Coping with Bankruptcy
Like it or not, bankruptcy affects all of us. In the current economic and political climate, businesses and individuals are feeling the pinch and filing bankruptcy petitions at a record pace. Many of us in North Carolina have been affected by the bankruptcies of Midway Airlines, Kmart, and WorldCom, whether it be by the loss of a customer, employment, or an otherwise valuable investment. Others have been written off open credit accounts or faced the added difficulty of enforcing orders for alimony, child support, or property distribution when a personal bankruptcy case has been filed. Understanding some of the basics of bankruptcy can help people identify when to take action.
Bankruptcy is authorized by federal law and is administered by federal bankruptcy courts. In North Carolina, the three bankruptcy court districts are: the Eastern District (e.g., Wilson, Raleigh, Wilmington), the Middle District (e.g., Winston-Salem, Greensboro, Durham), and the Western District (e.g., Charlotte, Statesville, Asheville). The general policy behind bankruptcy relief is to provide a fresh start in financial matters by a reduced payment plan and modified payment terms or through a total liquidation of all assets. Individual persons that successfully complete a bankruptcy proceeding receive a “discharge,” which relieves them of the legal responsibility to pay certain debts. Businesses seek bankruptcy protection as a means of reorganization to continue operations or to orderly liquidate assets.
The person or business seeking bankruptcy relief is generally referred to as the “debtor” or “debtor-in-possession.” In individual cases, a trustee is appointed by the bankruptcy court to administer the case, collect assets, pay creditors, and bring suits on behalf of the bankruptcy estate. A trustee may also be appointed in a business reorganization case under specific circumstances. However, in many business cases the debtor-in-possession serves this function. A bankruptcy case is initiated by the filing of a petition in bankruptcy, which is usually voluntarily filed by the debtor. The debtor files several “schedules” with the bankruptcy court showing assets, debts, income, expenses, and other financial information. In a personal or business reorganization case, the debtor also proposes a plan of repayment.
The Bankruptcy Code is divided into several chapters containing provisions for the administration of the case. A Chapter 7 bankruptcy is commonly known as a liquidating bankruptcy or “straight” bankruptcy and is typically chosen by persons and businesses having little to no assets, high debt that is not secured by collateral (e.g., credit cards, medical or doctor bills), and income that barely meets expenses. In a Chapter 7, the trustee investigates the debtor’s property and possible claims and rights that make up the “bankruptcy estate” to determine if anything may be sold in order to pay creditors. Creditors receive payment in a Chapter 7 case only if the trustee recovers assets. Individuals are entitled to keep a certain amount of their property free from distribution to creditors by claiming “exemptions” of property necessary for the basic living needs of themselves and their families.
Chapters 11, 12, and 13 are generally cases in which a reorganization of financial affairs is sought by the debtor. In cases under these chapters, creditors are paid through a plan “confirmed” or approved by the bankruptcy court. Repayment under such plans generally occurs over several years. Chapter 11 is typically known as a business reorganization, usually employed by corporations. However, persons owing large debts may qualify for relief under Chapter 11. The Chapter 11 case can also be used to sell property and wind down operations, and such a case is commonly referred to as a “liquidating 11.” Chapter 12 provides for bankruptcy relief to the family farmer. A Chapter 13 case is the means for individuals to effect a personal reorganization, i.e., reducing or changing payment terms and keeping property free from liquidation. Commonly known as the “wage-earner plan,” a Chapter 13 bankruptcy requires the debtor to have sufficient income to pay a specific amount to be distributed to creditors. Chapter 13 cases are usually filed by debtors that are delinquent in payments to creditors having security in collateral, such as in a house or car. The Chapter 13 trustee acts on behalf of creditors to collect the payments of the debtor and disburse them to the creditors in the case under the terms of the confirmed bankruptcy plan.
When a bankruptcy notice arrives, the worst thing that a creditor can do is ignore it. Upon the filing of the bankruptcy petition the debtor is under the protection of the bankruptcy court. An “automatic stay” occurs immediately with the filing of the case, preventing creditors from taking any collection action. Telephone calls, letters, repossession, seizure, lawsuits, and obtaining liens or judgments are all prohibited actions. A creditor that ignores the automatic stay or takes action against the debtor can be subject to sanctions by the bankruptcy court, which can include an order to pay damages and attorney’s fees to the debtor or worse yet an order for arrest for contempt of court. The bankruptcy notice will give key information as to the type of case filed and important deadlines, such as when the creditors’ meeting will be held, the time to file proofs of claim, and the deadline for objecting to discharge or the dischargeability of debts. Generally, the bankruptcy case will move along quickly and a missed deadline can be fatal to the creditor. In addition to notices received in the case, creditors may obtain information directly from the bankruptcy courts by accessing their web sites. Access is through the following sites for North Carolina: Eastern District – www.nceb.uscourts.gov, Middle District – www.ncmb.uscourts.gov, Western District – www.ncwb.uscourts.gov.
Before taking any course of action in a bankruptcy case, creditors should consider the amount of the claim, the costs of action, and the perceived benefit or increased recovery. In addition to properly and timely filing a proof of claim, which is a statement of the amount owed made on an official court form, creditors should keep some primary strategies in mind: (1) seek information; (2) seek payment from alternative sources; and (3) seek better treatment. Valuable information about the debtor’s case can be learned at the creditors’ meeting, and the creditor should consider attending. The creditors’ meeting or “Section 341 Meeting” is conducted at the beginning of the case, and the debtor is required to provide information under oath as to assets and liabilities. Creditors have an opportunity to ask limited questions and possibly speak with the debtor’s attorney as to issues pertaining to their claim or the case.
If there is a codebtor or guarantor on the creditor’s claim, the creditor should consider whether payment may be sought from that source. In Chapter 13 any codebtor on a debt of a consumer nature is protected by an automatic stay effected by the debtor’s bankruptcy filing, even if that codebtor is not a debtor in bankruptcy (e.g., wife who did not file a joint bankruptcy petition with her husband). This codebtor stay does not apply to the collection or enforcement of business-related debts or claims. There is no codebtor stay in Chapter 7 and 11 cases, and it is not necessary to cease collection activity against any codebtors, cosigners, or guarantors in those cases. However, in some instances special orders may be entered in a Chapter 11 case to protect a nondebtor. In the individual case, the creditor should read all notices from the bankruptcy court carefully to ensure that the debtor’s spouse has not joined in the petition to avoid any violations of the stay. The continued, lawful pursuit of codebtors can perhaps result in the enforcement of the codebtor’s obligation, better treatment of the creditor in the proposed plan, or a reaffirmation agreement from the Chapter 7 debtor agreeing to remain personally liable on an otherwise dischargeable obligation.
There are ways for creditors to seek better treatment by making objections in the bankruptcy case. For example, objections can be made to the proposed plan of reorganization in the Chapter 11, 12, or 13 case or to the dischargeability of the creditor’s debt in the Chapter 7 case. Generally, objections to proposed plans of reorganization are made if the plan does not comply with the requirements of the Bankruptcy Code, is not proposed in good faith, does not pay secured creditors the value of their claims in consideration of the value of the collateral, and is not feasible (i.e., debtor will not be able to pay or comply). An objection to the “dischargeability” of the creditor’s claim in Chapter 7 is made by the filing of an “adversary proceeding” or lawsuit in the bankruptcy court. For example, an objection to dischargeability may be brought by creditors with claims for false pretenses or actual fraud of the debtor in obtaining property or credit, for willful and malicious injury by the debtor to another or property of another, and for separation or divorce obligations incurred by the debtor (e.g., equitable distribution order or property settlement agreement). Before filing an adversary proceeding objecting to the dischargeability of the claim the creditor should carefully assess the amount of the claim, the cost of pursuit, including legal fees, the supporting evidence, the likelihood of success, and the future ability of the debtor to pay the debt (e.g., age, health, family circumstances, skills, and earning potential). If the creditor is successful in the suit, the debtor will remain obligated on the claim even though other debts were discharged in the bankruptcy proceeding. Creditors should not hesitate if they have grounds to object to the dischargeability of their claim. A suit must be filed within 60 days of the first date set for the creditors’ meeting, and this is a firm deadline.
There is nothing that can absolutely prevent a creditor from being affected by a bankruptcy filing. However, there are some general things to keep in mind for the voluntary creditor (one affirmatively choosing to lend, such as a bank or trade supplier) and the involuntary creditor (one that by application of law is owed a claim or debt, such as a former spouse or automobile accident victim). For voluntary creditors, the key is to make informed lending decisions. It is crucial to get detailed information on the credit application. Be sure that the applicant, not a representative of the creditor, completes the application in full, signs, and dates it. Get credit references, authorization from the applicant for you to contact the references, and then call them. Assess the risk of loss early and know what risk level is appropriate in consideration of the consequences if the applicant cannot pay. An increased credit risk may be worth an additional down payment, collateral, cosigner, or higher interest rate. Know that additional sources of repayment can improve collection success and get a cosigner or guarantor. If the applicant does not qualify for credit in his or her own standing under the creditor’s standards, document the file with this information and then seek a cosigner or guarantor that meets the usual standard for creditworthiness. A cosigner or guarantor on the account or debt is leverage against the debtor to make timely payments. It also increases the chance of repayment in the event that the primary obligor files a bankruptcy case.
For voluntary and involuntary creditors alike, keep the following in mind: (1) get paid; (2) get security; and (3) get a judgment. Monitor the payments that are due and don’t let the receivable get out of control. Allowing late or skipped payments makes the debtor believe that the creditor is not serious about enforcing the terms of repayment. If the debtor offers payment, take it. The creditor should, however, be careful not to facilitate an implied modification of terms or payment amount. Creditors should not be afraid to take voluntary payments from debtors that suggest that a bankruptcy filing is around the corner. While there are certain instances under the Bankruptcy Code that payments made prior to bankruptcy may be recovered from the creditor, generally money in the bank is better than no money at all as the creditor may have defenses to any demand or action in the subsequent bankruptcy case.
Creditors with unsecured credit lines or loans are usually not prevented from later requesting security or collateral once the debtor has defaulted under the terms of the credit agreement. Security can be in many forms: personal property, real estate, bank accounts, receivables, or cash. If security is obtained, the creditor must ensure that the security interest is properly documented and recorded as may be required under law. As with the acceptance of payment followed by the debtor’s bankruptcy filing, obtaining security on an unsecured debt prior to bankruptcy may subject the creditor to a recovery or avoidance action in the bankruptcy case. However, the risk may be worth it and the creditor may have defenses under the Bankruptcy Code.
Be realistic about the debtor’s ability and intent to pay and don’t wait to get tough. Being quick to sue and bring the claim to judgment can increase the collectability of the claim as the debtor may have real or personal property that can be seized to pay the judgment. If the debtor is not repaying one creditor, then there are most likely others that are not being paid. Be the first creditor with the ability to lawfully seize property to enforce collection. In the event of a bankruptcy, if the debtor has real property to which the judgment lien has attached the creditor will have a better likelihood of payment than the creditor with only a defaulted loan or account.
It is generally rare that a creditor will receive full payment of a claim in a bankruptcy case. “No asset” cases in Chapter 7 are the norm, and nothing is available for liquidation or distribution to creditors. In Chapter 11 and 13 cases, payments take several years and are usually a small fraction of the creditor’s total claim. Bankruptcy reform legislation has been debated in Congress over recent years. In March the U.S. House of Representatives passed a bill proposing widespread changes to the Bankruptcy Code that generally will make discharge of debts more difficult and require greater repayments to creditors. The bill has yet to be passed by the U.S. Senate. Meanwhile, bankruptcy will continue to impact our businesses, our lives, and our bottom lines.