Bankruptcies grant relief from creditors, allow restart

December 7, 2009
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What do Lehman Brothers, Washington Mutual, WorldCom and General Motors have in common? Bankruptcy.

Lehman Brothers was the largest bankruptcy in United States history; it filed with $691 billion in assets. General Motors filed June 1, 2009, with $82 billion in assets.

But what is bankruptcy, anyway?

History of bankruptcy

The concept of bankruptcy is no recent development. Under Hammurabi's Code, circa 1790 B.C., an insolvent debtor was sold into slavery to repay his debts. Ancient Greece went further, forcing an insolvent male debtor's wife, children and servants into slavery, as well.

Medieval England allowed imprisonment of debtors, and presumed that all bankrupt persons were dishonest. Debtors could be forced to repay their debts — or be hung.

Fortunately, modern bankruptcy law does not include such harsh penalties.

Over time, American bankruptcy law has refocused on rehabilitating the insolvent debtor as opposed to seizing and distributing the debtor's property. Major laws were passed in 1800, 1898, 1978, and most recently in 2005, with the Bankruptcy Abuse and Prevention Consumer Protection Act.

The United States Code contains most of the current federal bankruptcy law. Title 11 covers bankruptcy and has nine chapters. The most well known are chapters 7, 11 and 13.

Chapter 7 bankruptcies

Chapter 7 bankruptcy is essentially a liquidation of the debtor's assets. Either the debtor or a creditor may file the action, although filing by the debtor is most common.

A bankruptcy trustee is appointed by the court and charged with selling (liquidating) the debtor's assets, and distributing the proceeds to the creditors. Secured creditors — e.g., mortgage lenders — are ensured the value of their collateral, while unsecured creditors — e.g., credit cards — may receive only a portion of the debt owed them.

Notably, a company that files Chapter 7 is dissolved through liquidation and ceases to exist. Only individuals filing Chapter 7 may obtain a discharge of debt. An individual may be able to keep certain "exempt" properties, such as a primary home or car. However, liens such as mortgages or auto loans will continue to exist.

Chapter 11 bankruptcies

Chapter 11 bankruptcy, in contrast, is a reorganization of a company's or an individual's financial structure. Congress believed that it is sometimes more economically efficient to reorganize and shift unpaid debt into ownership, rather than liquidate the company to pay its creditors.

Most Chapter 11 bankruptcies are filed by companies, rather than individuals, as they are typically complex and expensive.

A company that files acts as its own bankruptcy trustee, continuing operations subject to the court's oversight. It may obtain new loans by giving lenders first priority on subsequent earnings, and may cancel some pending contracts. An "automatic stay" puts a hold on current collection proceedings and litigation against the debtor.

If debts exceed assets, the current owners lose the company, and ownership shifts to the creditors. However, unlike Chapter 7 bankruptcy, the company continues to exist.

Chapter 11 reorganizes the company by accepting plans from the debtor and its creditors, upon which the creditors vote. A confirmed plan is legally binding, and addresses the treatment of current debts and future business operations.

At the end of the plan, the debtor finally "emerges" from bankruptcy protection to resume normal operations. This may take months or years, depending on the size and complexity of the bankruptcy.

Chapter 13 bankruptcies

Chapter 13 also reorganizes the debtor, but it applies to individuals only. The goal is to rehabilitate individual debtors, provided they have sufficient on-going disposable income and fulfill a court-approved plan. Unlike a Chapter 7 liquidation, creditors are not immediately compensated.

The debtor proposes a plan to pay his creditors over a three- to five-year period. The plan must detail all of the payments that will occur, and the debtor must begin repayment within 45 days. During the plan period, the debtor is protected from creditors' attempts to collect on previously incurred debts.

Chapter 13 bankruptcy allows an individual to keep most of his property, and creditors often end up with less than they are owed. However, all unsecured creditors must receive at least as much as they would receive through a Chapter 7 liquidation. Further, all creditors must approve the plan, the plan must repay all creditors in full, or the debtor must commit all its disposable income to the plan for at least three to five years.

Although legally complicated, bankruptcies simply grant relief from creditors and allow the debtor to start over again with a clean slate. Debtors may file using federal forms, bankruptcy software, a paralegal-type preparer, or with a bankruptcy attorney. Only an attorney is able to provide specific, fact-based advice, so those concerned with their current financial situation are advised to seek legal counsel.

Art Dykhuis, who is a student at Notre Dame Law School, was a 2009 summer associate with Varnum LLP.

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