapter 7 of the Bankruptcy Code). This type of bankruptcy, also known as liquidation, allows the bankruptcy trustee to make an accounting of all the available assets in order to pay off creditors in the order of priority. Once the available assets are spent, the remaining debt is discharged. 

Under Chapter 7, a debtor can be an individual or business entity. As with all bankruptcies, the process starts when the debtor files a petition. In 2005, Congress passed the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) in an effort to curb what many (especially creditors) considered to be abusive (too frequent) bankruptcy filings. The major piece of BAPCPA involved requiring Chapter 7 debtors/petitioners to pass the "means test." Congress wanted to keep wealthy individuals out of Chapter 7.

To apply the means test, the debtor must make less than the state's median income. Courts look at the average of the last 6 month's income to make this determination. If the income is less than the median, then the debtor can move forward with a Chapter 7. You can find a sample Idaho means test calculator here. If the debtor makes more than the median, then the debtor must file a Chapter 13 bankruptcy discussed below.

Assuming the bankruptcy proceedings move forward, the trustee will collect all the assets of the estate that are not exempt, sell them, and distribute the assets to the creditors in the priority noted above. Once the estate is distributed in this manner, the judge will order that all remaining debts are discharged (except for the non-dischargeable debts). If the debtor committed fraud (i.e., concealed assets, fraudulently transferred assets, etc.), the discharge will be revoked. If a business entity has filed bankruptcy, it does not receive a discharge. Rather, the entity is dissolved after the assets are liquidated. Debt may remain, but it becomes non-collectible since the business is no more.

Chapter 11: Reorganization

Chapter 11 of the Bankruptcy Code provides a process for businesses to rehabilitate themselves and continue to operate free from the burden of debts that it cannot pay. K-Mart, Delta Airlines, and General Motors all have applied for Chapter 11 protection. In most cases, the business will retain possession and control of the business through the bankruptcy. A creditor's committee is formed to represent the interests of those with claims against the business.

The business must present a reorganization plan. The plan must:

1. designate classes of claims and ownership interests,
2. specify which classes or interests are impaired (which claims are going to be negatively affected by the plan),
3. specify the treatment of any claims or interests that is impaired by the plan,
4. provide the same treatment for each class, and
5. provide adequate means to carry out the plan.

In essence, the plan must outline how it is going to fairly deal with the debts that it owes the creditors. At that point, the plan must be accepted by a certain percentage of the creditors. Obviously, not every creditor is going to be paid, so the plan must be fair, proposed in good faith, and show that the company is likely to come out of bankruptcy with a good chance of survival. Once approved, the court grants the petition and the remaining debts are discharged.

Chapter 13: Adjustment of Debts

Imagine Chapter 13 Bankruptcy as the left-overs. No one really wants it. If you don't qualify for, or get kicked out of Chapter 7, you will end up in Chapter 13. Whereas Chapter 7 can grant a discharge relatively soon after filing, a Chapter 13 serves to prolong the time the debtor has to make payments on the debt before a discharge can occur. Under the plan, debtors must make payments on their debt between 3-5 years before receiving the discharge. Chapter 13 is available only to individuals and not to businesses.