The state of insolvency or inability to pay debts.
Bankruptcy courts deal with two broad types of cases: Voluntary Bankruptcy by debtors seeking a fresh start, and Involuntary Bankruptcy filed by a sufficient number of creditors, who believe the debtor has committed an Act of Bankruptcy by concealing assets or favoring one creditor over another. In both cases, the objective is a fair and equitable settlement of claims and distribution of assets. Filing a petition initiates an automatic stay against further debt collection until a debt is discharged, the petition is dismissed, or a repayment plan is accepted by creditors. Once a petition is filed, the bankruptcy remains on a debtor’s credit bureau report for a 10-year period.
The Bankruptcy Reform Act of 1978, the first major revision in the bankruptcy code in four decades, brought about several important changes: the new code simplified the procedures for filing petitions, modified the absolute priority rule giving secured creditors seniority over other creditors, limited creditor rights to Set-Off claims against a debtor’s assets, and expanded the powers of federal bankruptcy judges to decide cases. Amendments to the code in 1984 gave bankruptcy courts the power to dismiss so-called abusive petitions by debtors concealing assets. Amendments enacted in 2005 (the Bankruptcy Abuse Prevention and Consumer Protection Act) further modified the bankruptcy code to prevent abusive petitions. Individuals who have sufficient income to repay some of their debts (as determined by a “means test”) must instead file a Chapter 13 bankruptcy petition.
The important chapters in the revised code are the following:
Chapter 7: called a Liquidation allows a court-appointed trustee with broad discretionary powers to distribute assets among creditors and arrange interim financing. In general, the trustee represents the interests of the unsecured creditors, or general creditors. If, however, there are no assets, the debt is discharged, and the creditors receive nothing.
Chapter 9: a rarely used section of the code, designed for adjustment of debts of a municipality. Also called a municipal reorganization.
Chapter 11: a Reorganization normally by a business, allowing the debtor (called a Debtor-In-Possession if no trustee is named) to maintain operating control, while restructuring debts and working out a repayment schedule acceptable to creditors. Creditor loans to Chapter 11 debtors are permitted under certain conditions.
Chapter 12: a new provision dealing with agricultural bankruptcies, allows small family-owned farms with debts under $1.5 million to repay obligations based on fair market value of the loan collateral.
Chapter 13: a debt repayment plan, called a Wage Earner Plan , filed by individuals earning regular income. The debtor files a budget with the court, and agrees to make partial payment (less than 100%) of obligations owed to creditors over a three- to five-year period, normally within three years. See also Composition; Cramdown; Discharge of Bankruptcy; Preference; Priority of Lien; Reaffirmation; Redemption; Voidable Preference.