The Bankruptcy Process
Reprint from Had Enough (soon to be published)
with permission of Ken Gross Copyright 2009
Bankruptcy is a tool for Financial Crisis Management. As a tool, we use it in two ways. On a frequent basis, we remind the creditors we deal with that we are bankruptcy attorneys, representing our clients for financial crisis management and that if matters cannot be resolved on a satisfactory basis, we will file for bankruptcy relief. This is using the “threat of bankruptcy” as a tool to persuade the particular creditor to reach terms that we find to be acceptable and consistent with the plan. The “Threat of Bankruptcy” is critical to negotiations we pursue with junior mortgage holders and the credit card industry in Debt Resolution. The threat doesn’t really have significant impact with the first mortgage holders because they are secured by the first lien on the property. The distinction is that the first mortgage holder has a secured claim so the vast majority of its protection is derived from the property as the security. The junior mortgage holders, whose liens do not attach to any equity due to the depressed values of real estate, as well as the credit card companies, hold what we call “unsecured claims.” In bankruptcy proceedings, unsecured creditors are very use to receiving nothing for their claims. Because of this, the threat of bankruptcy to an unsecured creditor carries greater magnitude and if they believe the threat to be genuine they are apt to settle their claim for small dollars.
Beyond the “threat of bankruptcy,” the actual filing of bankruptcy proceedings is a valued tool in financial crisis management. There are three basic types of bankruptcy cases for individuals. They are named by the Chapters they reside in the Bankruptcy Code. For our purposes, you need to understand which Chapters we use to accomplish the appropriate tasks in the context of financial crisis management and realizing our ultimate goal of shedding debt and preserving future income. In this context, the optimal case is a Chapter 7 Bankruptcy. In this type of case, an individual is able to discharge all of his debts existing as of the date the bankruptcy case is filed, excluding certain non-dischargeable claims such as certain tax obligations, student loans, as well as debts procured by fraud and other improper actions that are not germane for this discussion. The other major type of case filed for individuals is a Chapter 13 bankruptcy which is often called a wager-earners plan or debt adjustment for individuals. Chapter 13 applies only to “individuals with regular income” and is akin to what I call a personal reorganization where debts are adjusted downward and extension on the time frame to pay is achieved. Chapter 13’s greatest feature from a Financial Crisis Management perspective is that it is the ideal type of case to file in order to stop a foreclosure of the house and seek to cure mortgage payment arrearages. As will be explained shortly, Chapter 13 has limitations as to the amount of unsecured and secured debt a person is allowed. Chapter 11, which is the formal “reorganization” chapter for businesses, as well as individuals, is available in situations where the individual does not meet the Chapter 13 debt limitations.
Chapter 7 is often referred to as the “fresh start” case. To file a Chapter 7 case, the individual’s attorney prepares a bankruptcy petition. The petition lists the assets the person owns, along with his or her secured and unsecured claims to all creditors, A limited number of exemptions is allowed on the asset side. The person filing the case is referred to as the “debtor.” The debtor actually has a choice between the specified federal exemptions or those provided under the laws of the debtor’s state. When a Chapter 7 case is completed, the debtor obtains a “discharge” of his or her pre-petition debts with the benefit of not having to pay any of the debt on a going forward basis. Though certain debts such as student loans, child support and alimony are not dischargeable, the vast majority of pre-petition debt is dischargeable and the obtaining of the discharge coupled with the retention of the specified exempt property is the operable event in providing the person a “fresh start.” In the context of my view that Financial Crisis Management’s goal is to preserve future income and to avoid allowing it to be used to pay debts of the past, a Chapter 7 case, when applicable, can be an ideal tool. Chapter 7, however, is not the tool we use when seeking to save a house from foreclosure and unfortunately, with the revisions to the Bankruptcy Code in 2005, Chapter 7, when desired, is not always available.
The availability of Chapter 7 relief for individuals was limited by The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (called “BABCPA”) as a result of intensive and successful lobbying efforts of the banking industry. The 2005 amendments changed over 100 years of bankruptcy law. The most critical change in the law is that the amendments created what is referred to as “means testing,” which has the effect of precluding someone from filing a Chapter 7 case in circumstances where they have regular income such that they have the “means” to pay back a portion of the debt. If you “fail” the means test and do not meet any other available exception for Chapter 7, you are precluded from filing a Chapter 7 case and obtaining the discharge. In this situation you must file a Chapter 13 case if you qualify, and if not, a Chapter 11 reorganization for an individual.
Chapter 7 Eligibility
An individual files his or her case in the federal district where he or she has resided the most during the 180 days immediately preceding the filing of the case. If you have previously obtained a Chapter 7 discharge, you must wait eight years after the last discharge to file another. The prime goal in filing a Chapter 7 case is to obtain a fresh start. In this context, “the debtor is exchanging his or her nonexempt property for the forgiveness of dischargeable debts.” This quoted sentence speaks to two key issues. You are only able to retain “exempt property” which means the non-exempt property will be subject to sale by trustee in order to liquidate the asset and provide funds to distribute to the creditors. Secondly, the discharge does not apply to “non-dischargeable debts.”
The exempt property is the property which the individual is allowed to retain when filing a Chapter 7 case. You are permitted to elect either the Federal Exemptions or the state law exemptions for the state you are filing in. This can be a sensitive issue that calls for the expertise of the bankruptcy attorney to address. The goal is to select the exemption scheme that will protect your most valued assets. The Federal Exemptions are listed in 11 USC 522 (you can readily find this on the Internet using a search engine). The primary federal exemptions are:
|Property||Federal Exemption Value as of
|Household – one item||$525|
|Household Items – aggregate||10,775|
|Tools of the Trade||2,025|
|Wild card||10,125* + 1,075|
* Only available to the extent the homestead exemption is not used and limited to ½ the amount
The Wildcard, in the aggregate totals, $11,200 when the debtor is not utilizing any of the Homestead exemption. This exemption is typically used to protect cash. The exemptions are per debtor, so if a husband and wife are filing, together they are each entitled to the various exemptions.
There are a total of 21 types of debts listed under 11 USC 523(a) of the Bankruptcy Code that are non-dischargeable. This list includes marital debts and support obligations, taxes (some of which are dischargeable), student loans, debts procured through fraud, as well as fraudulent conveyances.
The critical path to eligibility for obtaining a discharge in a Chapter 7 case is whether you will need to pass the means test, and if so, whether you do in fact pass the test. If your debts are not primarily consumer debts then you are not subject to the means test calculation. Consumer debts are debts incurred by an individual primarily for a personal, family or household purpose. A mortgage debt on your residence or vacation property is consumer debt. Credit card debt can be consumer or non consumer depending up on the nature of the purchases made.
Debts arising from personal guarantees of business debts are non consumer debts. Income tax liabilities and student loans have been determined to be consumer debts. We call this the Business vs. Personal Debt analysis when we review a client’s situation. In many cases, clients in Financial Crisis have substantial business debt due to a business failure. The business failure, coupled with adverse real estate holdings, has placed the client in crisis. This same client may still have solid income from his profession or other businesses such that, as we will discuss shortly, makes a Chapter 7 unavailable if the client is subject to the means test calculation. This particular client will typically have significant debts arising from guarantees on a failed business venture, along with significant credit card debt some of which is consumer and some of which is business. In these times, the same client may also be way underwater in his house along with rental properties that no longer have tenants. In this situation, we carefully analyze the Business versus Consumer Debt issue and look to strategies where by the use of some planning we can derive an outcome where the business debt can exceed the consumer debt. If we can accomplish this task, then we will be eligible to file Chapter 7 case and discharge the debts rather than being forced into either a Chapter 13 or Chapter 11 case. There are two major strategies that we’ve used. Typically, the greatest chance to shift the ratio of business versus consumer debt is to eliminate mortgage debt. This can be achieved by allowing the house to go through foreclosure or elimination of the debt through a deed in lieu of foreclosure or short sale. Once the mortgage debt is discharged or to the extent it is discharged, the ratio of Business Debt will increase compared to Consumer Debt. In situations where we’ve been able to narrow the margin, we’ve then settled out on some of the consumer credit card debt by settling those claims for 10-20 cents on the dollar in order to shift the balance so that post settlement, the business debt exceeds the consumer debt.
Beyond the Business vs. Consumer debt method of avoiding the means test in a Chapter 7, disabled veterans whose debt was primarily incurred when on active duty or while performing in homeland defense activity are not subject to the means test calculation.
The Means Test Calculation
There is a two step process in passing the means test. Remember, if you pass the “means test” you are eligible to seek the discharge in Chapter 7. If you fail the “means test” you must file under Chapter 13 if eligible, or Chapter 11 if you want to gain benefits under the Bankruptcy laws. In this sense, the term, in my view, is reversed. It is easier for me to understand the notion that if I have the means to pay back some of my debt; I should not be eligible for a Chapter 7 case. Thus, what the rule is saying is that “if you have the means to pay back some of your debt, you fail the means test and you cannot file a Chapter 7.” I hope this helps clarify the issue. You can typically count on one thing in the law, if there is a more confusing way to say something then that will be the approach taken!
The first component requires an analysis of the person’s current monthly income which is referred to as their CMI. This is the average monthly income from all sources, that the debtor receives in the preceding six-month period ending on the last day of the calendar month preceding the date the case is filed. CMI is broadly defined and includes the income of both spouses even if only one spouse is filing (unless, in limited circumstances it can be proven that the non filing spouse keeps his or her finances separate. Once the six month average CMI is calculated, it is multiplied by 12 and compared to the applicable state’s annual medium income for a household that is the same size as the individual’s according to the U.S. Census Bureau. If your CMI is less than the average, there is no presumption of abuse and you will be able to proceed with a Chapter 7 without any further means testing. The effect of CMI is that the higher the CMI, the greater chance exists that you will not pass the first component of the test leaving you in the situation where you have to continue to the second step of the process.
Census Bureau Median Income by Family Size is set forth below:
Census Bureau Median Family Income By Family Size
(Cases Filed On and After March 15, 2009)
Needless to say, the lower the CMI, the greater ease it is to qualify for a Chapter 7 filing. An interesting component in determining CMI is the effect that drawing money from an IRA or 401(k) has on the calculation of CMI. The present law in this area is not clear. Some jurisdictions include withdrawals from a person’s IRA or 401(k) in the calculation of CMI. I want to point this out for two important reasons. First, this is an unfair and unfortunate result because these funds represent monies that you’ve already earned and when you draw them from your retirement, they are not recurring sources of income so they should not be included in the calculation of CMI. Remember, our goal is to keep CMI down. The second and much more important point that I want to emphasize is the YOU SHOULD NEVER, NEVER, NEVER borrow from your IRA or 401(k) to pay credit card debt or to service a mortgage on a house under water. These funds are protected in bankruptcy proceedings and under virtually all state laws so that a creditor cannot get to these funds in or outside of bankruptcy. Taking this money from your retirement and using it to pay past debts, in my view, is like burning it. Since I have never been a fan of fire, I will tell you one more time:
NEVER, NEVER, NEVER borrow from your IRA or 401(k) to pay credit card debt or to service a mortgage on a house under water.
Let’s move on. If your annualized income is greater than the annual medium income, the next phase requires that a determination be made whether your income is sufficient to fund a meaningful repayment plan in a Chapter 13 case. If the answer is yes, then you will have failed the means test and you cannot file a Chapter 7 case. If the answer is no, you will have passed the means test and absent one more hurdle you will be on your way to a Chapter 7 discharge.
This test is often called the “net disposable income test.” The test results works like this. We evaluate your expenses to determine your annual expenses to be charged against annual income. Under the Bankruptcy Code the numbers are evaluated from the standpoint of the total dividend that would be paid to your unsecured creditors over a 60 month plan. It’s easier in some respects to think of this number in terms of annual disposable income or monthly, which are both determined by dividing the 60 month number by 5 for the annual and by 60 for the monthly. The rules work this way:
- If the net disposable income for the 60 month plan is greater than $10,950 (which is $2,190 annually and $182.50 monthly) then you can provide a meaningful repayment plan under Chapter 13 and you FAIL the means test.
- If the net disposable income for the 60 month plan is less than $6,575 (which is $1,315 annually and $109.58 monthly) then you cannot provide a meaningful repayment plan under Chapter 13 and you PASS the means test.
- If the net disposable income for the 60 month plan is less than $10,950 ($2,190 annually and $182.50 monthly) and greater than $6,575 ($1,315 annually and $109.58 monthly) AND the 60 month amount is greater than 25% of your unsecured claims then you can provide a meaningful repayment plan under Chapter 13 and you FAIL the means test.
- If the net disposable income for the 60 month plan is less than $10,950 ($2,190 annually and $182.50 monthly) and greater than $6,575 ($1,315 annually and $109.58 monthly) AND the 60 month amount is LESS than or EQUAL to 25% of your unsecured claims then you cannot provide a meaningful repayment plan under Chapter 13 and you FAIL the means test.
These determinations are “presumptions” which means that absent a showing of “special circumstances” the rules are applied as stated. The below chart illustrates the application of the rules as well:
TEST CALCULATION – STEP 2
|Net Disposable Income||Outcome – Pass or Fail Means Test|
|60 Month Plan||Annual||Monthly|
|If Greater than||10,950||2,190||182.50||FAIL MEANS TEST|
|If Less than||6,575||1,315||109.58||PASS MEANS TEST|
|If in Between and 25% of Unsecured Claims are Greater than 60 Month Amount||6,575-10,950||1,315-2,190||109.58 – 182.50||PASS MEANS TEST|
|If in Between and 25% of Unsecured Claims are Greater less than or equal 60 Month Amount||6,575-10,950||1,315-2,190||109.58 – 182.50||FAIL MEANS TEST|
Evaluation of expenses in the calculation of net disposable income is a process that requires application of limits to specific categories dictated by the process. National standards set limits on expenses for food, housekeeping, apparel, supplies and services, etc. These limitations are explained in the Internal Revenue Service Manual and can be found on the web at www.irs.gov/irm/part5/irm_05-015-001.html. The specific tables setting forth the applicable limits are found at www.irs.gov/individuals/article/0,,id=96543,00.html. I guess it’s no surprise that the website link is as convoluted as the rest of the federal framework. So you have the flavor of the limitations, the National Standard for “food, housekeeping supplies, apparel and services, personal care products and services, and miscellaneous is as follows:
|IRS NATIONAL STANDARD FOR FOOD, HOUSING, ETC.|
|Expense||One Person||Two Persons||Three Persons||Four Persons|
|Apparel & services||$86||$162||$209||$244|
|Personal care products &
For each additional person, you add $262 to the four person allowance. The guidelines may be exceeded by up to 5% for food and clothing if the excess is reasonable and necessary.
If the means test is passed, absent unusual circumstances, the case can proceed as a Chapter 7. The rest of the process is easy from the individual’s perspective. After the case is filed, it is unlawful for any creditor to contact you or take any affirmative action to pursue its claim except through the bankruptcy process. The phone calls stop, the hassle ends. You will need to attend a 341 hearing, which is conducted by the U.S. Trustee assigned to the case and typically occurs 4 to 6 weeks after the case is filed. The hearing is very short, you appear with your counsel, state your name, that you read petition when you signed it and that it was true then and true now. The trustee and any creditors can attend and ask you questions. The hearing is short and in the normal situation that is the only appearance you make. Approximately 8 to 12 weeks later, a discharge is granted by the Court and mailed to you.
Chapter 13 often called the wage-earner’s plan or debt adjustment plan is a trustee supervised reorganization of an individual’s debts. In a situation where an individual fails the means test, we evaluate whether they can derive a benefit from a Chapter 13 case. There are, however, several circumstances, where a Chapter 13 case, on its own, is a valuable tool in Financial Crisis Management. There are primarily four sets of circumstances where Chapter 13 can provide a positive outcome that is not available through a Chapter 7 filing.
The first and I’d say the foremost compelling reason to file a Chapter 13 case is that is the only way a homeowner can stop a mortgage lender from pursuing foreclosure of the house and allow for the right to cure the arrearage in payments over the course of the plan. Of course, a loan modification could achieve the same result, but this can only occur on a consensual basis with the lender – which, unfortunately, is often not available. Another key benefit to a Chapter 13 case is that if you have a second, third or other junior mortgage on your residence and there is no equity attaching to the security because the fair market value of the home is less than the first mortgage, then these junior mortgages can be stripped of all secured value and treated as an unsecured claim. Similarly, Chapter 13 allows you to strip the lien of first and all junior mortgage lenders on real estate that is not your personal residence. To the extent the mortgage balances exceed the market value of the real estate, such amounts can be treated as unsecured claims.
Chapter 13 allows you to save a vehicle from repossession or if the vehicle has been repossessed, you can compel the return of the vehicle. Chapter 13 is also a valuable tool in situations where you own real or personal property with significant equity and wish to retain these assets. Keep in mind, under Chapter 7; you only are able to retain the exempt assets. Beyond the exemptions, the remaining assets are property of the bankruptcy estate and it is the Chapter 7 trustee’s duty to sell these assets for the benefit of the creditors. Chapter 13, on the other hand, allows you to retain the assets. The tradeoff is that the value of the equity in these assets is taken into account in the determination of the amount that is to be paid to your creditors over the life of the plan.
Qualification Limits in Chapter 13
In order to be eligible to file a Chapter 13 case, the filer must be an individual with regular income and meet the debt limitations. The maximum amount of unsecured debt is $336,900 and the maximum amount of secured debt is $1,010,650. These amounts adjust every three years based upon changes in the Consumer Price Index. The next adjustment date is April 1, 2010.
Chapter 13 Timeline and Process
Once the Chapter 13 case is commenced, the 341 meeting of creditors is scheduled 25 to 45 days later. This hearing serves the same function as in a Chapter 7 case and is typically the only date in which the filer has to appear. The Chapter 13 case requires that a Chapter 13 Plan be filed. All creditors are provided a copy of the plan, as well as the U.S. Trustee who supervises the process. The Plan is approved though the process of confirming the plan. During the period between the filing of the proposed plan and the Confirmation Hearing, is scheduled approximately 90 days following the filing of the case, objections from the Trustee and Creditors can be filed and the debtor’s attorney seeks to resolve these issues in advance of the hearing or, if not resolved, they matters are addressed by the Bankruptcy Court judge at the Confirmation Hearing.
The Chapter 13 Plan length ranges between 36 and 60 months. The length of the plan is determined by the Means Test. As explained in the discussion of Chapter 7, if the filer’s median income is equal to or below the median income for the state and household size, then the plan is 36 months. If median income is above the median income for the state and household size, the plan must run for 60 months. If creditors are to be paid in full, the plan can be less than the required periods. Keep in mind, if you are below the median income, you “pass” the means test and could pursue a Chapter 7 case. This means that the reason the Chapter 13 would be filed in such a situation is to derive one of the benefits available in a Chapter 13 that is not available under Chapter 7.
Once the plan is completed, the process is completed the court will issue the discharge – which discharges the debtor from any further liability on all dischargeable claims.
Chapter 11 Reorganization
Chapter 11, which is the business reorganization provision of the Bankruptcy Code is also available for individuals. The process is complex and costly. Chapter 11 is nonetheless a tool used in Financial Crisis Management. For individuals, we consider it a tool of last resort due to its cost. At the same time, if you’re financial situation is such that you need the protection from creditors available through the bankruptcy process but you cannot pass the means test due as a result of your income being high and you fail to meet the debt qualification limits of Chapter 13, then Chapter 11 must be considered as a viable alternative.
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