Debtor in Distress

Robert S. Bernstein, Esq.
Managing Partner, Bernstein-Burkley, P.C.

Bankruptcy need not always be the final word when it comes to the rights of creditors. Most individuals filing for bankruptcy (and some creditors) have a tendency to believe that when bankruptcy is filed, their assets and properties are untouchable, perhaps an effective way for debtors to avoid creditors. However, bankruptcy is not always the best avoidance technique for the debtor, as the creditor is not left without options when a debtor files for bankruptcy.

First, certain kinds of claims are non- dischargeable in an individual’s Chapter 7 bankruptcy case; that is, they cannot be eliminated in bankruptcy or may only be discharged through the filing of Chapter 13 bankruptcy, where an individual with a regular income is put on a payment plan, typically scheduled over a three to five year period. Second, creditors of a bankrupt debtor have the right to share in the bankrupt estate’s distribution, according to claim priority. The estate is best described as the legal and equitable interests of the debtor. Liquidation is the collection of a debtor’s nonexempt property followed by the distribution of the proceeds to creditors. Third, creditors may be entitled to a court hearing to determine the debtor’s plans to liquidate nonexempt assets in Chapter 11 (relating to the reorganization of a corporation or partnership), Chapter 12 (relating to the reorganization plan of a family farmer or fisherman) and Chapter 13 (where an individual with a regular income agrees to a payment plan, typically scheduled over a three to five year period).

Non-Dischargeable Debts

Non-dischargeable debts typically arise in family support and criminal scenarios, such as certain obligations arising out of divorce, debts incurred by fraud or willful and malicious acts by the debtor or damages arising from illegal acts, such as driving while under the influence of drugs or alcohol. Certain debts, can only be discharged if they are paid in full through Chapter 13 plans.

Title 11 of the United States Code, Section 523 provides a list of exceptions to bankruptcy discharge. Some examples included in the section are: for taxes and custom duties; for money, property, services, or an extension, renewal, or refinancing of credit, to the extent obtained by false pretenses, a false representation, or actual fraud, other than a statement respecting the debtor’s or an insider’s financial condition or use of a statement in writing that is materially false; embezzlement or larceny; for willful and malicious injury by the debtor to another entity or to the property of another entity; to a spouse, former spouse, or child of the debtor that is incurred by the debtor in the course of a divorce or separation or in connection with a separation agreement, divorce decree or other order of a court of record; for death or personal injury caused by the debtor’s operation of a motor vehicle if the operation was unlawful because the debtor was intoxicated from using alcohol, a drug, or another substance; and, certain education expenses.

Even if a debt is dischargeable, creditors have the right to ask the debtor to honor the debt even after it has been discharged. This is known as “reaffirming the debt.” You may be thinking,
“Why would a debtor ever agree to this?” This is an acceptable option to the debtor when there is a cosigner or guarantor of the debt, who may be a family member, friend, or employer, whom the debtor would prefer not to make responsible for the debt. A debtor may also wish to reaffirm a debt in order to avoid having a secured creditor take the collateral. Another reason a debtor may agree to reaffirm the debt is to ensure that his or her business interest with you, the creditor, will not be lost in the future, as payment of the debt is a way to agree to engage in business with the creditor again.

Creditors also have the right to challenge the status of the debt as dischargeable. Certain claims, such as those relating to child support and student loans, survive the discharge without the creditor having to do anything to protect the claim. Other types of claims survive the bankruptcy only if the creditor takes action in the permissible and allotted time frame. A claim arising out of fraud, for example, requires the filing of a non-dischargeability action.

Bankrupt Estate’s Distribution

The debtor/bankrupt’s estate is made up of all of the Debtor’s legal and equitable interests as of the start of the case. Certain property may be exempt, as claimed by the debtor, while the remainder of the estate is liquidated. The amounts paid first go to the administrative costs of the bankruptcy proceeding. The remainder of the liquidated estate is then distributed to creditors according to their priority.

Secured creditors have a greater right to distribution than do unsecured creditors. Secured creditors have collateral in securing the debt, usually stemming from an agreement with the debtor. Secured creditors have an assurance that the amount owed will be paid up to the value of the collateral. Unsecured creditors are those that have no collateral securing the debt. Because of the lack of any lien on property of the debtor, unsecured creditors are far less likely to receive a distribution from the debtor, and often receive far less than would a secured creditor. The worst case scenario is a “no-asset” chapter 7 case, where there are no non-exempt, unsecured assets and most unsecured debts will be discharged.

Court Hearing on Debtor’s Liquidation Plan

Creditors have the right to be heard by the Bankruptcy court regarding the debtor’s plan in chapters 11, 12 and 13. All creditors are entitled to be heard by the court responsible to determine whether the plan of reorganization complies with the purposes of the bankruptcy code and provides for fair and equitable treatment of all parties-in-interest. Because Chapter 11 is a reorganization of the Debtor’s business through a plan of reorganization, where creditors are paid all or a portion of the debts, rather than liquidation of its Debtor’s assets. The plan allows the Debtors to emerge from a Chapter 11 bankruptcy. Debtors in Chapter 11 have the right to propose a plan of reorganization for a period of time, after which creditors may also propose plans. There are certain criteria that proposed plans must meet in order to be confirmed by the bankruptcy court. For example, one of the requirements is that creditors vote to approve the plan of reorganization or if a Debtor cannot propose a confirmation plan within a reasonable time, the court may either convert the case to a liquidation under Chapter 7 or, if in the best interests of all parties, dismiss the case. The debtor must prove that the plan pays creditors more than they would receive through Chapter 7 liquidation of Debtor’s assets. If dismissal is the result, creditors must look to non-bankruptcy law in order to satisfy their claims.

Ultimately, it is important to remember that just because a debtor files bankruptcy does not mean you the creditor are without recourse. There are three main courses of action for the creditor. First, examine whether the debt is non-dischargeable. If so, pay attention to whether there is a right to challenge the status. If the debt is dischargeable, consider requesting that the debtor reaffirm the debt. Second, remember your right to share in the estate distribution according to your claim’s priority. If your debt is not listed on the Debtor’s Bankruptcy Petition, contact Bankruptcy Court counsel about filing a Proof of Claim, which puts your claim on the Court’s record. Lastly, remember your right to participate in the bankruptcy hearing to approve the debtor’s plan of reorganization.

Although as a creditor you are provided with a variety of rights if the debtor files a petition in bankruptcy, it must be cautioned that the filing of a petition in bankruptcy also prohibits the creditor from taking any action to attempt to collect a debt. As soon as the debtor files his/her petition in bankruptcy, in most cases, non-bankruptcy activities to collect outstanding debts are prohibited. That is, it is against the law for a creditor to contact a debtor and request that the debtor pay any part of an outstanding debt outside of the bankruptcy process.

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For additional information on perfection of security interests and the usage of other credit enhancements, please see the other articles in this Publications section.

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