One of the most common problems that financial institutions face is when a customer files for bankruptcy. It is essential that financial institutions have a fundamental understanding of the institution’s rights and obligations under the provisions of the U.S. Bankruptcy Code. Knowing what actions to take and, perhaps even more important, what actions not to take, is imperative. (Reference prior article “Basics of Bankruptcies” for more information).

Understanding the different types of bankruptcies is important to ensure your institution is protecting its rights and complying with bankruptcy rules. Each type of bankruptcy has some basic principles that require awareness and advisable actions.

Chapter 7 (Liquidation)

  • This is, by far, the most common type of bankruptcy.
  • It is most commonly filed by an individual person or jointly by spouses.
  • Typically, there is little to no non-exempt property that is part of the bankruptcy estate that will cause the Trustee to pursue liquidation of those assets, so there may not be an actual liquidation of the debtor’s assets.
    • “Non-exempt” property means assets that are not encumbered by liens and which are not protected by a state or federal exemption, such as the homestead exemption or ERISA-qualified retirement investments.
  • Chapter 7 bankruptcies are often referred to as “no-asset cases”.
    • A “no-asset case” does not mean the Debtor has no assets, but rather that there often are no assets in excess of the claims of secured creditors and/or the applicable state or federal exemptions.
  • If your loan is secured, you will need to determine what the Debtor intends to do with the collateral pledged to the institution (see the Statement of Intentions).
    • If the Debtor has elected to reaffirm the debt, contact your attorney to discuss drafting a proposed reaffirmation agreement. If the Debtor decides to reaffirm a debt, the Debtor must do so before the discharge is entered.
    • If the Debtor chooses to redeem the property (this is the least likely option that will be chosen by a Debtor), the Debtor will propose a lump sum payment, equivalent to the current value of the collateral (not the amount of the loan balance).
    • Often the Debtor will state the intention to retain the collateral and make payments. This is not technically an option. However, the Debtor wants to discharge the obligation and retain the collateral, which protects the Debtor in the event of a default later.
  • If the loan was already in default, you may wish to pursue a motion to obtain relief from the automatic stay if you do not want to wait until a discharge is granted.
  • Monitor the bankruptcy until you receive a Notice of Discharge from Bankruptcy. After the discharge is granted, the automatic stay is no longer in effect and you can pursue enforcement of rights to pursue collateral, but collection of the debt may not be pursued against the Debtor.
  • Business entities may also file Chapter 7 bankruptcy, but business entities are not entitled to receive a discharge of their obligations through a Chapter 7 bankruptcy.
    • The automatic stay does come into effect upon a business entity filing Chapter 7 and you may not pursue liquidation of assets or other relief unless relief from the automatic stay is obtained or the bankruptcy is closed (there will not be a Notice of Discharge).
  • If the Trustee sends a Notice to File a Proof of Claim, you will want file a Proof of Claim prior to the deadline set by the Trustee or you will lose your right to a pro-rata distribution based on the amount of the institution’s debt.

Chapter 11 (Reorganization)

  • This is almost always a business reorganization case; rarely will an individual will file Chapter 11.
  • In most cases, if you have a loan secured by real or personal property, you will want to consult with your attorney to protect the institution’s rights.
  • Generally, the Debtor continues to operate its business as a “Debtor-in-possession”, subject to the protection and control of the bankruptcy court.
    • A Trustee generally is not appointed to operate/control the Debtor’s business operations.
  • The goal of the Debtor is to propose a plan of reorganization where the Debtor agrees to pay all or a portion of its debts out of future operations and profits or
  • by a controlled liquidation of its business over a period of timeCalendar the deadline to file a Proof of Claim and prepare and file a Proof of Claim; be sure to identify the extent to which your loan obligation(s) is secured by collateral.
  • If your loan is secured by cash assets/proceeds of the Debtor, you will need to reach an agreement with the Debtor for the use of cash collateral during the bankruptcy.
  • The Debtor will develop a plan of reorganization, which will propose to pay a portion of its debt over time.
    • The Debtor may restructure its debts, continue to operate its business, and pay its creditors from post-bankruptcy earnings or the Debtor may sell all or part of its business as a going concern and then propose a plan to liquidate its remaining assets, or a combination of both.
  • Review the Disclosure Statement and proposed Plan of Reorganization to see how your claim will be treated.
    • If your debt is secured, perform an analysis of the collateral and determine if the obligor is proposing adequate protection of the institution’s secured interest while the Chapter 11 bankruptcy is pending.
    • Also, when reviewing the Plan of Reorganization, analyze whether the obligor is attempting to “lien strip” or “cram down” the institution’s secured or partially secured claim.
  • You will be given the chance to vote for or against the proposed Plan of Reorganization.
  • If a Plan of Reorganization is approved, it will govern the terms of your relationship with the Debtor from that point on.

Chapter 12 (Family Farmers and Fishermen)

  • This is a “family farmer” or “family fisherman” with “regular annual income” bankruptcy, which is similar to a Chapter 11 bankruptcy, but is more streamlined and takes into account the fact that these debtors typically have seasonal income.
  • Both individuals and entities may qualify for a Chapter 12 bankruptcy.
  • A Chapter 12 bankruptcy is much more rare than other types. Please contact your attorney if you receive a Chapter 12 bankruptcy filing.

Chapter 13 (Consumer Reorganization)

  • This is an individual reorganization case, often known as a “wage-earner plan.”
  • The Debtor(s) remains in possession of his/her/their property and proposes a plan whereby the Debtor agrees to pay all or a portion of his/her/their debts over three to five years.
  • The proposed plan is usually filed contemporaneously with the petition and schedules and the deadline to respond to the plan is generally set at the time the bankruptcy is filed.
  • Unique to a Chapter 13, there is a co-debtor stay in effect as to other consumer debtors, so both the borrower and co-obligors should not be contacted while the automatic stay is in effect, i.e., if one spouse files bankruptcy and the other does not, the co-debtor stay may apply to both.
  • Calendar the deadline to file a Proof of Claim and prepare and file a Proof of Claim. You will need to determine if you are unsecured, fully secured, or partially secured.
  • Review the proposed Chapter 13 Plan.
    • If your debt is secured, perform an analysis of the collateral and determine if the Debtor is proposing adequate protection of the institution’s secured interest.
    • Also, when reviewing the Chapter 13 Plan, analyze whether the Debtor is attempting to “lien strip” or “cram down” the institution’s secured claim. If the institution does not object to the Chapter 13 Plan, the institution may be stuck receiving less than the full amount of its secured claim or on terms different from those in the original loan.
    • The plan will be in effect for up to 60 months after it is confirmed.
    • The automatic stay remains in effect until the plan is completed or the bankruptcy is dismissed.
  • While not as complex as a Chapter 11 bankruptcy, a Chapter 13 is complex and can significantly affect your rights to collect and to collateral. We recommend that you contact your attorney to best protect the institution’s rights.