The Parties: The Chapter 7 Bankruptcy Process

The Parties is part 2 of a 10 part series on Chapter 7 bankruptcy and will provide general information regarding bankruptcy under Chapter 7. 

A. The Debtor.

The debtor is the person or entity that commences a case in Bankruptcy Court by filing a petition. A married couple may—but does not have to—file a joint petition as co-debtors. Unmarried persons may not file a joint petition. “Who may be a debtor” is outlined in Code § 109. In rare cases, an involuntary bankruptcy may be commenced by creditors, an event that is outside the scope of this outline.

The individual debtor’s goal in Chapter 7 is a discharge, which is the debtor’s fresh start. The discharge is the court order stating that the debtor is legally excused from all prepetition debt (that is, debt which the debtor incurred prior to the moment of filing the petition) that is otherwise dischargeable in bankruptcy. The concept of dischargeability is discussed below.

Entities such as corporations and LLCs are not entitled to a discharge in Chapter 7. Entities that are no longer doing business generally do not file a Chapter 7 petition and will die a different kind of death, through expiration of state registration, going out of business sale, return of assets to secured lenders, etc. There nevertheless may be good reasons for an entity to file a Chapter 7, such as to permit an orderly liquidation of assets supervised by a bankruptcy trustee, or where a bankruptcy filing may result in payment of priority debts such as tax debt that the company principal may be liable for and particularly wants to see paid.

B. The Creditors.

“Creditor” is very broadly defined in the Bankruptcy Code. A creditor is anyone with a claim against the debtor. A “claim” is a right to receive a payment, whether or not such right is reduced to judgment, liquidated, unliquidated, fixed, contingent, matured, unmatured, disputed, undisputed, legal, equitable, secured, or unsecured. § 101(5). In other words, anyone claiming any right to payment of any kind, even if that right is disputed or speculative, is a creditor. For that reason, a debtor should list in the schedules all persons who may have a claim, even if the debtor believes no such right exists.

How a creditor fares in a Chapter 7 bankruptcy proceeding depends on what kind of claim that creditor possesses. There are four main types of claims: 

1. Administrative expenses.

These are expenses incurred post-petition and during the administration of the bankruptcy estate. § 503. They include the claims of the trustee and the professionals hired by the trustee, and any costs of liquidation such as storage fees and sales expenses. Except for a limited priority given to domestic support obligations, all administrative expenses are paid before any prepetition creditors are paid. All administrative expenses must be approved by the court.

2. Secured claims.

Secured creditors include real estate loans, car loans, purchase money security interests, mechanics’ liens, judgment liens, etc. A secured claim is effective in bankruptcy only if the creditor has properly perfected its interest under applicable law. An unperfected secured claim is not enforceable against a Chapter 7 bankruptcy trustee.

The bankruptcy discharge only affects a creditor’s in personam rights against the debtor. It does not typically affect any in rem rights against the collateral. As a result, secured creditors have heightened protection in bankruptcy because of their perfected interest in the collateral held by the debtor. If the debtor does not maintain payments, the creditor will ultimately be able to assert its rights against the collateral under applicable law. If the trustee sells the asset, the secured creditor ordinarily gets paid in full with interest, and the bankruptcy estate takes the balance. Unless the trustee sells the asset, the secured creditor will typically need to look to its collateral and will not be entitled to any distribution in the bankruptcy case.

Trustees typically will not sell fully encumbered property in Chapter 7. That said, under certain circumstances trustees may conduct short-sales of over-encumbered real property with the consent of the secured creditor and permission of the Bankruptcy Court.

In the case of secured consumer loans, such as car loans, the debtor and creditor may enter into a “reaffirmation agreement” creating a new, post-petition obligation of the debtor to make payments on the loan that is unaffected by the debtor’s discharge. § 524. In the absence of a reaffirmation, the creditor may (but will not always) have the right to repossess its collateral.

Where the value of the collateral has declined, a debtor may be able to reduce the amount of the secured claim to the value of the collateral. This right, however, is not available to modify liens secured by principal residences. Thus underwater or entirely undersecured consensual liens on residences may not be modified through a Chapter 7 case. A debtor also may not reduce or “cram down” the value of liens secured in automobiles, if they have been financed within 910 days prior to the bankruptcy filing.

The Code gives the Bankruptcy Court the ability to make rulings regarding the validity and extent of secured claims. § 506. Debtors and creditors alike can take advantage of judges knowledgeable in all aspects of commercial law in order to litigate disputes over issues arising in secured claims.

While consensual liens are favored in bankruptcy, nonconsensual liens such as judgment liens are disfavored. Judgment liens and non-purchase money liens may be stripped off property (i.e., “avoided”) if those liens interfere with the debtor’s exemption claims. § 522(f). It is critical for debtor’s counsel to determine whether there are any judgment liens on otherwise exempt property (most often the debtor’s homestead), and if so to take steps during the bankruptcy case to avoid the lien. Otherwise, debtor’s counsel may pick up the phone several years later with a client on the line who is seeking to refinance his house and wondering why a debt that was discharged is showing up on title. The easiest way to protect against this happening is to routinely check county records for any recorded judgments before the petition is filed.

3. Priority claims

Priority creditors are unsecured creditors who have been afforded special treatment in the Code. Priority claims are entitled to payment in full before general unsecured creditors receive any distribution.

Priority claims are listed in § 507, and include: Domestic support obligations (i.e., spousal maintenance and child support), claims for certain wages, contributions to employee benefit plans; deposits for the purchase of property or services; and most (but not all) tax claims.

Priority taxes are not dischargeable. But certain tax claims are not given priority status and are dischargeable in bankruptcy. For a tax to be dischargeable, it must be a tax on income, where the return was filed more than two years prior to the bankruptcy filing, the tax return was due (including extensions) more than three years prior to the filing, and the tax was assessed more than 240 days before filing. § 507(a)(8). These time periods may be tolled by intervening bankruptcy filings or offers in compromise, so it is important to read the statute carefully and review detailed tax transcripts from the IRS in order to determine if a particular tax may be discharged.

4. General unsecured claims

This category includes everyone else—charge cards, personal loans, medical bills, tort claims, business debts, etc. If there is enough in the bankruptcy estate to go around after administrative expenses and priority claims are paid in full, unsecured creditors will share the balance on a pro rata basis. If there is enough to pay such claims in full, interest is paid at the federal judgment interest rate from the date of filing.

5. The Debtor

In very rare cases, everybody gets paid and there is money left over. That money goes to the debtor.

C. The Chapter 7 Trustee.

Chapter 7 bankruptcy is largely an administrative process. In most cases, debtors never see the inside of a courtroom, and bankruptcy judges never see the case file. The trustee is the case administrator. The Chapter 7 trustee is a member of a panel of professional trustees, primarily but not exclusively lawyers, who periodically gets a calendar of filings. The trustee’s primary job functions are to review the petitions and schedules, convert to money any non-exempt property, and distribute the proceeds to creditors. This process is discussed below.

Additionally, the trustee will respond to inquiries from creditors; preside over the meeting of creditors, where the debtor is examined under oath regarding assets and liabilities; review each filing for the possibility of fraud or abuse of the Bankruptcy Code; bring avoidance actions for preferential payments or fraudulent transfers; and perform other duties relating to the administration of the bankruptcy cases.

Trustees are currently paid $60.00 for each non-asset case. For cases where assets are administered, trustees are paid a percentage commission tied to the amount of money disbursed in the case. § 326.

D. The Professionals.

In a Chapter 7 with significant assets to be administered, the trustee may employ an attorney to do the legal work necessary to assemble, liquidate, and distribute the assets to creditors. An accountant may be employed to prepare tax returns for the estate; an individual’s Chapter 7 bankruptcy estate is a separate taxable entity. Auctioneers may be employed to sell property. The trustee employs these professional persons only upon entry of a court order authorizing that employment. § 327. The professional must disclose all connections with all parties in interest, and declare that there are no conflicts of interest.

A Chapter 7 debtor will almost never formally employ a professional through the bankruptcy court. The standard flat fee typically charged by debtors’ attorneys in Chapter 7 does not require court approval, but must be disclosed in the petition. Unless the trustee employs debtor’s counsel in the bankruptcy case—a very rare occurrence—post-petition fees incurred by debtor’s counsel may not be paid out of funds acquired by the bankruptcy estate. The debtor and his or her counsel will have to strike their own deal for payment for post-petition services.

Creditors need not obtain approval for employment of their own professionals.

E. The United States Trustee.

The Office of the United States Trustee is a division of the federal Department of Justice. Its function is oversight of the administration of bankruptcy cases. Its primary duties, as defined in 28 U.S.C. § 586, include supervising the Chapter 7 panel trustees, and supervising the administration of cases under Chapters 7, 11, 12, and 13. The U.S. Trustee also reviews consumer filings for signs of abuse and all filings for issues that might warrant a challenge to the discharge. In rare instances, the U.S. Trustee may also get involved in referrals to the U.S. Attorney for criminal prosecution.

F. The Bankruptcy Judge.

Bankruptcy law has its own code, its own rules, its own courts, and its own judges. Bankruptcy judges are appointed for 14 year terms. The judges sit as officers of the United States District Court.

There are five judges in the Western District of Washington: three in Seattle, and two in Tacoma. Each judge has his or her own assigned caseload. Judges’ calendars, as well as individual chambers’ procedures, are posted on the court’s web site (www.wawb.uscourts.gov). Questions regarding chamber procedures may often be easily addressed with a telephone call to the courtroom clerk.

Rulings of the bankruptcy judges may be appealed to the U.S. District Court or, alternatively, to the 9th Circuit Bankruptcy Appellate Panel (BAP), a three-judge panel of bankruptcy judges. Either party to the appeal has the option of declining to go to the BAP, and having the matter heard by the District Court. Appellate decisions of the BAP or District Court may be appealed of right to the full Ninth Circuit. Rules provide for direct appeals to the Ninth Circuit from Bankruptcy Court in certain circumstances. 

Contact the bankruptcy attorneys at Wenokur Riordan PLLC today at (206) 724-0846 to discuss your situation.

This article is intended to provide you with enough detail to give you a good basic understanding of the process, without snowing you under with too much information. Obviously, there are exceptions and nuances to just about everything described in this outline. The Bankruptcy Code, Federal Rules of Bankruptcy Procedure, and reported case law are the primary sources of information. All section references here are to the United States Bankruptcy Code, 11 U.S.C. § 101 et seq. All Rule references are to the Federal Rules of Bankruptcy Procedure.