Define: Bankruptcy

Quick Summary of Bankruptcy

A legal proceeding that relieves you of the responsibility of paying your debts or provides you with protection while attempting to repay your debts. There are two types of bankruptcies: liquidation, in which your debts are wiped out (discharged), and reorganisation, in which you provide the court with a plan for how you intend to repay your debts.

Bankruptcy is the legally declared inability or impairment of the ability of an individual or organisation to pay their creditors. A declared state of bankruptcy can be requested or initiated by the bankrupt individual or organisation, or it can be requested by creditors in an effort to recoup a portion of what they are owed. The “bankrupt” person or organisation, however, is the one who files for bankruptcy in the vast majority of cases.

The primary purposes of the bankruptcy laws are:

1. to give an honest debtor a “fresh start” in life by relieving the debtor of most debts, and
2. to repay creditors in an orderly manner to the extent that the debtor has property available for payment.

Bankruptcy allows the debtor to resolve his debts through the division of his assets among his creditors. Additionally, the declaration of bankruptcy allows debtors to be discharged of most of their financial obligations after their assets are distributed, even if their debts have not been paid in full. During the pendency of a bankruptcy proceeding, the “Debtor” is protected from extra-Bankruptcy action by creditors by a legally imposed “stay.

In the United Kingdom (UK), a Trustee in bankruptcy must be either an official receiver (a civil servant) or a licenced insolvency practitioner.

Following the introduction of the Enterprise Act, a UK bankruptcy will now normally last no longer than 12 months and maybe less if the Official Receiver files in court a certificate that his investigations are complete.

It is expected that the UK Government’s liberalisation of the UK bankruptcy regime will massively increase the number of bankruptcy cases; initial Government statistics appear to bear this out. It remains to be seen whether the leash has been loosened too far and whether the legislation will need reviewing if the system becomes too overheated with debt-dumping debtors.

Bankruptcy Types

Bankruptcy is primarily of two types: voluntary bankruptcy and involuntary bankruptcy. Bankruptcy proceedings initiated by the debtor is termed voluntary bankruptcy. Involuntary bankruptcy is the term for bankruptcy cases brought on by creditors. A bankruptcy order can be initiated without the consent of the debtor. A dispute between debtor and creditor over monetary claims can be settled before the petition is heard in a legal court.

Financial Limits

Bankruptcy involves the following actions:

• The debtor cannot officially receive credit beyond a certain predetermined limit
• debtor(s) suffer a loss of control over its assets
• The debtor cannot function as a company director.
• Trading in other businesses by the debtor is prohibited until all parties concerned with the matter are informed.
• The debtor cannot become a member of parliament
• The debtor can be examined publicly in a courtroom.
• Credit is affected for a considerable period of time

Relative Advantages

There are certain advantages for a company or an individual to declare bankruptcy. The event allows the debtor a possible discharge in a year’s time. A new life is possible after that. Creditors may also use bankruptcy proceedings to conduct a thorough investigation into the debtor’s business.

Pre-packaged Bankruptcy

It is a plan for financial refurbishment that a company fixes in conjunction with its creditors. The plan takes effect after the company becomes bankrupt. It is compulsory to obtain the consent of shareholders before a pre-packaged bankruptcy is created and applied.

The concept behind pre-packaged bankruptcy is to simplify the whole process. An effective package helps the business entity save on accounting and legal costs. A quicker recovery would help a company yield greater profits and create revenue from core activities.

Bankruptcies In The United States

Bankruptcy is federal statutory law (Title 11 of the United States Code) based upon the Constitutional requirement for “uniform laws on the subject of Bankruptcy throughout the United States.” (Article I, Section 8). Bankruptcy proceedings are undertaken in the United States Bankruptcy Courts, part of the District Court system.

There are several types of proceedings that fit under the general category bankruptcy. The US Bankruptcy Code has multiple chapters, each describing a different procedure available for debt resolution. Liquidation under a Chapter 7 filing is the most common form of bankruptcy. Liquidation involves the appointment of a trustee who collects the non-exempt property of the debtor, sells it and distributes the proceeds to the creditors. Bankruptcy under Chapter 11, Chapter 12, or Chapter 13 is more complex and involves allowing the debtor to use future earnings to pay off creditors. In addition, there is Chapter 9 bankruptcy, available only to municipalities; perhaps the most famous example of a municipal bankruptcy was in Orange County, California. Chapter 9 is a form of reorganisation, not liquidation. Chapter 12 is somewhat like Chapter 13 but is only available to farmers in certain situations. As recently as mid-2004, Chapter 12 was scheduled to expire, but in late 2004, it was given a renewed lease on life.

Bankruptcy can be entered into voluntarily by the debtor. It can also be commenced involuntarily by as few as one creditor if the debt owed is large enough. An involuntary bankruptcy may be used as a collection tool but its use can be very risky and, if wielded improperly, may subject the creditor to large damages.

Some property is exempt from being sold to pay debts in bankruptcy. The law varies greatly from state to state. In some states, exempt property includes equity in a home or car, tools of the trade, and some personal effects. In other states, an asset class such as tools of the trade will not be exempt by virtue of its class except to the extent it is claimed under a more general exemption for personal property.

One major purpose of bankruptcy is to ensure orderly and reasonable management of debt. Thus, exemptions for personal effects are thought to prevent punitive seizures of personal items of little or no economic value (diary, toothbrush, ordinary clothing), since this does not promote any desirable economic result. Similarly, tools of the trade may depend on the available exemptions and be a permitted exemption as their continued possession allows the insolvent debtor to move forward into productive work as soon as possible.

Not every debt may be discharged under every chapter of the Code. Certain taxes owed to federal, state, or local government, government-guaranteed student loans, and support obligations are not dischargeable (but guaranteed student loans are potentially dischargeable should the debtor prevail in a difficult-to-win adversary proceeding brought in the nature of a complaint to determine discharge ability that’s brought against the lender; also, the debtor can petition the court for a “financial hardship” discharge, but it is very rare that such a discharge is granted). The debtor’s liability on a Secured debt, such as a mortgage or mechanics lien on a home, maybe discharged, but the effects of the mortgage or mechanics lien cannot be discharged in most cases if it is attached prior to filing, so if the debtor wishes to retain the property, the debt must usually be paid for as agreed. (See also lien avoidance and reaffirmation agreement.) (Note: there may be additional flexibility available in Chapter 13 for debtors dealing with over sealed collateral, such as a financed auto, so long as the over sealed property is not the debtor’s primary residence.)

Also, any debt tainted by one of a variety of wrongful acts recognised by the Bankruptcy Code, including defalcation, consumer purchases or cash advances above a certain amount incurred a short time before filing, cannot be discharged. However, certain kinds of debt, such as debts incurred by way of fraud, maybe dischargeable through a Chapter 13 super discharge. All in all, as of 2005, there are 19 general categories of debt that cannot be discharged in a Chapter 7 bankruptcy and fewer debts that cannot be discharged under Chapter 13.

Bankruptcy Abuse Prevention & Consumer Protection Act of 2005

The United States Congress is considering (in 2005) legislation that would vastly change the laws of bankruptcy as they pertain to individuals. Some of the more significant and controversial changes include:

Making it more difficult for individuals to receive a Chapter 7 discharge. A means test is to be imposed on would-be filers, one that is linked to whether the debtor’s earnings in the six-month period prior to filing were above or below the median income for the debtor’s state of residence.

Making Chapter 13 far less attractive by, amongst other things, eliminating its “super discharge,” eliminating the ability of debtors to “cram down” non-residential secured property (i.e., to disallow them from paying off the real value of the secured property as secured while treating the excess value as unsecured, by disallowing the reduction of interest charged on the debt to reasonable values), by removing the credit for payments on retained secured property from the calculation of disposable income, and by requiring that debtors undergo counselling in order to file under Chapter 13.

Requiring that debtor counsel conduct an investigation of their clients’ filings and be personally liable for them, a duty apparently unprecedented under U.S. law. A similar requirement will likely force debtors desiring to reaffirm to attend a court hearing and prove to the court that they can meet obligations they wish to reaffirm (because few debtor’s attorneys will wish to certify their belief of their client’s prospective ability to pay on a reaffirmed debt). Those who cannot thus prove will be compelled to surrender the property.
Limiting the homestead protection to $125,000 in equity and establishing a 40-month residency period before such protections are recognised in bankruptcy.
Democrats oppose the legislation, while ex-President George W. Bush supports it. This legislation was originated during the Clinton Administration and had more bipartisan support at the time. But the bill has languished for years due to disagreements in Congress as to the level of the means test and whether anti-abortion groups can use bankruptcy to discharge fines levied on them by courts for actions that resulted in property damage or injury, such as bombing abortion clinics.

Bankruptcy Fraud

Bankruptcy fraud is a federal crime. Its provisions are found at Title 18 of the United States Code. After receiving a referral from the United States Trustee, the Interim Trustee, or a bankruptcy judge, the United States Attorney typically prosecutes bankruptcy fraud.

When bankruptcy is filed with criminal intent, as bankruptcy fraud is a business crime, the debtor may be subject to felony prosecution in federal court. This should be distinguished from strategic bankruptcy, which is not a criminal act. Common types of bankruptcy fraud include petition mills, false oath, concealment of assets, fraudulent conveyance, etc. Multiple filings are not per se fraudulent; as with all things in the law, it depends on the circumstances.

Bankruptcy fraud can also sometimes lead to criminal prosecution in state courts under the charge of theft of the goods or services obtained by the debtor for which payment, in whole or in part, was evaded by the fraudulent bankruptcy filing.

Disclaimer

This site contains general legal information but does not constitute professional legal advice for your particular situation. Persuing this glossary does not create an attorney-client or legal adviser relationship. If you have specific questions, please consult a qualified attorney licensed in your jurisdiction.

This glossary post was last updated: 9th April, 2024.