The B Word
A bankruptcy filing gives a person or business a stay (stop) on debt collection, discharge of many debts, and a chance to reorganize. It can be a lifeline for a debtor at the end of his rope, for as soon as the bankruptcy petition is filed, all debt collection actions must cease. That includes phone calls, letters demanding payment, and court actions, including foreclosure. Fishermen and farmers have the benefit of a special kind of filing, about which more below.
There are two fundamental types of bankruptcy filings. In one type (characterized under the bankruptcy code as “Chapter 7”), the bankruptcy estate may sell some of the debtor’s assets and use the money to pay creditors. In the second type (Chapter 11, 12 and 13), the debtor undertakes to stretch out and reduce debts, without the need to liquidate assets to pay creditors.
The first type, Chapter 7, is far and away the more common. In 2014, in Maine, of 2,094 total bankruptcy filings, 83% were Chapter 7 liquidations.
For the consumer, the cost of a simple Chapter 7 is around $1,500, and it is typically over and done in a matter of a few months, without fuss. A Chapter 11, 12 or 13 bankruptcy may and often does convert to a Chapter 7 when the reorganization plan fails, perhaps due to an overly optimistic income projection.
Chapter 11, 12 and 13 bankruptcies are expensive relative to a Chapter 7, and they tend to be drawn out. Twelve years later, the Great Northern Paper bankruptcy of 2003 still chugs along, resolving a few final disputes, liquidating a few hard to value assets and so on; the bankruptcy estate’s legal fees are well over $1 million.
The concept of a “bankruptcy estate” is important to understand. When a person files for bankruptcy, he or she (the “debtor”) loses control, to a lesser or greater extent, over his or her assets. Those assets become part of the bankruptcy estate, overseen by the bankruptcy judge, assisted by an appointed bankruptcy trustee. As a practical matter, so long as matters go smoothly and there is no funny business the court’s and the trustee’s involvement will be minimal, almost non-existent. However, if the trustee believes the debtor has failed to disclose assets or is paying favored creditors under the table, the trustee and the court may became very involved indeed.
In any bankruptcy there are classes of creditors, and some get treated much better than others. The clearest distinction is between the “secureds” and the “unsecureds.” An example of a secured creditor is a bank which loaned a business money, with the loan secured by a mortgage on business (non-home) real estate. If Tom files bankruptcy, the bank may ask for and will almost certainly get the bankruptcy court’s permission to sell the real estate and use the proceeds to pay down or pay off the mortgage. On the other hand, suppose a couple of years before the bankruptcy Tom borrowed $100,000 from his brother in law, with no security, just a promissory note. Tom’s brother in law is an unsecured creditor, and in the typical Chapter 7 the unsecureds are lucky to get pennies on the debt dollar. This is exactly why, in lending, we pay such close attention to security for the loan, not just the paperwork, but the fair market value of the collateral as well.
Taxes, both state and federal, can be discharged in bankruptcy, if the taxes have been due for more than three years, and if an honest return was timely filed for the taxes due. There are variations and this is a complex topic.
A note on home mortgage foreclosures in bankruptcy. To avoid foreclosure, many homeowners will, after filing for bankruptcy, “reaffirm” the obligation to the bank, agreeing to pay the mortgage loan despite the bankruptcy. With the unsecured debt (credit cards, medical bills, trade debt etc.) discharged, the homeowner now has the cash flow to pay the mortgage. Saving the family home in this manner is a common reason people file bankruptcy. Reaffirmation can also be used to keep a vehicle or any other loan collateral.
In the most consumer bankruptcies the creditors get nothing or almost nothing, because of laws protecting many of the typical consumer’s assets. Oddly, although bankruptcy is a creature of federal law, and is heard in a federal court, these protections (“exemptions”) are for the most part found in state law and they vary greatly from state to state.
In Maine, assets in a retirement account are, to a great extent, protected. So, generally, are household furnishings. There are other protected assets: $400 in cash, $5,000 in a car, $5,000 in tools of the trade, and “the debtor’s interest in one boat, not exceeding 46 feet in length, used by the debtor primarily for commercial fishing.” Just as with a house, if there’s a vessel mortgage, the bank can and will sell the boat toward satisfaction of the loan. On the other hand, if the fisherman owns the boat free and clear, or if the boat has value in excess of the loan balance, the value is exempt from creditors.
A short list of unprotected “non-exempt” assets – assets which may be used to pay creditors – includes ATV’s, snowmobiles, extra vehicles, valuable collections, non-residential real estate including camps, brokerage accounts and bank accounts.
The exemption of most importance to many consumers is for equity in the home. Maine provides that $47,500 of the equity in a person’s home cannot be reached by creditors. If the consumer is 60 years of age or older, or is disabled, or resides in the home with minor dependents, the exemption rises to $95,000. You can have but one home: if you own a house and a camp, only one gets the exemption.
Florida and Texas have no limit to the exemption one can claim in the home, and millionaires smelling trouble commonly head to those states and buy a $20 million place and move in. That way they can sell the home after receiving a bankruptcy discharge, leaving them a few bucks to rub along on.
There is an important detail here, of great importance to the average consumer. A mortgage lender does not have to respect the home equity exemption. If a bank loaned money secured by a mortgage on a residence, the bank may sell the home toward satisfaction of the debt, without any concern for the $47,500 or $95,000 exemptions. But if there is no mortgage, or if the home’s value significantly exceeds the mortgage loan balance, $47,500 or $95,000 of that equity will be exempt from creditors.
Farmers and fishermen have the great advantage of being able to file a reorganization bankruptcy under Chapter 12. Under Chapter 12, mortgage lenders and other secured creditors must be paid, over time, the value of the collateral pledged for the debt, but any balance owed in excess of the value of the loan’s collateral can be treated as unsecured debt, and unsecured debt is generally paid little or nothing in Chapter 12 cases. That means if you owe the bank $300,000 on a boat mortgage, but the boat is now worth $100,000, you can discharge $200,000 of the loan balance and pay the $100,000 over time. And another great advantage of Chapter 12 is that payments on that $100,000 can be stretched out for years, often with reduced interest.
In bankruptcies there is a 90-day “look back” period. Transactions occurring within the 90 days before filing can, generally, be unwound. For insider transactions the look back period is a year and sometimes more. So if in anticipation of bankruptcy you quitclaim your share in the house to your wife, let some time pass before you file – and talk to a lawyer, please.
A final word. In working with a bankruptcy attorney it is really important to be forthcoming and truthful. If you forget to list a debt in the bankruptcy petition the debt may not be discharged. And every year people try to hide assets from the bankruptcy court and every year people do hard time in federal prison for the crime. The temptation to hide assets representing years of labor is powerful, but it’s a mistake.