What is Bankruptcy and How Does it Work?
What is Bankruptcy?
“Bankruptcy” law is a law baked right into the Constitution. Highly detailed bankruptcy laws, which taken together are called the “bankruptcy code,” are federal laws that allow people (or companies) that are in debt to escape payment obligations and gain a “fresh start.” The general idea is that society is better off giving people or companies crippled by debts a new chance, rather than subjecting them to never-ending servitude to their creditors. This allows people to fail first, before eventually succeeding.
While American bankruptcy laws are designed to help people and companies in debt (called “debtors”), the law also gives creditors the ability to fight back against people who use the bankruptcy process unfairly or improperly. Let’s be clear: the price for this chance to escape or reorganize one’s debts is strict adherence to the rules governing how bankruptcy works and complete honesty about one’s finances. So filing for bankruptcy is not a workable option for those who have something to hide or who do not like to follow the rules.
What Are the Different Types of Bankruptcy?
There are various types of bankruptcies. Subject to meeting eligibility requirements, the debtor generally gets to pick which type of bankruptcy they want to pursue.
Chapter 7 bankruptcy
A Chapter 7 bankruptcy allows a debtor to simply turn over to a trustee all of his or her assets that are not exempt from turnover (and often there are no such assets to turn over), and then receive a “discharge,” which makes all of his or her past debts no longer collectible. The trustee then takes all the nonexempt assets that used to belong to the debtor and distributes them to creditors. The two major questions that often come up in chapter 7 are these: (1) what assets does a debtor get to keep, in other words, what assets are exempt or protected from turnover to the trustee?, and (2) Has the debtor truly turned over to the trustee all assets that are not exempt from turnover, or is the debtor hiding some of its assets?
Chapter 13 bankruptcy
A chapter 13 bankruptcy is also called a “wage earners” plan. Chapter 13 allows a debtor to keep its assets so long as it enters into a payment plan that can last between 3 to 5 years. The Bankruptcy code creates a series of tests to make sure that the payments under the plan are sufficient. Chapter 13 is most often used to save a home from being lost in foreclosure. Chapter 13 allows for a mortgage that is in default to be rehabilitated, so long as all future payments under the mortgage are made on time.
Essentially, the Debtor is allowed to cure over time all the payments that it has missed in the past. The debtor cannot rewrite the terms of a household mortgage and cannot miss making new payments going forward. Chapter 13 is geared generally towards helping out middle-class people with moderate household debts and mortgage problems. It cannot be used for large commercial debts or for large unsecured debts like credit card debt.
Regular Chapter 11 bankruptcy
Chapter 11 bankruptcy is the biggest, most complicated, and most expensive type of bankruptcy, and it is normally used by companies that may have debts in the millions or billions. This is the 2-ton Cadillac of the bankruptcy world. Chapter 11 works somewhat like Chapter 13, by requiring a debtor to come up with a reorganization plan that must satisfy a series of complicated tests. Chapter 11 allows a debtor to modify its debts to a degree, and to force creditors to take serious “haircuts” or discounts on what they will receive in repayment. A Chapter 11 plan must be proposed to creditors, who then vote on whether they accept or reject the plan.
However, under some circumstances, a plan can be forced on a rejecting creditor in a process colorfully known as a “cram down.” A Chapter 11 plan normally only works if the debtor company has a strong business with regular income that is struggling to overcome a past crisis or historic problem that is now over and not likely to repeat itself. A Chapter 11 plan cannot help a company that just does not have a good business model to begin with.
Again, chapter 11’s are long, complicated, expensive, and extremely time-consuming. While chapter 11 is ongoing, a company must obtain approval from the bankruptcy court for most of its major business decisions that are not made in the ordinary course. A company in chapter 11 will face extreme scrutiny of its finances and must have excellent corporate financial records, or it must hire professionals to get its financials up to the standards required.
Entrepreneurs, who often like their freedom and do not care for bureaucracy, can find chapter 11 to be frustrating and constricting. Once chapter 11 starts it cannot be easily called off. A company’s management needs to understand just how demanding and complicated chapter 11 will likely be. Chapter 11 is a serious project that can take years, cost hundreds of thousands of dollars, and consume the valuable time of management. A company dealing with its creditors often makes threats of “going bankrupt” to gain concessions, but it needs to think twice about such a major decision, which should never be taken lightly.
The upside of Chapter 11 is that a company can shave millions of dollars of debt off its balance sheet using this rather clunky legal tool. No other bankruptcy proceeding offers or demands as much as a Chapter 11. The trouble and expense involved in normal Chapter 11s made this legal tool too expensive and unwieldy for many smaller companies.
Small Business Chapter 11 bankruptcy
In response to the problems with normal Chapter 11s, in 2019 Congress passed a new law called the “Small Business Reorganization Act” which allowed for small businesses to enjoy many of the benefits of a full Chapter 11, but in a faster and cheaper format. This seemed like the best of both worlds: all the power and options of chapter 11, but without the hassle, delay, and cost. The catch was that Congress put in an eligibility requirement that made companies with debts above a certain amount ineligible for a small business organization. For a while, the cut-off was just $2.7 million in debt.
Unfortunately, by setting the number so low Congress made companies whose debts were higher than $2.7 million ineligible for a small business organization. The problem was temporarily fixed by a legislative “patch” that pushed the eligibility ceiling up to $7.5 million in response to the COVID-19 crisis. That patch, which was highly successful in helping many small businesses to reorganize their debts using an expedited Chapter 11, has now lapsed and the current cut-off for eligibility is now a little over $3 million. Companies with debts over $3,024,725 are thus once again ineligible for a small business Chapter 11 and must use the regular Chapter 11 process.
The Author’s Expertise
Bankruptcy and insolvency lawyers usually have expertise either as pro-debtor or pro-creditor bankruptcy attorneys. Normally, a bankruptcy attorney has to “pick a side.” This is often due to conflicts of interest that can arise. A pro-debtor lawyer working to fight banks in the bankruptcy arena, for example, will seldom be able to work for banks. Attorney Joseph Brown was trained as a pro-creditor attorney, once worked for a bank, and has considerably more experience as a creditors’ rights attorney than as a debtor’s attorney. If you have any bankruptcy questions, please contact Joseph Brown at Fausone & Grysko, PLC at (248) 380-0000.