The purpose of chapter 7, the most common type of bankruptcy, is to give the debtor a “fresh start” by extinguishing the debtor’s personal liability on debts. The discharge in Chapter 7 is only available to individuals and not business entities such as corporations. Most individual chapter 7 cases end with a discharge of debts, but some types of debts such as domestic support obligations, most taxes, and student loans, are not dischargeable. A discharge does not extinguish liens on the debtor’s property.
Qualifying to file Chapter 7
Individual debtors who earn a high monthly income may not be eligible for chapter 7. The “means test” asks whether a debtor has the financial means, after paying monthly living expenses, to repay something to the unsecured creditors. If so, then the debtor is ineligible to file chapter 7. The means test is so complex that most websites with online means test calculators are useless. In order to determine if someone is truly eligible for chapter 7, a detailed thorough examination of the debtor’s finances is required.
How Chapter 7 works
The typical chapter 7 case takes about 90 days. The debtor files a petition with the bankruptcy court in the district where the individual resides. Business debtors file where their main office or principal assets are located. The debtor files schedules listing all assets and liabilities and a statement of financial affairs. A husband and wife may file together or there may be reasons for one spouse to file individually.
Filing the petition creates an “automatic stay” which stops most creditor actions against the debtor and the debtor’s property. With few limited exceptions [such as enforcing a domestic support obligation], creditors cannot begin or continue lawsuits, repossessions, or wage garnishments while the stay is in effect.
The debtor in most individual Chapter 7 will keep their assets. Federal bankruptcy law allows an individual to retain their assets by claiming “exemptions” in the property using federal bankruptcy law or the exemptions of the debtor’s state. California law provides some of the best exemptions.
A creditor meeting is held approximately 30 days after the case is filed. The bankruptcy trustee, who was appointed at the beginning of the case, runs the creditor meeting. The debtor must attend the meeting or the case can be dismissed. Creditors may ask limited questions but rarely attend the meeting.
The trustee questions the debtor to verify the information in the debtor’s bankruptcy papers and to identify assets which may not be exempt. The trustee can sell non-exempt assets and then distribute the proceeds to creditors according to priority [i.e., past due child support is paid before general unsecured creditors]. If there is a loan against an asset, the debtor usually gets to keep the asset as long as he remains current on the loan secured by that asset.
Sixty-one days after the initial creditor meeting, the court clerk normally issues a discharge notice. A copy of the discharge is mailed to the debtor and the creditors listed in the bankruptcy papers.
Role of the Trustee
Filing a bankruptcy petition creates a “bankruptcy estate” consisting of all of the debtor’s property, including intangible assets such as lawsuits, tax refunds or other rights to payment, and patents or copyrights. The trustee is the administrator of the bankruptcy estate.
The trustee’s primary task is to conduct the creditor meeting and liquidate non-exempt assets. In the most cases, all of the debtor’s assets are exempt or subject to liens, so there are usually has no assets for the trustee to sell. If the debtor has non-exempt assets, or if the trustee recovers estate assets, the creditors are given a deadline to file a form stating the basis of their claim against the debtor or the debtor’s assets.
A bankruptcy discharge releases the debtor from personal liability and prevents the creditors from taking any further action against the debtor individually. As a general rule, individual debtors receive a discharge in most chapter 7 cases. Business entities do NOT receive a discharge in Chapter 7.
A creditor has two options to oppose the discharge:
file a complaint objecting to the discharge of any of the debtor’s debts; or
file a complaint to determine if the creditor’s claim is an exception to the discharge.
A creditor may pursue one or both of these remedies by filing a complaint with the bankruptcy court.
The grounds for objecting to the chapter 7 discharge are narrow, and the creditor or trustee objecting to the discharge has the burden of proving the case. The most common grounds for objecting to a discharge are:
the debtor failed to list significant assets in the papers filed with the court
the debtor gave false answers in the bankruptcy papers that were material to the case
the debtor failed to keep and produce adequate financial records;
the debtor failed to explain satisfactorily a loss of assets;
the debtor failed to obey a lawful order of the bankruptcy court; or
the debtor fraudulently transferred, concealed, or destroyed property.
Certain categories of debts are not dischargeable in a chapter 7. Alimony and child support, most taxes, student loans, and debts for criminal restitution orders are not discharged. To the extent these types of debts are not paid by the trustee in the chapter 7 case, the debtor is liable for them after the bankruptcy regardless of whether the creditor files a complaint with the court.
Debts obtained by false pretenses, debts for fraud while acting in a fiduciary capacity, or debts for willful and malicious injury will be discharged unless the creditor files a timely complaint with the court. The creditor must file the complaint within 60 days after the first date of the creditor meeting. Otherwise these debts will be discharged in the chapter 7, assuming the creditor was listed in the debtor’s papers and was notified about the chapter 7 petition. In these lawsuits the creditor has the burden of proof to show the debt meets the exception to the bankruptcy discharge.
Secured creditors normally retain the right to seize their collateral after a discharge is granted. The debtor must decide whether to keep the asset. If a debtor returns the collateral, and if a discharge is granted, the debtor will have no further personal liability to the creditor.
A debtor wishing to keep an asset, such as an automobile, may reaffirm the debt or redeem the property. A reaffirmation is an agreement between the debtor and the creditor where the debtor promises to pay all or a portion of the money owed. The reaffirmed debt will still be owed after the discharge. In return, the creditor promises as long as payments are made, the creditor will not repossess the automobile or other property and report the loan in good standing to the credit bureau. If the debtor defaults on the payments, the creditor may repossess and sell the collateral. Unfortunately, if the sale price is not enough to pay off the debt, the debtor will owe a deficiency to the creditor.
A debtor may opt to redeem an asset by paying the fair market value in one lump sum. For example, if the balance on a car loan is $18,000 but the car is only worth $10,000, it may be sensible to redeem the car for its market value. However, most debtors who have just filed bankruptcy do not have ready cash [or a rich relative] to pay the market value in one lump sum. There are companies who provide redemption financing. Their interest rates are high, but if the gap between the loan balance and the value of the car is large enough, the total cost of a redemption loan may be less expensive than the existing loan on the car.