Bankruptcy is federal statutory law (Title 11 of the United States Code) based upon the Constitutional requirement for “uniform laws on the subject of Bankruptcy throughout the United States.” (Article I, Section 8). Bankruptcy proceedings are undertaken in the United States Bankruptcy Courts, part of the District Court system.
There are several types of proceedings that fit under the general category bankruptcy. The US Bankruptcy Code has multiple chapters, each describing a different procedure available for debt resolution. Liquidation under a Chapter 7 filing is the most common form of bankruptcy. Liquidation involves the appointment of a trustee who collects the non-exempt property of the debtor, sells it and distributes the proceeds to the creditors. Bankruptcy under Chapter 11, Chapter 12, or Chapter 13 is more complex and involves allowing the debtor to use future earnings to pay off creditors. In addition, there is Chapter 9 bankruptcy, available only to municipalities; perhaps the most famous example of a municipal bankruptcy was in Orange County, California. Chapter 9 is a form of reorganization, not liquidation. Chapter 12 is somewhat like Chapter 13 but is only available to farmers in certain situations. As recently as mid-2004 Chapter 12 was scheduled to expire but in late 2004 it was given a renewed lease on life.
Bankruptcy can be entered into voluntarily by the Debtor. It can also be commenced involuntarily by as few as one creditor if the debt owed is large enough. An involuntary bankruptcy may be used as a collection tool but its use can be very risky and, if wielded improperly, may subject the creditor to large damages.
Some property is exempt from being sold to pay debts in a bankruptcy. The law varies greatly from state to state. In some states, exempt property includes equity in a home or car, tools of the trade, and some amount of personal effects. In other states an asset class such as tools of trade will not be exempt by virtue of its class except to the extent it is claimed under a more general exemption for personal property.
One major purpose of bankruptcy is to ensure orderly and reasonable management of debt. Thus, exemptions for personal effects are thought to prevent punitive seizures of personal items of little or no economic value (diary, toothbrush, ordinary clothing), since this does not promote any desirable economic result. Similarly, tools of the trade may, depending on the available exemptions, be a permitted exemption as their continued possession allows the insolvent debtor to move forward into productive work as soon as possible.
Not every debt may be discharged under every chapter of the Code. Certain taxes owed to Federal, state or local government, government guaranteed student loans, and support obligations are not dischargeable (but nb., guaranteed student loans are potentially dischargeable should the debtor prevail in a difficult-to-win adversary proceeding brought in the nature of a complaint to determine dischargeability that’s brought against the lender; also, the debtor can petition the court for a “financial hardship” discharge, but it is very rare that such a discharge is granted). The debtor’s liability on a Secured debt, such as a mortgage or mechanics lien on a home, may be discharged, but the effects of the mortgage or mechanics lien cannot be discharged in most cases if it affixed prior to filing, so if the debtor wishes to retain the property, the debt must usually be paid for as agreed. (See also lien avoidance, reaffirmation agreement)(Note: there may be additional flexiblity available in Chapter 13 for debtors dealing with oversecured collateral such as a financed auto, so long as the oversecured property is not the debtor’s primary residence.)
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