What Is Bankruptcy?
If you are an individual struggling to pay back your debts, bankruptcy would be the best option once you are certain that you cannot pay back. Although this gives a fresh start to people and organizations that cannot pay their bills, it can considerably affect your creditworthiness. Since it may stay on your credit reports for a number of years, it makes it difficult for you to borrow at any time in the future.
All bankruptcy cases in the US are handled by federal courts and governed by bankruptcy codes. In addition, the United States Trustee functions as an “auxiliary to the Bankruptcy court.” The trustee oversees administrative matters in bankruptcy cases in most jurisdictions to prevent fraud.
How Does Bankruptcy Work?
- Things to Consider Before Filing for Bankruptcy:
Before taking the important step of filing for bankruptcy, consider other alternatives:
- Credit counseling – If you have a steady income and can repay debts with some aid, then credit counseling will be a better option. First of all, you must sign up with an approved credit counseling agency. With this option, you will be able to get counseling from a certified credit counselor. The state and judicial district-approved list of credit counseling agencies is provided by the U.S. Department of Justice on their website. Select the counseling agency you want and contact them immediately.
- The CARES Act – Some federal foreclosure and eviction activity are suspended by the CARES Act (Coronavirus Aid, Relief, and Economic Security). It is a $2 trillion coronavirus economic stimulus bill, signed on March 27, 2020, by then-President Donald Trump. With this Act, you might be able to stabilize your overall financial situation.
- Take a loan from your 401(k) Plan – Instead of filing for bankruptcy, you can take a loan from your 401(k) plan. You may be able to borrow half of your vested 401(k) balance. Generally, you cannot borrow more than $50,000, and most retirement experts recommend this option only as the last resource.
- Filing for Bankruptcy:
- When a borrower cannot afford to repay their debt, and the creditors want to receive payment based on the borrower’s financial situation and assets, the debtor can declare bankruptcy by filing a bankruptcy “petition.”
- The debtor will also have to file a schedule of their assets and liabilities, their income as well as expenses, a statement of their financial matters, and other required documents.
- Depending upon the debtor’s financial condition, they may also need to pay a filing fee or move to in forma pauperis status.
By filing for bankruptcy, a debtor is actually trying to eliminate or reduce the debts that they owe to their creditors.
- Bankruptcy Estate:
- After filing for bankruptcy, a bankruptcy ‘estate’ is formed. This estate includes all the properties of the debtor, but a debtor in a Chapter 7 and 13 case does exempt certain properties from entering the estate. State law oversees these estate exemptions generally; if not, the bankruptcy code does include an exemption list.
- You should understand what part of your assets will be protected and what will become part of the estate before filing for bankruptcy.
- Until the assets that are part of the bankruptcy estate are removed, they will remain under the control and protection of the bankruptcy court. This means that assets that are not under the estate are not controlled by the bankruptcy court and are not subject to further proceedings such as automatic stay.
- The bankruptcy trustee manages all the assets in the estate; this includes collecting your payments and distributing them to your creditors.
- Automatic Stay:
- The United States bankruptcy law, the automatic stay, temporarily prevents creditors from collecting on debt. It comes under Section 362 of the U.S. Bankruptcy Code.
- As soon as a debtor files for bankruptcy, the automatic stay comes into effect. It protects debtors from any further judicial action, foreclosure, or liens against the debtor’s property and also attempts to repossess collateral.
- When filing for bankruptcy, ensure to list all the creditors. So, they will be informed that automatic stay is in effect.
- This stay will remain in effect until the bankruptcy court closes the case or grants the debtor a discharge.
- Automatic stay prevents one creditor from seizing the debtor’s assets without giving others any opportunity.
- Creditors are less likely to receive the full amount they owe. Instead, they will only get a proportional share of the debtor’s limited assets.
- Creditors can also file a petition for lifting the automatic stay if they believe they have sufficient grounds.
Types of Bankruptcy:
The three major methods for declaring bankruptcy in the US are:
- Liquidation
- Reorganization
- Adjustments of debts
Chapter 7 of the bankruptcy code discusses the liquidation of assets, chapter 11 deals with company or individual reorganization, and chapter 13 deals with the arrangement of debts. When filing for a bankruptcy petition, the debtor can choose a chapter from the bankruptcy code under which to file. However, there are some eligibility criteria that the debtor should pass to file for bankruptcy under these chapters. In some cases, the debtor would be eligible for filing bankruptcy under more than one chapter. In such cases, he may choose the one which is more advantageous. There are also situations when a debtor is not eligible for filing bankruptcy under any of the chapters.
Chapter 7 – Liquidation
Most of the bankruptcies are filed under this chapter. These are designed to give debtors a new start by discharging debts that cannot be repaid through the liquidation of the debtor’s assets.
However, individual debtors must clear a means test in order to qualify under this chapter.
Some of the leading companies that have filed bankruptcy under Chapter 7 include the Benigan’s restaurant chain, the Arena Football League, etc.
When you apply for bankruptcy under Chapter 7, a trustee will be designated who will sell your non-exempt assets and distribute the money to creditors.
For individuals, certain assets such as retirement funds, clothing, and personal vehicles are exempted by the law.
Chapter 11 – Reorganization
These are bankruptcies primarily for companies. It allows companies to reorganize their debt structure so that they can continue to operate.
Some notable examples of companies that have filed under Chapter 11 bankruptcy are Kmart, General Motors, Alex and Ani, etc.
Filing under Chapter 11 gives a company a chance to make their company profitable and also find new ways to increase productivity.
Chapter 11 is the most complicated bankruptcy and is only advisable if the other options are already explored.
Chapter 13 – Adjustments
Chapter 13, titled “Adjustment of Debts of an Individual with Regular Income,” enables individuals to create workable debt repayment plans.
This chapter stands in contrast with Chapter 7 as it allows individuals to refrain from liquidating their assets.
You can file under this chapter only if you have a regular income, and the debt should not exceed the limit established by the statute. Naturally, non-individual debtors cannot file for bankruptcy under this chapter.
The debtor must repay the debt as an installment, typically within 3 to 5 years. When the payment plan is finished, the remaining unsecured debts will be discharged.
Although Chapter 7, Chapter 11, and Chapter 13 are the most common bankruptcy fillings, there are other types as well, some of which are listed below.
Chapter 9: These are bankruptcies available for financially distressed municipalities such as villages, cities, towns, etc. Municipalities filing for bankruptcy under this chapter may not have to liquidate their assets. Instead, they can develop a plan with which they can repay the debt over time.
Chapter 10: This was officially ended in the year 2005 due to its complexity and was replaced by Chapter 11.
Chapter 12: Bankruptcies filed under this chapter offers a great relief to family farmers and fishermen. It allows them to maintain their business while adopting a new strategy to repay their debt.
Chapter 15: This particular chapter was added to the law in the year 2005. It was added mainly to deal with cross-border cases. That is, it involves cases when the debtor, creditor, and assets are in more than one country. They are usually filed in the debtor’s home country.
Conditions Under Which You Cannot Apply for Bankruptcy
Your bankruptcy petition would not be approved under the following circumstances:
- When the debtor has done any fraudulent activity in the past.
- When the debtor couldn’t present required tax documents.
- When the debtor transfers his assets to somebody else’ name intentionally to deceive the creditors.
- When the debtor intentionally hides or destroys any related documents.
- When the debtor obtained any new assets in between the bankruptcy proceedings and has not notified about it to the court.
- When the debtor fails to submit any additional documents required for auditing.
- When the debtor has disobeyed a law order.
Alternatives to Bankruptcy
Sell Assets:
Consider selling your assets on your own before filing for bankruptcy. You may get a higher price and can use the extra funds for paying debt.
Negotiate with Creditors:
Lenders often prefer negotiation as they might get more money over going through bankruptcy. You may take assistance from debt settlement companies, but it is not advisable as they might charge you high fees. Also, most creditors prefer not working with them.
Consolidate Debt:
If you have a good credit score, then you might be able to consolidate your debt for a lesser interest rate. For instance, you have three loans to pay at different rates; the interest that you might have to pay for each loan may be high, but when you consolidate your debt, your lender will determine an average interest rate based on your credit score. This might help you save a lot of money.
Conclusion
Bankruptcy is a solution that helps you to have a fresh start when you cannot pay back your debt. Although they offer you a new start, they can considerably affect your credit score. Individuals and organizations can file for bankruptcies under many chapters depending on their eligibility. People must consider filing for bankruptcy as their last option as it has a negative effect on your credit score as well as your future.