How Does Bankruptcy Work

Bankruptcy is a legal process through which debtors may obtain full or partial relief from their debts. Bankruptcy relief normally involves the full or partial discharge of the petitioner's debt, sometimes following the completion of a repayment program based upon the debtor's financial means.

Forms of Bankruptcy

The most common types of bankruptcy are:

Chapter 7 Bankruptcy - "Straight Bankruptcy" or "Liquidation"

When people think of bankruptcy, they usually think of a Chapter 7 personal bankruptcy, through which most or all of the petitioner's debts are discharged by a bankruptcy court. In a Chapter 7 bankruptcy:

  • You submit a list of your creditors and debts to the bankruptcy court;

  • A trustee is appointed to oversee your property;

  • Depending upon the application of state and federal exemptions, some of your assets may have to be surrendered to the trustee who will sell them to pay your creditors;

  • You will be allowed to keep some or all of your personal property, and probably an interest in your home (although perhaps not all of your equity).

  • Most or all debts are cancelled.

Before you may file for Chapter 7 bankruptcy, you must undergo credit counseling. Your income and assets will also be reviewed under a means test, designed to determine if you are reasonably capable of repaying a portion of your debts. If you qualify for Chapter 7 bankruptcy, you will either have some non-exempt assets that may be liquidated for the benefit of your creditors, or you will proceed with a no-asset bankruptcy based upon your not having any non-exempt assets.

If you have filed and dismissed a Chapter 7 bankruptcy petition within the last 180 days, or if you were granted or denied a Chapter 7 discharge in a prior bankruptcy case within the past six years, you will likely be unable to file a Chapter 7 bankruptcy. You should discuss these restrictions with a bankruptcy lawyer, as you may qualify for an exception to those rules.

Chapter 11 Bankruptcy

Chapter 11 is primarily used for business bankruptcies, but is rarely used in personal bankruptcy cases. Although this form of bankruptcy is available to individuals, the increased cost and complexity of a Chapter 11 case makes it a poor option for those who qualify for Chapter 7 bankruptcy, and undesirable for most people who qualify to file under Chapter 13.

Most Chapter 11 petitioners owe debt in excess of the Chapter 13 limits, and thus file for bankruptcy under Chapter 11 due to their being disqualified from filing under Chapter 13.

This form of bankruptcy allows a business to remain in operation, while sheltering it from some of its debts from creditors.

Chapter 13 Bankruptcy (Wage-Earner Bankruptcy

In a Chapter 13 Bankruptcy:

  • You will propose a repayment plan for your debts based upon your disposable income (your income remaining after you pay your reasonable living and business expenses);

  • A typical repayment plan lasts for between three and five years;

  • Over the course of your repayment program, you will repay a portion of your debts to your creditors, with a discharge of any remaining balance upon completion of the repayment plan;;

  • If approved by the court, a trustee will be appointed to represent your creditors, at your expense. The trustee will collect your payments, distribute them to your creditors, and to supervise your compliance with the repayment plan.

Debtors whose debts exceed certain limits are barred from seeking Chapter 13 bankruptcy. As of April 1, 2016, in order to file for Chapter 13 bankruptcy a debtor must hold less than $394,725 in noncontingent, liquidated unsecured debt, and less than $1,184,200. in noncontingent, liquidated secured debt.

You will most likely be unable to file a Chapter 13 bankruptcy if you have filed and dismissed a Chapter 13 petition within the last 180 days. If that restriction applies to you, discuss with your bankruptcy lawyer whether you qualify for an exception.

Chapter 13 bankruptcy is a difficult process, and most debtors end up dropping out of Chapter 13 bankruptcy before their repayment plans are completed. Carefully consider your budget when you prepare your repayment plan, including whether you will reasonably be able to live under its tight financial restrictions for three or more years. If you fail to comply such that your bankruptcy case is dismissed, or voluntarily dismiss your bankruptcy case, you will get credit for payments made to creditors over the course of the plan, but no portion of your debt will be forgiven and your creditors will once again be able to pursue you for the balances owed.

Chapter 13 bankruptcy may be particularly useful to debtors who is dealing with a short-term financial crises, and who expect their incomes to rise in the future.

Corporations and partnerships cannot file for Chapter 13 bankruptcy protection, and must instead seek relief under Chapter 11.

"Chapter 20" Bankruptcy

A so-called "Chapter 20" bankruptcy is the process filing of a Chapter 7 bankruptcy to discharge unsecured debts, followed by a Chapter 13 bankruptcy to allow the debtor to catch up on mortgage payments or payments on other secured or nondischargeable debts. Under current bankruptcy laws, a Chapter 13 bankruptcy may be filed only once every two years, and three years must pass after the filing of a Chapter 7 bankruptcy before a Chapter 13 filing. Some debtors attempt to circumvent those restrictions by filing for Chapter 13 protection while the Chapter 7 petition is still pending. That option is not available in all bankruptcy courts.

In a Chapter 20 bankruptcy, debtors should be aware that missing even one mortgage payment after filing the initial Chapter 7 petition may cost them their ability to save their home in a subsequent Chapter 13 filing.

For Chapter 13 cases filed less than four years after a Chapter 7 discharge, no further discharge of debt is permitted. As a consequence, the Chapter 13 portion of a "Chapter 20" bankruptcy will involve a repayment plan for 100% of the petitioner's remaining debt.

Immediate Benefits of Bankruptcy

After you declare bankruptcy, an automatic stay of your debts takes effect. While the stay remains in effect, your creditors are barred from taking action to collect your pre-petition debts, including foreclosure, eviction and wage garnishment. Creditors who appear on the schedules of debts that you file with the court will be served with notice of the bankruptcy, and are thus informed of the stay.

If you are contacted by a creditor about a debt after filing for bankruptcy, tell your attorney immediately. It is important that your attorney know not only of improper contacts, but also of the possibility that a creditor was omitted from the list of creditors you submitted with your bankruptcy petition, or of the possibility that notice was not properly served upon the creditor.

If a creditor intentionally violates the automatic stay, your attorney may bring their misconduct to the attention of the bankruptcy court and ask that the creditor be held in contempt of court.

What Is Reaffirmation?

Reaffirmation is a procedure through which you agree to pay a debt that would otherwise be discharged in bankruptcy. For example, you may want to keep your car after filing for bankruptcy, and thus may agree with your lender to continue to be responsible for the car loan. Debtors should cautious with reaffirmation, as once a debt is reaffirmed a debtor continues to owe the debt as if no bankruptcy petition was filed.

If you make the choice to reaffirm a debt, you will file a reaffirmation agreement with the bankruptcy court. The court will evaluate that agreement to determine if it:

  • Is voluntary;
  • Is in your best interest; and
  • Will not create an undue hardship.

You may be able to cancel a reaffirmation agreement within sixty days of filing it with the court, or before your bankruptcy petition is approved.

Some debtors will not seek reaffirmation of a debt, but will instead simply make payments on their debt pursuant to their loan agreements with their secured creditors. Most car and mortgage lenders will not pursue repossession or foreclosure if they are receiving timely payments, even if the debtor does not reaffirm the debt.

What is Conversion?

Conversion is the process of transforming a Chapter 7 petition for bankruptcy relief into a Chapter 13 petition, or vice versa. It may become apparent during the course of a bankruptcy that a debtor will be better served through the conversion of his petition to the other form of bankruptcy. However, a debtor is not permitted to keep switching back and forth between chapters, and should be cautious about taking this step.

What is Involuntary Bankruptcy?

Under rare circumstances, creditors will petition a court to have a debtor declared insolvent. If the court grants relief to the creditors, as the bankruptcy proceeds without the debtor's consent, the subsequent process is termed an involuntary bankruptcy. If a petition for involuntary bankruptcy is denied, a debtor may be awarded attorney fees and costs and, depending upon the facts of the case, may potentially even receive punitive damages.

Involuntary bankruptcies occur only under Chapters 7 and 11 of the Bankruptcy Code, and not under Chapter 13.

What are Preferences?

A preference involves a situation in which a debtor treats one creditor more favorably than another. For example, a debtor may choose to use all of its assets to pay off the entire debt owed to one creditor, leaving another (or multiple others) unable to collect any money at all.

A Court will disallow a preference when:

  • Payment is made for the benefit of a creditor,

  • Payment is for a debt owed prior to the initiation of bankruptcy,

  • The payment is made while the debtor is insolvent, and

  • The transfer is made within 90 days of the debtor's filing the bankruptcy petition, or within 1 year if the payment was made to an "insider" such as a relative or corporate director.

A creditor receiving a preference may be forced to restore it to the debtor's estate, so that it may be distributed fairly to the benefit of all creditors.

What is a Fraudulent Conveyance?

A fraudulent conveyance or fraudulent transfer is the exchange of property prior to the filing of a bankruptcy petition, usually in an effort to shield the asset from the bankruptcy. Pursuant to the Uniform Fraudulent Transfer Act, a Court may bring certain property back into the estate, if it was improperly transferred. However, if property was sold for its reasonable market value, a court cannot recover the property even if the debtor was irresponsible with the proceeds of the sale.

There are two forms of fraudulent conveyance:

  • Constructive Fraudulent Conveyance: A constructive fraudulent conveyance occurs when a debtor transfers an asset to a third party without receiving reasonable value in exchange while insolvent, or where the debtor becomes insolvent as a result of the transfer. A debtor is insolvent when the value of the debtor's debts exceed the value of the debtor's assets, or where the debtor is unable to service (pay) debts. For this form of fraudulent transfer, it does not matter whether or not the debtor intends to harm or hinder creditors.

  • Actual Fraudulent Conveyance: An actual fraudulent conveyance occurs when the debtor transfers an asset to a third party with the intent of hindering, frustrating, or fraudulently preventing a creditor from reaching the asset to satisfy a debt. For this type of transfer, proof of the debtor's intent is sufficient to establish that the transfer is fraudulent even if the transfer is made for fair market value.

A debtor who engages in fraudulent transfers may be ordered to return the transferred assets, or the value of those assets, to the bankruptcy estate, and may face additional consequences including having the bankruptcy petition dismissed or, in extreme cases, possible criminal charges.

Can A Court Refuse To Grant a Bankruptcy Discharge?

While most debtors are able to obtain relief through bankruptcy, in certain situations a bankruptcy court may refuse to grant bankruptcy. In most cases, the denial of bankruptcy protection follows from the court's finding that:

  • The debtor has failed to adequately explain the loss of assets that could be used to fully or partially satisfy outstanding debts;
  • The debtor has committed perjury during the course of the bankruptcy;
  • The debtor has failed to obey the lawful orders of the bankruptcy court; or
  • The debtor fraudulently transferred, concealed, or destroyed property that should have been included in the bankruptcy estate.

Some debts are not dischargeable in bankruptcy. For example, injury judgments that result from intentional conduct or intoxicated acts, child support judgments cannot be discharged in bankruptcy. Federally guaranteed student loans are difficult to discharge in bankruptcy and most debtors will not qualify for discharge.

Should a Married Person File Individual or Joint Bankruptcy?

The question of whether a married person should file as an individual depends in large part upon whether that person's debt is held individually or is held jointly with their spouse, and upon the laws of their state. This is a decision best made after a consultation with a bankruptcy attorney.

How Much Does Bankruptcy Cost?

The cost of bankruptcy will vary substantially, depending upon the complexity of the case and the type of bankruptcy that is filed. You may be able to obtain a Chapter 7 personal bankruptcy for a relatively modest flat fee, while the cost of a Chapter 11 bankruptcy can easily exceed $15,000 in the first year. Some business bankruptcies cost hundreds of thousands of dollars to complete.

How to Find a U.S. Bankruptcy Court

To find the U.S. Bankruptcy Court for your jurisdiction, along with bankruptcy forms and self-help instructions, use the U.S. Courts court locator.

Copyright © 2000 Aaron Larson, All rights reserved. No portion of this article may be reproduced without the express written permission of the copyright holder. If you use a quotation, excerpt or paraphrase of this article, except as otherwise authorized in writing by the author of the article you must cite this article as a source for your work and include a link back to the original article from any online materials that incorporate or are derived from the content of this article.

This article was last reviewed or amended on May 7, 2018.