Chapter Seven Bankruptcy: An Overview

Chapter 7 Bankruptcy: An Overview

            What can someone do when he hits a rough stretch and faces financial trouble? Bills are mounting and bankruptcy may be his only option. It’s not so simple, though. Under which chapter of bankruptcy should the debtor file? They’re not all the same and he might not have the time or patience to handle a three to five-year process with Chapter 13 bankruptcy.

            Chapter 7 bankruptcy is the “default” bankruptcy option for many people. Chapter 7 seeks to provide a fresh start.[1] Not only is it quicker than other bankruptcy proceedings, it is the most common form of bankruptcy. In 2016, more than 63% of the 819,159 bankruptcy cases filed in the United States were Chapter 7.[2]  Chapter 7, also known as a “straight bankruptcy,” entails the sale of a debtor’s assets, payment to creditors, and freedom from debts.

            In a Chapter 7 proceeding, the debtor’s assets are collected and distributed to his or her creditors. This may include cash, bank accounts, stocks, bonds, and other investments, a second car or truck, a vacation home, expensive valuable items, or collections of stamps, coins, and family heirlooms.

            However, some property is exempt from collection and distribution. Exempt property varies by state but the debtor is typically entitled to keep as exempt equity in his primary residence, his primary car, 401(k) plans, disability or veteran’s benefits, household furnishings and appliances and reasonably necessary clothing and personal items.

            Aside from loss of non-exempt property, the most important disadvantage of Chapter 7 is that it depresses the debtor’s credit score. Moreover, the bankruptcy filing remains on a debtor’s credit report for several years after filing under Chapter 7.[3] Debtors who’ve filed for Chapter 7 typically have reduced access to credit, as well as reduced credit limits. Lenders and credit card companies are less willing to work with debtors who have filed under Chapter 7 because they appear more likely to default.[4]

The most important advantage of a Chapter 7 proceeding is the discharge, which wipes out the debts of the filer. However, Section 523 of the Bankruptcy Code provides a list of debts that are not dischargeable.[5] These include:

·         Income taxes less than three years from the time they were first due;

·         Alimony and child support payments;

·         Many government-guaranteed student loans;

·         Debts related to a divorce settlement agreement; and

·         Non-dischargeable debt from a prior bankruptcy

Procedure

            There are several steps to completing a Chapter 7 bankruptcy. The first steps occur well before the bankruptcy petition is filed.

            In the six months prior to the filing for Chapter 7, a debtor must complete two tasks. First, she must complete credit counseling from an approved credit counseling agency. The United States Trustee’s Office provides a list of pre-approved agencies on its website.[6] Credit counseling serves to help a debtor understand the economic consequences of filing for bankruptcy and to educate her on non-bankruptcy alternatives.[7]

            Second, she must complete a means test to determine eligibility to file for Chapter 7. If the debtor’s current monthly income, calculated as an average of her income over the six months prior to the filing, is below the state median, she can file for Chapter 7 immediately.[8] If it’s above the state median, then she must calculate her disposable income and determine whether it is above or below a certain threshold. Disposable income is measured by taking one’s income and subtracting certain child support and child care expenses, expenses necessary for basic support (such as rent, utilities, clothing, food and medical expenses) and payment of secured debts or those that cannot be discharged (such as mortgage and car loan payments).

If one’s disposable income is still above the state median income, one can file for Chapter 13 bankruptcy only. Chapter 7 is meant for those in the direst of financial circumstances and if the debtor has a lot of disposable income, then Chapter 13 is the more appropriate option. It should be noted that, if circumstances change, bankruptcies can be converted between the various types.

            Once counseling and the means test are complete, Chapter 7 formally begins with the filing of the bankruptcy petition, which includes schedules of assets and liabilities, income and expenditures, financial affairs, executory contracts and unexpired leases. In these forms and schedules, the debtor must list all her assets, debts, property, including exempt property, secured creditors, and unsecured creditors. “Property” here means all assets or possessions, including personal property, intellectual property, business interests, etc. Additionally, the debtor must provide a recent financial history to explain why she’s filing for Chapter 7. Schedules are signed under penalty of perjury and false information could prevent a debtor from getting a discharge and in criminal penalties.

Once the petition is submitted, an automatic stay takes effect, meaning that creditors must cease most types of collection efforts for the duration of the bankruptcy proceeding.[9] This initially applies even to secured creditors such as mortgage holders, though they can sometimes get the stay lifted. The automatic stay rules are covered in more detail in other presentations.   

            After filing the petition, the court appoints a trustee who will handle the bankruptcy “estate” and will give notice to the creditors that a bankruptcy petition has been filed. The trustee serves numerous roles. First, he reviews the paperwork to ensure that the information is accurate. He will also collect and sell the non-exempt property and furnish creditors with information about the debtor’s assets. Finally, he will make a final report and file it with the court and wrap up the estate “as expeditiously as possible.”[10]

            With the trustee in place, the bankruptcy court requires the debtor to appear at the first meeting of creditors, also called a §341 meeting.[11] The meeting takes place between 21 and 40 days after the filing and its purpose is to bring the debtor's financial affairs, assets, and liabilities to light and allows the trustee and creditors to assess the validity of the claimed exemptions.[12] Additionally, the bankruptcy code requires the trustee to ask the debtor questions at the meeting to ensure that she is aware of the potential consequences of Chapter 7 bankruptcy and its effect on credit history, the ability to file a petition under a different chapter and how a discharge works.  

            Once this meeting is complete and the debtor’s Chapter 7 eligibility is confirmed, the trustee will begin asset distribution, which is the sale of non-exempt assets and satisfying debts. Many Chapter 7 bankruptcies are “no-asset” cases, where there is little or no non-exempt property and so the creditors will get nothing. When there are assets, the trustee first pays the expenses of the administration of the case (including the trustee’s fees), then distributes any remaining funds to creditors with allowed claims, according to the priority of the claims. Priority of claims follows this order:

·         Secured creditors, paid on their security interests;

·         Claims with priority;

·         Unsecured creditors who filed their claims on time;

·         Unsecured creditors who were late in filing, if they had no notice of the bankruptcy;

·         Unsecured creditors who were late and had notice;

·         Claims by creditors for fines, penalties, and exemplary or punitive damages; and

·         Interest for all creditors, at the legal rate

            Once the trustee completes the sale of non-exempt property, the debtor must complete a course of financial education from an approved provider.[13] The class is several hours long and is available online from several providers. The class will teach the debtor about budget preparation, money management, consumer protection laws, and dealing with financial crisis.

            The debtor then gets her discharge and the automatic stay is lifted.[14] A discharge isn’t the end of the bankruptcy filing, however. The bankruptcy court closes a case only after it enters a final decree of bankruptcy.

Chapter 7 isn’t the only way to declare bankruptcy and certainly isn’t always the best option for debtors, but it is a manageable and expeditious way to discharge debts and allows people to get a fresh start when necessary.