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Key Concepts to Understand Bankruptcy Process

4. What key concepts are necessary to understand the bankruptcy process?

Below are some key concepts and definitions to understand prior to continuing with this chapter.

•    Filing for Bankruptcy – Filing for bankruptcy means submitting a bankruptcy petition along with all supporting documents to the bankruptcy court. For individuals, a bankruptcy filing is voluntary (optional for the individual). A business bankruptcy may be voluntary or involuntary. In a voluntary petition, the bankruptcy court will review the initial filing for completeness. If accepted, the court will initiate the bankruptcy process. If applicable, the court will then forward the case to the office of the trustee. In a business reorganization, the debtor-in-possession will begin exercising the authority granted a trustee under the bankruptcy law. In an involuntary bankruptcy filing, the debtor has the option of agreeing with the petition or contesting the petition before the bankruptcy court.

•    Bankrupt Estate – Upon filing bankruptcy, the court will issue an “order of relief”. This order serves to form the bankruptcy estate. The bankruptcy estate includes all non-exempt assets and debts of the debtor at the time of the bankruptcy filing. Basically, the debts and assets of the debtor are held in trust and managed for the benefit of creditors. Assets acquired or debts incurred after the filing of bankruptcy may be excluded from the bankruptcy estate, absent a specific bankruptcy law allowing the estate to incur the debt or claim an interest in the asset.

⁃    Note: Bankruptcy law incorporates federal and state laws regarding assets that are exempt from the bankruptcy estate. This may include an equity value in a primary residence, a dollar value of specific types of personal property, retirement accounts, etc.

•    Automatic Stay – The automatic stay is an important protection afforded a debtor and the bankruptcy estate. Once the court issues the order of relief, the law grants the debtor a stay from all collection efforts by creditors or their representatives. The stay of proceeding places penalties on any creditor who seeks to collect a debt incurred prior to the bankruptcy filing. This provision gives the debtor the ability to assemble debts and develop a plan for liquidation or reorganization.

•    Meeting of Creditors – Once the order of relief is issued, creditors have the opportunity to meet to examine debtor records and discuss claims against the estate. This meeting is more common in business bankruptcies than in individual bankruptcies. In chapter 7 cases, the trustee will orchestrate the vote to elect a permanent trustee.

•    Creditor Priority – Priority in bankruptcy refers to the order in which creditors of the debtor or bankruptcy estate are paid. Generally, secured creditors must be paid in full from the liquidation or reorganization, or the asset(s) securing the secured creditors’ claims must be surrendered to them. Once secured creditors are paid, unsecured creditors are paid in their established order of priority. Unsecured debtors with similar priority are treated as a class. If each unsecured debtor in a class is not paid in full, each member of the class receives payment based upon an equal percentage of her debt. Creditor priority may be established by the nature or type of the debt, the timing or order in which the debt is incurred, or the contractual provisions associated with the debt. Generally, unsecured creditors only receive payment of a fraction of their total claim (if they receive anything at all) due to the scarcity of assets in the bankruptcy estate. For this reason, creditors often argue over their priority.

⁃    Note: The concept of priority is covered in greater detail in the chapter on secured transactions.

•    Discharge – The debts of the debtor that are included in the bankruptcy estate are generally discharged after the successful completion of the bankruptcy process. This means that the debts are satisfied and the creditors cannot later seek repayment of these debts. Whatever amount the debtor receives as payment on the debt from the bankruptcy estate is final. The type of bankruptcy will determine whether a creditor receives a single payment (in a liquidation) or whether the debtor receives installment payments for a period of time (in a reorganization).

⁃    Note: Certain obligations cannot be discharged in bankruptcy, such as tax, alimony and child support obligations, intentional tort liability, student loan liability, breach of fiduciary duty, drunk driving liability, certain government fines, and debts not submitted to the trustee.

•    Discussion: Why do you think the debts and assets of the debtor are held in trust during the bankruptcy process? What do you think is the value of the automatic stay? How do you think priority rules affect the conduct of creditors when lending to debtors, if at all?

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