The Chapter 7 Filing

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Overview to the Chapter 7 Filing

The Chapter 7 filing, also known as “liquidation” or as an “ordinary” or “straight” bankruptcy is what people generally envision when they conceptualize a bankruptcy. In a Chapter 7 filing, which is available to both individuals and to most companies, the entity filing for the court’s protection simply turns all assets over to a representative of the court, known as a “bankruptcy trustee.” This individual is appointed by the court to oversee the bankruptcy process. See 11 USCS § 701-703.

The Process

A Chapter 7 filing includes several steps:

1. The Filing
The first step in the bankruptcy process is the filing of a “petition in bankruptcy.” This filing, made with the appropriate federal bankruptcy court in the individual's or entity’s domicile (residence of the individual or main   headquarters of the company) may be made either voluntarily or involuntary.

A voluntary filing, if made by an individual, is completed in a simple manner. The debtor files an appropriate set of forms with the bankruptcy court, indicating that the debtor understands that he (or it) is filing for liquidation and a listing of all the debts and assets belonging to the individual or company. In listing the debts, the debtor must be certain to include all its debts outstanding and the amounts of each debt. In addition, the debtor must also provide a list of all of its current and expected expenses. 

Next, the individual must accurately report all items of income she has in addition to all the property that she owns. It is important to note that this report must be accurate. Any deviation from the truth may result in dismissal of the petition by the court. It is also important to understand that an individual need not be wholly insolvent to file for bankruptcy. So long as the person has a debt outstanding to at least one creditor, that person may file. Still, a bankruptcy petition must be filed in “good faith” (because the debtor honestly believes that this is his only realistic financial option), or a court can dismiss the petition. See Huckfeldt v. Huckfeldt (In re Huckfeldt), 39 F.3d 829 (8th Cir. 1994).

EXAMPLE: Sharon has gotten herself into financial trouble due to excessive buying on high interest credit cards. Given her mounting debt burden and her inability to pay the debt, she decides to file for a Chapter 7 liquidation. In preparing for the filing, Sharon is advised by her attorney to prepare a list of all her credit card debts, along with any other debts she currently has. Additionally, she is told to prepare a list of all her property interests – including her house, car, jewelry, bank accounts, etc. – as this information will also be required by the court upon her filing. However, Sharon leaves out information about some of her assets because she feels that a judge may be less inclined to grant her petition if the judge knows about her assets. If the court later learns of these omissions, the court can dismiss the proceeding.

An involuntary filing is effected by a person or entity’s creditors. This type of proceeding is available under certain circumstances that show that the debtor will clearly not be able to repay all of his debts. See 11 USCS § 303. The filing, made with the court, must state the debts that are owed with particularity. The individual faced with such a proceeding will have a chance to challenge the assertions of the creditor. 

EXAMPLE: Before Sharon has a chance to file for bankruptcy protection, one of her credit card companies, who Sharon has failed to pay for the last six months, files a petition with the bankruptcy court to force Sharon into a Chapter 7 liquidation. The credit card company does so with the hope that it will be able to obtain at least partial payment of the debt owed to it by Sharon if they force her to liquidate her assets now. The company is afraid that, left to her own devices, Sharon will squander the assets that she does own, thus eliminating any chance the company has of recouping any of its loan to Sharon.

2. Automatic Stay
As soon as the petition for a bankruptcy is filed – whether by the creditor or by the debtor – an automatic stay kicks in, temporarily preventing any steps from being taken to collect money from the debtor. See 11 USCS § 362. This means that the debtor cannot be sued or otherwise lose her property to a creditor from the moment the petition is filed. If a creditor violates this stay without the court’s permission (court permission to override an automatic stay can be granted in exceptional circumstances) then that entity will be liable for damages to the debtor and may face penalties for contempt of court. 

EXAMPLE: Sharon files her bankruptcy petition in bankruptcy court because of her inability to pay off her credit card bills. After the petition is filed, the court grants an automatic stay under Section 362 of the bankruptcy code. Shortly thereafter, Sharon’s car is repossessed by the automotive firm that she bought the car from because Sharon has failed to make the requisite payments for the car. Upon discovering the fact of the repossession, Sharon petitions the court to have her car returned to her. The court grants her petition because Sharon had been granted an automatic stay upon filing her petition. Then, Sharon can sue the car company for her costs in having to rent a car to get around while her car had been repossessed. Sharon will succeed in this suit, because the car repossession was a violation of the automatic stay imposed by the bankruptcy court.

3. Assets Released
After the individual or company has completed filing the bankruptcy petition, he then turns all of his assets over to the legal control of the bankruptcy trustee. While the trustee is generally not in physical possession of the assets, he or she is considered to be in legal possession of them. Thus, any assets held by the filing debtor, such as stocks, bonds, property, notes payable, etc. are legally transferred to the trustee. This set of property is known as the “estate in property” and this is what the trustee will sell or distribute in order to pay off the creditors. See 11 USCS § 704.

In the instance of an individual debtor, certain assets are allowed to be excluded from the proceeding. While the list of such exemptions is fairly long, you can sum it up by saying that the individual may protect a small, but reasonable, portion of his assets in order to sustain his living conditions. In other words, a certain percentage of the value of items such as the person’s house, car, bank accounts, insurance and medical benefits, etc., cannot be touched by the creditors. 

EXAMPLE: Sharon, after appointment of a trustee, is then forced by the trustee to sign over rights to her investment portfolio so that the trustee will be able to sell the stock to raise cash to pay off Sharon’s creditors. However, Sharon is allowed to keep her car, which is the only means that Sharon has to get to and from work every day.

Although bankruptcy is within the province of federal law, it is generally state law that determines what property may be retained by a debtor in a bankruptcy proceeding. One exemption that is common to all jurisdictions is some level of “homestead” exemption so that the debtor should not be rendered homeless. This exemption is generally applied very liberally. See Prince v. Hake, 75 Wis. 638 (Wis. Sup. Ct. 1890).

4. The Meeting
Once the debtor’s assets are in the hands of the trustee, or sometimes even upon the filing of the petition, a meeting is held. This meeting includes the debtor and his counsel and all creditors listed by the debtor in his petition. At this meeting, conducted without a judge but including the trustee, the debtor is again told what happens after the proceeding and each creditor is required to file a proof of claim.

EXAMPLE: A hearing is held to determine the full extent of Sharon’s debts. Credit Co, one of Sharon’s creditors, comes to the meeting with a prepared proof of claim indicating that the terms of Sharon’s credit card agreement ensured them payments of the total $2,000 debt due at an interest rate of 18% per annum and that Sharon has not paid off he debt nor has she made any of the interest payments.

5. Distribution
Once all creditors have been heard and the debtor has turned over its assets, the trustee begins organizing the assets in a manner that makes them available for distribution. Ultimately, the methods taken by the trustee vary, but generally, the trustee may sell or mortgage assets to obtain cash to distribute to the creditors, or the trustee, may simply distribute physical assets from the debtor's property to the creditors. In the case of secured property (i.e., property on which a creditor has a lien) the trustee will give that property to the individual creditor. See 11 USCS § 726. 

As to all other general creditors, a formula is devised by the trustee to ensure that each creditor receives his pro-rata percentage of the remaining assets. However, before this formula is reached, there is a specific hierarchy devised by the law to insure that certain creditors receive assets first. This list of preferred unsecured creditors is fairly long and subject to a fair degree of interpretation. For ease of memory, the list goes something like the following:

1. Expenses from the administration of the bankruptcy (otherwise, no one would be a trustee)
2. Unpaid wages (if a company) / Ordinary expenses (if individual)
3. Employee benefits plans
4. Farmers and fishermens’ claims
5. Consumer deposits
6. Alimony and paternity payments
7. Certain taxes

See 11 USCS § 507. 

Finally, and only after the above creditors are paid (though several have dollar limits) other general unsecured creditors are paid. Secured creditors are, in essence, "exempt" from this process, because they can simply foreclose on whatever security interest they hold and receive their payments in that manner.

EXAMPLE: After taking title to Sharon’s assets and selling as many as possible, the Trustee then began to distribute funds. First, he paid his own fee for administering the bankruptcy and then paid off Sharon’s tax liability to the city and state which she had not paid the previous year. Finally, as no more senior creditors were left, he began paying off the other creditors.

It is important to note that the trustee’s powers as to distribution of the assets are not unlimited. The trustee is not allowed to show any single creditor a preference over the other creditors. Furthermore, any transactions conducted by the trustee which are fraudulent – i.e., sold for below a reasonable value or otherwise mismanaged – can result in liability for the trustee. See 11 USCS § 704. 

6. Discharge
After the above items are paid to whatever extent is possible based on the assets available to the trustee, the creditor’s debts are discharged. However, certain obligations remain on the debtor for payment in the event of future income he or she receives (they are not discharged by the bankruptcy):

1. Certain back taxes
2. Amounts borrowed to pay federal taxes
3. Items or money the debtor gained by fraud
4. Creditors not listed in the filing
5. Alimony and child support
6. Claims based on willful misconduct of the debtor
7. Some government fines and penalties
8. Certain student loans
9. Consumer debts for certain luxury items (loosely defined)
10. Some cash advances
11. Judgments and fines resulting from Driving Under the Influence violations

See 11 USCS § 727. 

EXAMPLE: Sharon, after the bankruptcy liquidation was completed, thought that she was now without debt. However, as it turned out, she later discovered that she was still required to make the $75 monthly payment on her student loan, as that debt was not discharged in the bankruptcy proceeding.

As you can see, the bankruptcy process covers many, but not all debts incurred by the debtor. In addition, if a debtor has lied or otherwise behaved in a fraudulent manner in the bankruptcy process (such as lying about or concealing assets) then the entire discharge may be revoked and all debts reinstated. 

Finally, note that in some situations, a debtor may wish to pay a debt that would otherwise be discharged. Agreements to make such payments, known as "reaffirmation" agreements, must be in writing, filed before the full discharge, and typically, agreed to by a court after a hearing. If this process if completed, the debt will remain enforceable despite the bankruptcy discharge. The debtor does not, however, have the power to demand a revocation of the entire bankruptcy discharge. See In re McQuality, 5 B.R. 302 (U.S. Bank. Ct. S.D. Ohio 1980).

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