BANKRUPTCY: THE PROCESS & PROCEDURE
By: Joel S. Treuhaft, Esquire
Nobody wants to see a bankruptcy attorney. It is often the hardest decision that potential clients have to make. The acknowledgment that finances have become out-of-control often leads to anxiety and depression for individuals, and strains relationships. The truth of the matter is, however, that the decision to investigate the bankruptcy process often proves to be a liberating experience as well as a practical method to regain control of a person’s financial situation.
There are any number of good reasons why people get into financial difficulty. People suffer injuries or illness, go through a divorce, lose a job, experience a business failure, or are laid-off. Improvident credit card spending can also lead to a situation where current monthly income is not sufficient to meet monthly expenses. However, other than advancing the proposition that one’s first obligation is to you and your family before your credit card obligations, and that it does not make sense to have to grow reliant on food stamps or aid for dependent children in order to pay your Sears bill, I am not nearly as concerned with how potential clients got into debt as I am concerned by what they are going to do about it. I don’t want my clients looking over their shoulder. I want them focused on what’s ahead, and how they can help themselves and their families.
A Brief History of the Debtor-Creditor Relationship
The beginning of the concept of the adjustment of the debtor-creditor relationship arises in the Old Testament, where it suggests that debts should be forgiven after seven years. The word “bankruptcy” comes from the Roman era when most merchants operated in marketplaces and their individual shops were actually long, narrow stone benches. If the merchant wasn’t paying his suppliers, his bench at the marketplace would be broken to show the general public that he wasn’t paying his bills on time (the word “bankruptcy” means “broken bench”).
The American legal system is a descendant of the British legal system. In Britain, a concept developed in the 1600’s which became known as debtor’s prison. The idea was that a person’s family would be so embarrassed if they had a member in jail for not paying his debts that the family would be motivated to make good for the poor soul. That worked out well if you were lucky enough to be born into the 3% or 4% of the population that was wealthy. However, for the 96% or 97% of the general population, it didn’t make a lot of sense. Not only was the head of the household kept in jail, often for years, but the rest of the family was left to fend for itself. An alternative to debtor’s prisons were debtor colonies. Georgia and parts of Australia were originally founded as debtor colonies.
When the founding fathers at the Constitutional Convention drafted the Constitution and the Bill of Rights, two of the provisions were that there would be no debtor’s prison in the United States, and that Congress would enact uniform bankruptcy laws. The purpose of this was twofold. First, it became apparent that debtor’s prison did not work. Second, the founding fathers realized that hard working people could get into financial difficulties when trying to establish themselves and make a living in new, unsettled areas of the country. At the time of the drafting of the Constitution, a greater part of the population was farmers. Often it was necessary to mortgage lands which had been in families for generations in order to economically survive a planting and growing season until it was harvest time. For any number of reasons, many of which had nothing to do with a farmer’s hard work, harvests failed. Events such as a fire, flood, blight, drought, or any number of other occurrences could cause property which had been in the family’s name for generations to be lost through no intentional bad act on the part of the land owner. For reasons such as those, Congress developed the philosophy that an honest debtor is entitled to a fresh start, not a head start, but a fresh start. Accordingly, this philosophy was incorporated into the Constitution through the two provisions mentioned above. These provisions ensure that, with relatively little variation, the adjustment of the debtor-creditor relationship is consistent on a nationwide basis.
As a young boy I used to watch cartoons early in the morning and on Saturdays. My favorite cartoons were the ones that were drawn in the 1930s, 1940s and 1950s. In those cartoons, whenever someone went into bankruptcy Court, they would come out dressed only in a barrel. In reality, the cartoons were not so far from the truth. The first permanent bankruptcy law enacted by Congress was known as the Bankruptcy Act and it was drafted in 1897. There was not a wholesale revision of that law until 1978. By that time, the outmoded exemption provisions and punitive aspects of the bankruptcy laws were found to be no longer appropriate for a society and economy which no longer resembled that which existed in 1897. The new bankruptcy laws provided standard federal exemptions, or allowed states to enact their own exemption laws to reflect the particulars of state law. Exemptions were intended to allow debtors to keep a reasonable amount of personal property which would be shielded from administration by the bankruptcy Court, and out of the reach of creditors of all types. Florida, for example, is a State which chose to opt out of the federal exemptions, and adopt its own. Therefore, Florida has been able to allow its state Constitutional Homestead provisions to remain intact, and to ensure that a Florida Homestead cannot be lost to creditors, except in a few rare circumstances, at least as of this date (there is currently legislation pending in Congress which may restrict Florida’s ability to retain its unlimited Homestead exemption).
Liquidation and Reorganization
Currently, the bankruptcy laws define situations in one of two ways, liquidations or reorganizations. Most people recognize bankruptcy as the Chapter 7 liquidation. This type of bankruptcy allows the debtor to choose how to treat their secured debts, and be able to wipe out most of their honestly incurred unsecured debt. Reorganizations require that money will be paid to creditors over a period of time. Reorganizations are divided into commercial and consumer subsets. Commercial reorganizations include municipalities (Chapter 9); corporations, other business entities, or persons who do not qualify for other types of reorganizations (Chapter 11) or; family farm reorganizations (Chapter 12). Chapter 13 is primarily for consumer debt, and requires a repayment plan for certain debts. It is officially titled “Adjustment of Debts for Individuals with a Regular Income.” The Chapter 7 liquidation acts as a starting point for all types of bankruptcy. Accordingly, most of the following discussion will be focused on the common elements, and the specific options offered by each of the reorganizations will be briefly touched upon at the end.
All forms of bankruptcy are started by the filing of a bankruptcy petition. A petition can be filed by an individual, a husband and wife, or an authorized legal entity, such as a corporation, partnership, etc. The Chapter 7 liquidation divides a petition filer’s life into assets and liabilities, and then looks to the petition filer’s income and expenses to see if a fair evaluation of the debtor’s budget could result in a meaningful payment to creditors in a Chapter 13 adjustment of debts. Assets are defined by law as items owned by the petition filer. By liabilities, the law means things that a petition filer owes, or their debts. Liabilities are comprised of the petition filer’s debts and are categorized into three types. The first category is priority debt. Priority debt consists of obligations such as wages and benefits owed by an employer to employees, security deposits held by landlords, certain farming and fishing warehousing concerns, and federal, state, and local taxes. The second category is secured debt. Secured debt consists of items which have been pledged as collateral for the repayment of an indebtedness in a legally valid and recognized way, such as a mortgage recorded in the proper county to secure the repayment of a loan for the purchase of a house, or a lien on a car title to secure a loan for the purchase of the vehicle. The third category is unsecured debt. Unsecured debt consists of everything else, such as credit cards, medical bills, signature loans, etc.
Priority and Secured Debt
Not surprisingly, the largest form of priority debt is clearly taxes, especially federal taxes. The same government which collects those federal taxes is the same government which enacted the bankruptcy laws, and which determined that most of those taxes would not be dischargeable (wiped out) in bankruptcy. With secured debt, the Court gives a petition filer four choices: (1) the petition filer can keep the item which secures the indebtedness and continue to make the regular monthly payments; (2) the petition filer can surrender (give it back) the item which secures the indebtedness, and owes no more money for that item; (3) the petition filer can “redeem” the item which secures the indebtedness, and only pay the fair market value for the item being redeemed and; (4) the petition filer can file a Motion for Lien Avoidance (discussed below). To better understand the concept of redeeming collateral, bankruptcy law only allows a creditor to be “secured” up to the value of its collateral. Any debt which is owed in excess of the value of the collateral would be considered an unsecured debt, and treated the same as all other unsecured debts. An example would be my desk. My favorite desk sells for about $900.00 new. If a furniture store were to sell me that desk on credit and retain a purchase money security interest (P.M.S.I.) in the desk, I would have to make regular monthly payments, including interest, until the desk was paid off. However, in bankruptcy, I could pay the holder of the P.M.S.I. the fair market value of the desk and treat the remaining balance as an unsecured debt. Now you may ask, what is the fair market value of my desk? My response would be that, in a garage sale, I would be lucky to get $50.00 for my executive desk. Now, you want to know, how do you get my desk for $50.00?
In order to get the desk for fair market “used desk” value, a Motion to Redeem must be filed in a Chapter 7 case, or a Motion to Value Collateral must be filed in a reorganization case (Chapter 11, 12 or 13). In order to file this motion, a basis for the opinion of the value must be attached to the motion requesting the bankruptcy Court to determine value. One method of valuation is the opinion of the owner of the property. However, unless the owner of the property has some special or expert knowledge with regards to the property owned, it is likely be determined that somebody who deals on a regular basis in the property to be valued would have a more credible opinion of that property’s value. Therefore, in order to establish values, a person filing a motion to redeem or motion to determine secured status usually needs to get an appraisal from somebody who deals in used goods of the kind, or to hire a professional appraiser (professional appraisers often work with bankruptcy attorneys, and a professional appraiser who works in your area can be referred to you upon request). Once a written estimate of value is obtained, it is attached to the motion, filed with the Court, and served on the party which holds the security interest in the collateral being valued. The party holding the security interest then gets a period of time to file a response which either agrees with the proposed value, or to suggest a value of the collateral that it thinks is more reflective of the fair market value (if no response is filed, the Court will generally grant the motion based on the value alleged in the motion).
If a Response is filed, and the value of the collateral is not agreed upon, the Court will conduct a hearing. To return to the example of the desk, let us say a Response was filed to my Motion to Redeem whereby the secured creditor alleged that the resale value of my desk was $200.00. My motion supported by an appraisal alleges that the fair market value of the used desk is $50.00. The appraiser would testify to this based on the age and condition of the desk, its original value, and the value that similar desks in the local marketplace would bring. Although there may be evidence to support that in a retail establishment a used desk similar to mine might bring $200.00, that would constitute the retail price after the cost of repossession, reconditioning, storage, re-advertising and commission. The Court will consider all the evidence before it to determine the value of the desk.
The same concept works with regard to a vehicle. Let us say I purchase a new car which costs $26,000.00. The minute I drive it off the lot I am lucky to get $20,000.00 for the same car. The problem is, if I have $20,000.00 lying around, I probably do not need to file a Chapter 7 bankruptcy. However, in a reorganization, such as a Chapter 13, a high value item such as a vehicle (but not real property) can be valued through a Motion to Value Collateral, and paid for, at the Court-determined value, plus a reasonable interest rate over 36 months or less (more time may be available if the secured creditor consents to payments over a period greater than 36 months). However, in the reorganization, a portion of the unsecured balance of the item being valued must be paid as well.
The fourth way secured debt can be treated is called a lien avoidance. A lien avoidance occurs in one of two instances. First, for people who own homesteads, if a judgment is obtained against them, and then re-recorded in the county where their homestead is situated, most title companies in the State of Florida will consider the judgment a cloud on title until there has been a judicial determination that the real property was homestead at all times the judgment lien attached to the subject property. The bankruptcy Court has the jurisdiction and power to determine homestead property and avoid judgment liens which purport to attached to them. To accomplish this, a Motion to Avoid Lien is required to be filed.
The second method of lien avoidance is when you go to a finance company and they agree to loan you money, but require that you pledge items in your house or tools of your trade as collateral for the loan. This type of loan is different from the purchase money security interest loan, because, unlike the P.M.S.I., you already own the property you pledged as collateral to the finance company. In this case, as long as you retained possession of your household goods or tools of the trade, a loan of this type (non-purchase money, non-possessory security interest) can be determined to be an avoidable lien in bankruptcy. Once again, the appropriate Motion to Avoid Lien must be filed. Once the Bankruptcy Court determines that a loan is this type, it can enter an order avoiding the lien, and treat the debt as unsecured, usually wiping it out completely.
All other types of debt, i.e., credit cards, medical bills, signature loans, informal agreements, installment payment agreements without a valid security agreement, etc., are unsecured debt and are discharged completely (wiped out), with several exceptions. The major exceptions are set forth as follows, however, if you have any particular concerns, be sure to bring it to the attention of the attorneys you speak to.
Exceptions to Discharge
The first requirements to obtain a discharge are disclosure and cooperation. Congress is willing to give an honest debtor a fresh start in exchange for complete disclosure. The documents filed with the Bankruptcy Court are signed under the penalty of perjury, and they require an honest and diligent effort to supply the information requested in the preliminary papers, as well as to the trustee (or United States Trustee) who is appointed to your case. Debtors are also required to make a reasonable attempt to maintain records, and explain any loss of assets in the recent past. Attempts to deceive a trustee or creditors by intentionally concealing or failing to disclose assets or financial records are grounds to deny a discharge in total.