Chapter 7 Bankruptcy

Chapter 7 of the Bankruptcy Code governs the process of liquidation under the bankruptcy laws of the United States. (In contrast, Chapter 11 governs the process of reorganization of a debtor in bankruptcy). Chapter 7 is the most common form of bankruptcy in the United States.

Businesses filing Chapter 7
When a troubled business is badly in debt and unable to service that debt or pay its creditors, it may file (or be forced by its creditors to file) for bankruptcy in a federal court under Chapter 7. A Chapter 7 filing means that the business ceases operations. A Chapter 7 Trustee is appointed almost immediately. The Trustee generally sells all the assets and distributes the proceeds to the creditors.

This may or may not mean that all employees will lose their jobs. When a very large company enters Chapter 7 bankruptcy, entire divisions of the company may be sold intact to other companies during the liquidation.

Fully-secured creditors, such as bondholders or mortgage lenders, have a legally-enforceable right to the collateral securing their loans or to the equivalent value, which right cannot be defeated by bankruptcy. A creditor is fully secured if the value of the collateral for its loan to the debtor equals or exceeds the amount of the debt. For this reason, however, fully-secured creditors are not entitled to participate in any distribution of liquidated assets which the bankruptcy trustee might make.

In a Chapter 7 case, a corporation or partnership does not receive a bankruptcy discharge. Only an individual can receive a Chapter 7 discharge (see 11 U.S.C. § 727(a)(1)). Once all assets of the corporate or partnership debtor have been fully administered, the case is closed. The debts of the corporation or partnership theoretically continue to exist until applicable statutory periods of limitations expire.

Individuals filing Chapter 7
Individuals can file for bankruptcy in a federal court under Chapter 7 ("straight bankruptcy", or liquidation) or Chapter 13 (a "reorganization", or debt adjustment case). (Although individuals can technically file Chapter 11 bankruptcies, those filings are rare.) In a Chapter 7 bankruptcy, the individual is allowed to keep certain exempt property. Some liens, however (such as real estate mortgages), survive. The value of property which can be claimed as exempt varies from state-to-state. Other assets, if any, are sold (liquidated) by the interim trustee to repay creditors. Many types of unsecured debt are legally discharged by the bankruptcy process, but there are 19 (as of 2005) general classes of debt that are not discharged in a Chapter 7. Common exceptions to discharge include child support, most taxes, most student loans (unless the debtor prevails in a difficult-to-win adversary proceeding brought to determine the dischargeability of the student loan), and fines and restitution imposed by a court for any crimes committed by the debtor.

A bankruptcy discharge stays on the individual's credit report for 10 years. This may make credit less available and/or terms less favorable, although high debt can have the same effect. That must be balanced against the removal of actual debt from the filer's record by the bankruptcy, which tends to improve creditworthiness. Consumer credit and creditworthiness is a complex subject, however. Future ability to obtain credit is dependent on multiple factors and difficult to predict.

Another aspect to consider is whether the debtor can avoid a challenge by the United States Trustee to his or her Chapter 7 filing as abusive. One factor in considering whether the U.S. Trustee can prevail in a challenge to the debtor's Chapter 7 filing is whether the debtor can otherwise afford to repay some or all of his debts out of disposable income in the five year time frame provided by Chapter 13. If so, then the U.S. Trustee may succeed in preventing the debtor from receiving a discharge under Chapter 7, effectively forcing the debtor into Chapter 13.

It is widely held amongst bankruptcy practitioners that the U.S. Trustee has become much more aggressive in recent times in pursuing (what the U.S. Trustee believes to be) abusive Chapter 7 filings. Through these activities the U.S. Trustee has achieved a regulatory system that Congress and most creditor-friendly commentors have consistently espoused, i.e., a formal means test for Chapter 7. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 has clarified this area of concern by making changes to the U.S. Bankruptcy Code that include, along with many other reforms, language imposing a means test for Chapter 7 cases.

Creditworthiness and the likelihood of receiving a Chapter 7 discharge are only a few of many issues to be considered in determining whether to file bankruptcy. The importance of the effects of bankruptcy on creditworthiness is sometimes overemphasized because by the time most debtors are ready to file for bankruptcy their credit score is already ruined.

Chapter 7 Bankruptcy Since 2005 Bankruptcy Reform Law Change
On October 17, 2005 the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) went into effect. This legislation was the biggest reform to the bankruptcy laws since 1978. The legislation was enacted after years of lobbying efforts by banks and lending institutions and was intended to prevent perceived abuses of the bankruptcy laws. The changes to Chapter 7 were extensive.

Means Testing
The most noteworthy change occurred within 11 U.S.C. § 707(b). Congress amended this section of the Bankruptcy Code to provide for dismissal (or conversion) of a Chapter 7 case upon a finding of “abuse” by an individual debtor (or married couple) with “primarily consumer debt.” Old §707(b) provided for dismissal of a chapter 7 case upon a finding of “substantial abuse.”

New §707(b) defines “abuse” in two ways. “Abuse” can be found when there is an unrebutted “presumption of abuse” arising under a newly created “means test,” [§707(b)(2)]. The second way to find “abuse” is through general grounds, including bad faith, determined under a totality of the circumstances [§707(b)(3)].

To determine whether a presumption of abuse arises under the means test under §707(b)(2), it is necessary to look at the debtor’s income compared with the median income in the debtor’s state. Income for purposes of this bankruptcy code section is defined as “current monthly income.” “Current monthly income” is defined in 11 U.S.C. § 101(10A) as a monthly average of all the income received by the debtor (and the debtor’s spouse in a joint case) including regular contributions to household expenses made by other persons, but excluding Social Security benefits and certain victim’s payments during a defined six-month time period prior to the filing of the bankruptcy case. Note that this average income may or may not be the debtor’s actual income at the time of filing. This has led some commentators to refer to the bankruptcy code’s “current monthly income” as “presumed income.”

The applicable median income will vary by family size. Generally, the larger the family, the greater the state’s median income and the more money the debtor must earn before a presumption of abuse arises.

This code section then requires a comparison between the debtor’s “current monthly income” and the median income for the debtor’s state. If the debtor’s income exceeds the median income, then the debtor must apply a “means test” designed to objectively determine the extent of a debtor’s ability to repay unsecured creditors. The “means test” requires the debtor to take the “current monthly income” and reduce it by a list of allowed deductions. Note that just as the “current monthly income” defined in the bankruptcy code is not necessarily “current,” “monthly,” or “income”, these deductions are not necessarily the actual expenses the debtor incurs on a monthly basis. Similarly, some commentators have referred to these deductions as “presumed expenses.” The deductions applicable in the “means test” are defined in §707(b)(2)(A)(ii)-(iv) and include: 1) living expenses specified under the ‘’collection standards of the Internal Revenue Service,’’ (2) actual expenses not provided by the Internal Revenue Standards including “reasonably necessary health insurance, disability insurance, and health savings account expenses,” (3) expenses for protection from family violence, (4) continued contributions to care of nondependent family members, (5) actual expenses of administering a chapter 13 plan, (6) expenses for grade and high school, up to $1,500 annually per minor child provided that the expenses are reasonable and necessary, (7) additional home energy costs in addition to those laid out in the IRS guidelines that are reasonable and necessary, (8) 1/60th of all secured debt that will become due in the five years after the filing of the bankruptcy case, (9) 1/60th of all priority debt, and (10) continued contributions to tax-exempt charities.

After the debtor’s “current monthly income” is reduced by the allowed deductions as described in the previous paragraph, it can be determined whether there will be a “presumption of abuse.” The “presumption of abuse” will arise if: (1) the debtor has at least $166.67 in current monthly income available after the allowed deductions (this equals $10,000 over five years) regardless of the amount of debt, or (2) the debtor has at least $100 of such income ($6,000 over five years) and this sum would be enough to pay general unsecured creditors more than 25% over five years. For example, if a debtor had exactly $100 of “current monthly income” left after deductions and owed less than $24,000 in general unsecured debt, then the presumption of abuse would arise, [§707(b)(2)(A)(i)].

Of course, presumptions could be rebutted and §707(b)(2)(B) requires the debtor swear to and document “special circumstances” that would decrease income or increase expenses such that the debtor’s remaining “current monthly income” would fall below the above two presumption of abuse trigger points discussed in the prior paragraph.

Even in cases where there is no presumption of abuse because the debtor’s “current monthly income” was below the median, or because the application of the “means test” did not trigger the presumption, it is still possible for a Chapter 7 case to be dismissed or converted. Only a judge or the United States Trustee (or bankruptcy administrator) can seek dismissal or conversion of the debtor’s case if the debtor’s “current monthly income” is below the median. Any party in interest can seek dismissal or conversion if the debtor’s “current monthly income” is above the median, even if no presumption of abuse was triggered. The grounds for dismissal under §707(b)(3) are “bad faith” or when “the totality of the circumstances (including whether the debtor seeks to reject a personal services contract and the financial need for such rejection as sought by the debtor) of the debtor’s financial situation demonstrates abuse.”

Longer waiting period between filings: Another change that resulted from the BAPCPA was an extension of the time between multiple bankruptcy filings. §727(a)(8) was amended to provide that the debtor would be denied a discharge if a debtor had received a discharge in a prior Chapter 7 case filed within eight (8) years of the filing of the present case. Prior to BAPCPA, the rule was six (6) years between chapter 7 filings. BAPCPA did not change the rule for the waiting period if the debtor filed a chapter 13 previously.

Credit counseling and debtor education requirements: Another major change to the law enacted by BAPCPA deals with eligibility. §109(h) provides that a debtor will no longer be eligible to file under either chapter 7 or chapter 13 unless within 180 days prior to filing the debtor received an “individual or group briefing” from a nonprofit budget and credit counseling agency approved by the United States trustee or bankruptcy administrator.

The new legislation also requires that all individual debtors in either chapter 7 or chapter 13 complete an “instructional course concerning personal financial management.” If a chapter 7 debtor does not complete the course, this constitutes grounds for denial of discharge pursuant to new §727(a)(11). The financial management program is experimental and the effectiveness of the program is to be studied for 18 months. Theoretically, if the educational courses prove to be ineffective, the requirement may disappear.

Applicability of Automatic Stay: The automatic stay in bankruptcy is the court order that requires all collection proceedings to stop. There are exceptions, of course, but generally this is the term for the “relief” from collection proceedings a debtor receives by filing the bankruptcy with the bankruptcy clerk’s office. BAPCPA limited the protections the stay provides in some re-filed cases. New §362(c)(3) provides that if the debtor files a chapter 7, 11 or 13 case within one year of the dismissal of an earlier case, the automatic stay in the present case terminates 30 days after the filing, unless the debtor or some other party in interest files a motion and demonstrates that the present case was filed in good faith with respect to the creditor, or creditors, being stayed. If the present case is a third filing within one (1) year, the automatic stay does not go into effect at all, unless the debtor or any other party in interest files a motion to impose the stay that demonstrates that the third filing is in good faith with respect to the creditor, or creditors, being stayed.

The provision presumes that the repeat filings are not in good faith and requires the party seeking to impose the stay (usually the debtor) to rebut the presumption by clear and convincing evidence.

There are exceptions. Notably, §362(i) provides that the presumption that the repeat filing was not in good faith would not arise in a “subsequent” case if a debtor’s prior case was dismissed “due to the creation of a debt repayment plan.”

BAPCPA also limited the applicability of the automatic stay in eviction proceedings. The stay does not stop an eviction proceeding if the landlord has already obtained a judgment of possession prior to the bankruptcy case being filed, §362(b)(22). The stay also would not apply in a situation where the eviction is based on “endangerment” of the rented property or “illegal use of controlled substances” on the property, §362(b)(23). In either situation the landlord must file with the court and serve on the debtor a certificate of non-applicability of the stay spelling out the facts giving rise to one of the exceptions. There is a process for the debtor to contest the assertions in the landlord’s certificate or if state law gives the debtor an additional right to cure the default even after an order for possession is entered, §362(l) & (m).

Stricter notice requirements
BAPCPA enacts a provision that protects creditors from monetary penalties for violating the stay if the debtor did not give “effective” notice pursuant to §342, [§342(g)]. The new notice provisions require the debtor to give notice of the bankruptcy to the creditor at an “address filed by the creditor with the court,” or “at an address stated in two communications from the creditor to the debtor within 90 days of the filing of the bankruptcy case. The notice must also include the account number used by the creditor in the two relevant communications [§342(c)(2)(e) & (f)]. An ineffective notice can be cured if the notice is later “brought to the attention of the creditor.” This means that the notice must be received by a person designated by the creditor to receive bankruptcy notices.

Dischargeability
BAPCPA also provided more protections to creditors because it expanded the exceptions to discharge. The presumption of fraud in the use of credit cards was expanded. The amount that the debtor must charge for “luxury goods” to invoke the presumption is reduced from $1,225 to $500. The amount of cash advances that would give rise to a presumption of fraud has also been reduced, from $1,225 to $750. The time period was increased from 60 days to 90 days. Thus, if a debtor purchases any single item for more than $500 within 90 days of filing, the presumption that the debt was incurred fraudulently and therefore non-dischargeable in the bankruptcy arises. Prior to BAPCPA, the presumption would not have arisen unless the purchase was for more than $1,225 and was made within 60 days of filing (§523(a)(2)(C)).

BAPCPA amended §523(a)(8) to broaden the types of educational loans that can not be discharged in bankruptcy absent proof of “undue hardship.” The nature of the lender is no longer relevant. Thus, even loans from “for-profit” or “non-governmental” entities are not dischargeable.

Applicability of exemptions
BAPCPA attempted to eliminate the perceived “forum shopping” by changing the rules on claiming exemptions. Exemptions define the amount of property debtors may protect from liquidation to pay creditors. Typically, every state has exemption laws that define the amount of property that can be protected from creditor collection action within the state. There is also a federal statute that defines exemptions in federal cases. In bankruptcy, Congress allowed states to opt out of the federal exemption scheme. Opt out states still controlled the amount of property that could be protected from creditors, or “exempted” from creditors, in bankruptcy cases.

Under BAPCPA, a debtor who has moved from one state to another within two years of filing (730 days) the bankruptcy case must use exemptions from the place of the debtor’s domicile for the majority of the 180 day time period preceding the two years (730 days) before the filing [§522(b)(3)]. If the new residency requirement would render the debtor ineligible for any exemption, then the debtor can choose the federal exemptions.

BAPCPA also “capped” the amount of a homestead exemption that a debtor can claim in bankruptcy, despite state exemption statutes. The new law caps homestead exemptions at $125,000 in situations where a debtor has been convicted of a felony demonstrating that the filing of the bankruptcy was an abuse of the provision of the Bankruptcy Code, or if the debtor owes a debt arising from a violation of federal or state securities laws, fiduciary fraud, racketeering, or crimes or intentional torts that caused serious bodily injury or death “in the preceding 5 years” [§522(q)]. There is an exception if the property is “reasonably necessary for the support of the debtor and any dependent of the debtor.”

Also, there is a “cap” placed upon the homestead exemption in situations where the debtor, within 1215 days (about 3 years and 4 months) preceding the bankruptcy case added value to a homestead. The provision provides that “any value in excess of $125,000” added to a homestead can not be exempted. The only exception is if the value was transferred from another homestead within the same state or if the homestead is the principal residence of a family farmer (§522(p)). This “cap” would apply in situations where a debtor has purchased a new homestead in a different state, or where the debtor has increased the value to his/her homestead (presumably through a remodeling or addition).

Lien avoidance
Some types of liens may be avoided through a chapter 7 bankruptcy case. However, BAPCPA limited the ability of debtors to avoid liens through bankruptcy. The definition of “household goods” was changed limiting “electronic equipment” to one radio, one television, one VCR, and one personal computer with related equipment. The definition now excludes works of art not created by the debtor or a relative of the debtor, jewelry worth more than $500 (except wedding rings), and motor vehicles (§521(f)(1)(B)). Prior to BAPCPA, the definition of household goods was broader so that more items could have been included, including more than one television, VCR, radio, etc…

2003 Statistics
Bankruptcy filings by individuals:
Chapter 7 filings: 1,156,284
Chapter 11 filings: 959
Chapter 13 filings: 468,562

Bankruptcy filings by businesses:
Chapter 7 filings: 21,008
Chapter 11 filings: 9,185
Chapter 12 filings: 698
Chapter 13 filings: 5,201
The total number of bankruptcies rose 7.4 percent over the previous twelve months. These totals were for the 12-month period ending September 30, 2003.

2004 Statistics
TOTAL bankruptcies:
Chapter 7 filings: 1,153,865
Chapter 11 filings: 10,368
Chapter 12 filings: 238
Chapter 13 filings: 454,412
Bankruptcy cases filed in federal courts fell 2.6 percent in fiscal year 2004 according to the Administrative Office of the U.S. Courts. During the 12-month period ending September 30, 2004, 1,618,987 bankruptcies were filed, down from the 1,661,996 bankruptcy cases filed in fiscal year 2003.

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