Introduction to the Bankruptcy Laws

Introduction to the Bankruptcy Laws

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Creditor / Debtor: 
In the case of bankruptcy, the debtor is the company (or individual) who has gone bankrupt and owes money to various other firms and individuals. Those firms and individuals are the creditors.

Bankruptcy "Chapters":
In the context of bankruptcy proceedings, a “chapter” refers to the section of the U.S. Bankruptcy Code that describes the situation and procedure to be followed, based on the type of debtor seeking the bankruptcy protection.

Overview to the Bankruptcy Law

For as long as there have been people there have been debtors and creditors. Moreover, as long as there have been debtors and creditors there have been debtors who have not been able to pay their debts. Throughout history, however, there has been very little in the way of organized bankruptcy proceedings to straighten out the mess left when debts go unpaid and the lender wants his money back or at least something in return for the lost funds.

Problems created because of bad debts and bad debtors create huge problems for economies. The simple fact is that any modern economy, as well as most of those economies that have existed throughout history, require a sound system that encourages loans and takes steps to assure repayment of those loans. Money is required to expand a business, buy a tractor, or to build a house. The person or business that needs those funds may not have them available when the opportunity or need arises. Thus, they may need to borrow those funds from someone else. Lenders fill that need; providing funds in the lean times in exchange for an expected greater return when the individual or business is prepared to pay back that money, the principal, along with interest, which constitutes the lender’s profit. 

The problem is, what happens if the company or business needs funds and the lenders refuse to lend because they have lost money on too many bad loans in the past? What happens when the borrower is simply no longer able to pay?

EXAMPLE: Expanding Inc. is a new company looking for funding in a bad economy. The place where Expanding is operating has no formal bankruptcy laws. Thus, lenders who do not get paid back find themselves with little or no recourse against the borrower. As such, lenders charge exorbitantly high interest rates on loans and require very high collateral. Therefore, Expanding, and the hundreds of other firms like it, are unable to expand to meet their growing needs. Over time, this leads to the stagnating of the country’s economy.

On the one hand, there is the lender's interest. The government and the courts are committed to keeping the lenders as satisfied as possible and thus willing to continue to lend funds. Any economy that operates on the basis of the extending of credit requires a system that protects the lenders. The role of government in such a situation is to provide laws that protect the lenders from bad debts and to ensure that they keep placing funds in the marketplace. 

On the other hand, there are the debtors. One problem for debtors is that they need some sort of legal system that protects them from creditors who are trying to impose harsh terms with their loans or who use unsavory collection practices. Debtors also have the problem that, there are times that they are simply unable to pay back the loans that they have borrowed. In such a case, should that individual debtor be financially crippled for life as he struggles vainly to pay back large debts that are constantly increasing due to high interest rates, or does he deserve a fresh start at some point?

Enter the Bankruptcy Laws

Given the above situation, it is clear that any economy requires some sort of governmental scheme for regulating the lending, payment, and collection of funds. It might be surprising then, that the Unites States failed to have any truly formal bankruptcy proceeding or law until the very end of the 1800’s.

In 1898, Congress enacted the first set of bankruptcy laws for the U.S. Subsequently, those laws were amended in the Bankruptcy Reform Act of 1978 and were amended again in the Bankruptcy Reform Act of 1994. These major changes, and numerous small alterations over the last century, have resulted in the modern "Bankruptcy Code," or simply the “Code,” as referred to by Bankruptcy practitioners. The Code is codified as Title 11 of the United States Code.

The goal of the Code is twofold. First, the Code provides some protection for lenders by setting forth a process as to how the assets that remain in possession of a debtor when it goes bankrupt are to be divided. Thus, the law provides a fairly clear hierarchy that defines the rights of creditors with respect to the debtor and as amongst various lenders. See 11 USCS § 507

Additionally, the Bankruptcy Code defines the rights of the debtor as to his obligations to his creditors. The Code describes how the creditors may act with regard to the debtor and what obligations the debtor will have with regard to each of his creditors. The Code also defines the means by which the creditor can have her slate “wiped clean” so that she can go on with her life and begin to rebuild her financial health. 

EXAMPLE: Brenda has “gone bust”. Her recent loss of employment, combined with the fact that she lives in an expensive neighborhood has led to a situation whereby she can no longer pay her bills as they come due. Brenda expects that she will be able to get back on her feet after several years, but in the meantime she has run out of cash and creditors have come knocking, wanting their money back. Brenda decides to declare personal bankruptcy. During the bankruptcy proceeding, she can, with the help of the court and the cooperation of her creditors, develop a plan whereby she pays her creditors part of the funds she owes them over the course of the next several years. At the end of that period, Brenda’s remaining debts will be discharged, and she will be able to start rebuilding her finances with a new job and clean account.

Sections of the Bankruptcy Code

The rules of bankruptcy differ somewhat, as they must, depending on whether it is a business or an individual who is going bankrupt. Furthermore, there is another issue that can develop regarding the case of a business going bankrupt. That is, the company can merely be going through a rocky financial period or it can be completely ruined, with little or no long term hopes for survival.

In drafting the Bankruptcy Code, Congress was cognizant of these differing situations. Thus, it decided to create a multifaceted bankruptcy scheme that allowed for variation in the bankruptcy process, based on who is filing for bankruptcy and what results are needed to achieve by the completion of the process. Thus, the resulting structure of the Code, as it remains to this day, breaks the bankruptcy process down into “chapters” (corresponding to sections of the Code) that apply to the various types of filers and their intended results. Some chapters of the Code provide for special definitions and procedures that relate to all types of bankruptcy filings. The key chapters of the Code which are most commonly used and which we will be studying in this chapter are as follows:

Chapter 7
Chapter 7 filings, for businesses and individuals, are also known as “liquidation filings.” As that name implies, Chapter 7 is for companies whose sole intent is to enter the bankruptcy process to pay off their creditors to whatever extent they are able to and then to dissolve the firm (or liquidate the personal assets, in the case of the individual) at the completion of the process. Given this situation, it is not surprising that the bulk of Chapter 7 is devoted to the rights of the debtor's creditors vis-à-vis each other, with little regard for the actual company itself, which, by definition, is earmarked for termination. 

Chapter 11
Chapter 11 filings are known as “reorganization” filings. Chapter 11 is generally used by companies but can also be used by individuals. See Toibb v. Radloff, 501 U.S. 157 (U.S. Sup. Ct. 1991). When a company files for Chapter 11 bankruptcy protection, it is indicating that, while it recognizes its dire financial condition, it feels that it still has valuable assets and a viable business plan, and thus it intends to keep the business in operation at the completion of the proceeding. Thus, while Chapter 11 is, of course, concerned with protecting the creditors by trying to ensure that those creditors get paid off over time, its design is also to give the debtor company a bit of “breathing room” in the form of extra time, in order to allow the debtor company to get back on its feet.

Chapter 13
Chapter 13 of the Code is solely for individual persons who are filing for bankruptcy protection. As we will come to see, Chapter 13 of the Code is a fairly straightforward process, with the goal of expediting a person through the process.

It is important to note that a Chapter 11 “reorganization” filing may ultimately be translated into a Chapter 7 filing either by election of the debtor company or by order of the court. Additionally, a Chapter 7 Liquidation may be converted into a Chapter 13 “repayment” plan if the debtor approves the change. See 11 USCS § 706.

Sources of Law

An additional point that should be made about the bankruptcy law is that the source of all bankruptcy law in the U.S. is solely federal law. The federal bankruptcy code (Chapter 11 of the U.S. Code) is the only allowable piece of legislation in the area of bankruptcy as Congress has shown a clear intent to usurp the authority for creating bankruptcy law and to preempt any state law in the field of bankruptcy actions. The logic behind this move by Congress is fairly straightforward. It would not do much good for a company or individual to seek bankruptcy protection from creditors in one state, only to have another state rule that the debts are still valid and thus force the debtor to go through a bankruptcy proceeding in every state in which a creditor resides. 

In addition, Congress has deemed it so important to have bankruptcy cases stay exclusively within the province of the federal system that federal legislation gives federal courts exclusive jurisdiction over bankruptcy cases. This means that state courts are prohibited from hearing and deciding bankruptcy cases. See 28 USC § 1334. In addition, Congress has created a specific set of federal bankruptcy courts under the general rules and guidelines of the U.S. District Courts. Bankruptcy court decisions can be appealed to the federal district (trial) courts.

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