Our Bankruptcy Attorney Blog

In the United States there are actually six different types of bankruptcy allowed by law, though for most people only two are really relevant; Chapter 7 (“straight bankruptcy”) and Chapter 13 (“wage earner bankruptcy”) bankruptcy. The other kinds of bankruptcy are more specialized and are not usually applied to individuals though there may be exceptions. These other four forms of bankruptcy are Chapter 9 (for municipalities), Chapter 11 (primarily for large corporations, but occasionally high net worth individuals), Chapter 12 (for family farmers and fishermen), and Chapter 15 (for international debtors and creditors).

Chapter 7 bankruptcy is what most people think of when they think of bankruptcy. The basic process entails liquidating the debtors non-exempt property and using the proceeds to pay as much of the outstanding debt as possible. Once this phase is complete, the rest of the debt is either discharged (or written off and invalidated) or restructured into a court ordered payment plan. Before 2005, most debts were discharged, more or less giving the debtor a second chance, but since the passing of the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) of 2005, many more debts have simply been restructured, reducing the value of the whole process in many cases.

Historically speaking Chapter 7 bankruptcy was a valuable tool to help people get a second chance, but the Bankruptcy Abuse Prevention and Consumer Protection Act has changed much of this. This bill was specifically written by the lending industry and completely serves their interests to the detriment of the debtor. This law instituted a means test, mandatory credit counseling, added a wide range of mandatory dismissal provisions to the instructions used by the judges for minor technicalities, and mandated that much less debt is to be discharged, in favor of court order restructuring. Basically the only people that Chapter 7 bankruptcy makes sense for today are people who are literally destitute except for their exempted property. Chapter 7 generally exempts property necessary for life (like your home and clothes) and property necessary for livelihood (like a primary vehicle and tools) from liquidation and collection efforts.

Chapter 13 bankruptcy is very different from Chapter 7 and does not result in any property being liquidated or any debt being discharged. Instead it basically amounts to a court order debt restructuring plan. Chapter 13 bankruptcy is known as “wage earner bankruptcy” because it only really applies to people with a significant regular income. This is the option usually chosen by professionals, who can rely of a decent regular income and who frequently own properties that would not be exempted from liquidation under Chapter 7 bankruptcy. Further, since the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 implemented a means test to Chapter 7 bankruptcy, in some cases Chapter 13 may be the only bankruptcy option open to the debtor.

Essentially the Chapter 13 process takes into account all of the debtor’s income and holdings and all of their debt and liabilities and develops a carefully structured repayment plan that usually lasts from three to five years. Virtually every aspect of the debtor’s spending is spelled out in and governed by the repayment plan; making it a very intrusive process. Further, any mistake – like a late payment – can result in the whole Chapter 13 repayment plan being scrapped, leaving the debtor in a much worse situation than they were in before.

Although many people think of bankruptcy as an absolute last resort measure to be taken in order to stave off utter destitution, in reality this is not what bankruptcy was designed for and does not represent the best use of the advantages it can offer. Despite the popular impression that bankruptcy is the absolute worst financial move that can be made, in reality there are many times when it is a much better idea than many of the alternatives. When looking at the possible advantages of bankruptcy, first you have to define which type of bankruptcy is being discussed: Chapter 13 (or “Wage Earner Bankruptcy”) or Chapter 7 (or “Straight Bankruptcy”).

Chapter 13 bankruptcy is the option chosen by people that have a lot of assets that would not be exempt under Chapter 7 bankruptcy and are earning a reasonable regular income. Unlike Chapter 7 bankruptcy, no debt is actually discharged or erased, but instead it is all restructured according to a detailed plan.  In effect, it is like court ordered loan modification and as long as the debtor follows the restructuring agreement perfectly, they get to pay off their debt over a three to five year period while preventing their creditors from taking any actions against their property or other measures. Further, Chapter 13 frequently involved the creditors stopping any additional interest or assessing additional fees, so at least in this respect some money is saved. The catch is that the debtor has to follow the restructuring plan to the letter, as any little mistake – like a single late payment – is enough to throw out the entire Chapter 13 repayment plan, leaving the debtor at the mercy of the creditors.

Chapter 7 bankruptcy is more what most people think of when they think of bankruptcy in general. In this process, the debtor loses his or her non-exempt property, which is put up for auction and the proceeds are paid out to the creditors. The remaining debt is discharged, or written off, by the court and no longer remains outstanding against the debtor. Chapter 7 bankruptcy allows most things that are required for living (home, furniture, clothing, etc.) as well as most things required to make a living (vehicle, tools, word-related equipment, etc.) exemption from being liquidated. So Chapter 7 bankruptcy automatically protects your most valuable assets – like your home – from your creditors and may (or may not) result in a significant amount of your outstanding debt being discharged.

Chapter 7 bankruptcy used to be much more beneficial to the debtor, but the passing of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) – a bill that was practically written by professional lending institutions and their lobbyists – changed much of this. Today a debtor has to pass a means test in order to qualify for bankruptcy, has to obtain the approval of a recognized credit counseling agency, can not exempt as much property as used to be the case, and fewer debts can be discharged. Nevertheless, Chapter 7 bankruptcy still offers a range advantages, the most important being the protection of your home and primary vehicle from your creditors.

In the United States, all bankruptcy filing fall under federal law and the federal government offers six different varieties of bankruptcy. However, of these the overwhelming majority of personal filings are either Chapter 7 or Chapter 13 bankruptcies, while the majority of business filings are either Chapter 7 or Chapter 11 bankruptcies. The remaining options are less commonly used, but still available to qualifying people and entities.

Basic, or “straight”, bankruptcy refers to Chapter 7 bankruptcy. This is where a debtor’s non-exempt assets are liquidated and the proceeds given to the creditors while the remaining debt is largely discharged. This is what most people think of when they think of bankruptcy in general. Most personal property that is necessary for living and making a living (employment) is exempted from liquidation. This is by far the most common form of bankruptcy filed and also the least expensive and simplest option available. Although it remains the most common option, the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 has made it more difficult to file for and taken away many of the benefits of this form of bankruptcy.

Chapter 13 bankruptcies are the more popular option for people with a lot of assets that would not be exempted from liquidation under a Chapter 7 bankruptcy. It typically only applies to professional people with a steady income, which is why it is frequently called “Wage Earner Bankruptcy”. No debt is actually discharged under a Chapter 13 bankruptcy; instead the court implements a strict debt restructuring agreement. Under this agreement, the creditors are forbidden from collection efforts outside of the agreed to terms of the Chapter 13 debt restructuring. However, should the debtor fail to meet his or her obligations under the Chapter 13 restructuring, the whole plan is usually thrown out and the creditors are allowed to pursue the debtor.

Chapter 11 bankruptcy is best known as “corporate bankruptcy” and primarily amounts to a comprehensive reorganization of the entire bankrupt entity. This option is most popular for large corporations since it allows them to continue operating while allowing the courts to design a workable debt repayment scheme to be followed. Some individuals, especially those with large numbers of debts and assets and complex investments, also file Chapter 11 bankruptcy. Such reorganization schemes tend to be very expensive and complex, so the only individuals dealing with this form of bankruptcy tend to be high net worth ones (people with more than a $1 million in investable financial assets, excluding real estate).

The three types of bankruptcy described above account for more than eighty percent of American bankruptcies, but there are other forms as well:

Chapter 12 bankruptcy is a special form of personal bankruptcy that is allowed to family farmers and fishermen in the United States. Though the qualifications are tighter, the benefits are also better for the bankrupt farmer or fisherman under a Chapter 12 bankruptcy.

Chapter 15 bankruptcy primarily deals with foreign, or non-U.S., debtors that owe money in the country. Primarily this is used for American branches of foreign corporations or financial entities (banks, insurance companies, et cetera). These can be extremely complex cases since frequently international treaty law comes into play.

Chapter 9 bankruptcy applies solely to American municipalities – local, city, or county governments that go bankrupt. As an internal government matter, the average person has little, if anything, to do with Chapter 9 bankruptcy.

Although your credit report is used today for far more purposes than was originally envisaged, its primary purpose is to provide lenders with an overall view of an individual’s history of handling his or her debts. The basic idea is simple enough: a credit report points out how responsible an individual is when it comes to their personal finances. Do they pay their debts? Do they pay their debts in full? Do they pay their debts on time? If not, is the problem habitual or was it just a one time problem?

Virtually all lenders have to weigh the risk represented by the individual borrower against the amount of money to be charged for the loan. People with excellent credit pay less to borrow money because they represent less of a risk. At the same time, people with mediocre – or even very bad – credit can still be lent to, but will be expected to pay a lot more for the favour and will be expected to pay back the loan much faster than would otherwise be the case. The lenders offset the risk posed by a borrower by charging higher interest rates and demanding larger monthly payments than someone with sterling credit would be expected to pay.

In view of the above, obviously bankruptcy is almost the worst thing that could appear on a borrower’s credit report. Bankruptcy is turning to the court for protection from one’s creditors and in modern American society generally viewed as a public admission of one’s inability to meet their financial obligations. That is, to declare bankruptcy is not only the ultimate statement of an individual’s financial irresponsibility, but it is also an open declaration that they are willing to turn to the government – the bankruptcy courts – for assistance, which – obviously – all creditors view negatively.

Therefore it can come as no surprise that bankruptcy will almost automatically reduce an individual’s personal credit rating to the bottom of the barrel. Further, a bankruptcy stays on an individual’s credit report for a full ten years and will always been seen extremely negatively by lenders.

However, realistically, responsible borrowers can begin rebuilding their credit almost immediately after a bankruptcy agreement has been concluded (either after the debt discharge in Chapter 7 bankruptcy or the restructuring plan concludes for Chapter 13 bankruptcy). In fact, since debtors cannot file for a second bankruptcy until a full eight years has passed, many of the more predatory credit card companies immediately offer new credit to people filing for bankruptcy since they know if these people get themselves in trouble they have no further recourse to the courts. In fact, assuming the bankrupt person has kept their credit perfect since the bankruptcy, they can qualify for government backed mortgages and the like within two years.

Ultimately, the only thing worse than a personal bankruptcy that can appear on a personal credit report is criminal indictment in financial fraud and conviction (along with court ordered reparation and punitive payments). Nevertheless, it is not the end of the line and people that learn their lesson and behave responsibly after a bankruptcy can actually have fairly decent credit scores within a few years. Nevertheless, the bankruptcy will still be listed on their credit report and they will remain obligated to pay a lot more for almost any sort of loan than other people are expected to.

Contrary to the popular view that the primary purpose of Chapter 7 bankruptcy is to wipe away debt after leaving the bankrupt person utterly destitute, in reality the truth is the exact opposite of this suggestion. Namely, the primary purpose of bankruptcy protection is to provide the debtor some respite from the actions of the lenders, especially lawsuits and other measures taken against the debtor’s property. While Chapter 7 bankruptcy does require turning over most unnecessary assets of value to the court – who then liquidates them and pays a portion to the creditors – the entire purpose precludes leaving the debtor an utter pauper. Instead, there are a number of different items – most of which are required to allow the debtor to live and make a living – that are exempt.

Though all bankruptcy cases go to the federal bankruptcy courts, there are actually two tiers of exempt property: one given by the federal government and another given by the state government. The person filing for bankruptcy has to claim his or her exempt property according to either the federal or state standard, however the state standards tend to offer more exempt items than the federal ones (since they are supplemental to the federal exemptions rules); most people end up choosing the state schedule of exempt items. This means they differ, with more conservative states offering little more than the federal exempt properties and more liberal states offering considerably more protection. 

Any item that the debtor wish to protect under exemption has to be listed on the appropriate schedule in the filing paperwork of the petition. Failure to include this schedule, or failure to include some particular item to it, is a common mistake made by people filing their own bankruptcy papers and the result is that the omitted item is not protected from creditors. Although the rules differ per state, in general there are two classes of properties that are frequently exempt from liquidation under Chapter 7 bankruptcy: items needed to live and items needed to make a living.

Items needed to live typically include a portion of the equity in their primary residence, up to a certain amount, which ensures that the debtor’s house cannot be taken from them. Other items in this category include reasonably necessary items such as clothing, household furnishings, household appliances, jewelry (up to a certain value), amounts of cash from public benefits such as welfare, social security, or unemployment; pensions and damages awarded for personal injury.

Items needed to make a living include one (or more) motor vehicles up to a certain value; the tools of the debtor’s trade or profession (usually only up to a certain value), and other items that can be reasonably claimed to be essential for the debtor to earn income. Every state has different requirements in this respect, but the requirements almost always have upper limits on them. That is, typically a debtor cannot claim a car worth $200,000 as their primary means of transportation or a private machine shop as necessary for income if the debtor is in fact a doctor.

Items that are almost always excluded from exemption include: secondary homes or real estate, secondary vehicles (unless more than one person works in the household), recreational vehicles (boats, RVs, motorcycles), valuable collectables, cash and financial instruments not connected to one’s retirement plan, pension, or public assistance, and so on. Being sure to claim everything that can be in any given jurisdiction – and NOT claiming things that should not be – is one of the most important reason to use a bankruptcy attorney when filing.