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A Bankruptcy Primer

Before filing for bankruptcy, it is important to know the different types of consumer bankruptcies that are available to you and how they function. Depending on your specific financial situation and long-term goals, one type of bankruptcy may be better for you than another. Also, different types of bankruptcy can be combined for the maximum possible effect. This section provides a brief overview of the various types of consumer bankruptcies and how the automatic stay and the bankruptcy discharge work.

The Different Types of Consumer Bankruptcies

Chapter 7

A Chapter 7 is an orderly, court-supervised procedure. A trustee takes over the assets of the consumer's estate, reduces them to cash, and makes distributions to creditors. This distribution is subject to the exemptions a consumer can claim.

In most chapter 7 cases, there may not be an actual liquidation of the consumer's assets. This is because there is little or no nonexempt property. In Illinois, state law establishes the exemptions you may claim. These exemptions are designed to protect some of your assets in a Chapter 7 bankruptcy. Most people have three primary assets: their homes, their cars, and retirement accounts. However, only the equity you have your assets is subject to liquidation. Your retirement accounts are completely immune from any creditor. Even when you have equity in your assets, your exemptions may protect them. If your home is underwater and your car is not paid off, you likely have no equity in these assets and they are exempt. When you don’t have any nonexempt assets, your case is referred to as a “no asset” case. The vast majority of Chapter 7 filings are no asset cases. A creditor holding an unsecured claim will get a distribution from the bankruptcy estate only if the case is an asset case and the creditor files a proof of claim with the bankruptcy court. An unsecured claim may include credit card debt or medical bills. A secured claim is debt like a mortgage or an auto loan. Secured and unsecured claims are discussed in more detail below.

Even when exemptions do not completely protect an asset, other factors may prevent the asset from being liquidated. In some situations, like the sale of a house, the costs associated with selling the house may outweigh the amount of non-exempt equity. When a house is sold, realtors get paid their commissions, title companies collect certain fees, and other closing costs are applied. These commissions, fees and costs all take away from the bottom line at the closing table. In other situations, it may be possible to negotiate with the trustee to keep the asset by paying the trustee. The money paid will then be distributed to creditors. How the payment is made is up to the trustee, based on the guidelines set by the law, and may be a lump-sum payment or a payment made over time. In general, if the payment is made over time, the longest period of time allowed will be 6 months. Again, this is entirely at the trustee’s discretion.

In most Chapter 7 cases, individual consumers receive a discharge that releases them from personal liability for certain dischargeable debts. The consumer normally receives a discharge just a few months after the petition is filed. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 requires the application of a "means test" to determine whether individual consumers qualify for relief under chapter 7. If a consumer’s income is in excess of certain thresholds, the consumer may not be eligible for chapter 7 relief. The means test will be discussed in more detail below, with examples that illustrate how it works.

Dean West, Bloomingdale, Illinois: Negotiating With a Trustee

Dean is a highly skilled auto mechanic who specializes in restoring classic cars. He bought expensive equipment and personally guaranteed hundreds of thousands of dollars worth of loans to pay for outfitting his business. That equipment is now worth a lot less than what he owes. The equipment is also economically obsolete because the value of the business that it generates is less than the cost of his monthly payments and operating expenses. He took a risk on buying the equipment and, for a long time, it paid off. However, during the economic downturn, his business suffered, and he ended up filing for bankruptcy relief under Chapter 7, severing the liability on the loans, allowing him to continue operating his business without the burden of the debt or the under-performing equipment.

Dean owns two cars. One is a Dodge Avenger, which has $6,000 in equity. The other is a 1962 Chevy II convertible, which he intends to restore and give to his son, Jack, on his 16 ^th birthday. Dean can combine his $2,400 vehicle exemption with his $4,000 wild card exemption and protect the equity in his Dodge. However, the Chevy II is an unprotected asset. Although it needs considerable restoration work, the car itself is currently valued at $8,000. The trustee informs Dean that he intends to sell the Chevy II and use the sale proceeds to repay Dean’s creditors. Dean explains to the trustee that an unrestored Chevy II will be difficult to sell, and that he is willing to pay to keep the vehicle. After some negotiations, Dean agrees to pay the trustee $1,500 up front, and make payments of $500 a month for three months. The trustee agrees to the payment schedule and Dean is able to keep and restore his Chevy II for his son. Remember, the purpose of bankruptcy is to give to “the honest but unfortunate debtor…a new opportunity in life and a clear field for future effort, unhampered by the pressure and discouragement of preexisting debt.” [i] Dean has already built his business, and has taken the first steps towards a future that is not financed by debt. His stated goal is to be debt free and grow his firm without the chains of interest payments.

Chapter 13: Repayment

A Chapter 13, sometimes called a Wage Earner’s Bankruptcy, may be available to consumers who do not meet the means test for a Chapter 7 filing. Chapter 13 allows consumers to keep their assets, because a Chapter 13 bankruptcy allows consumers to propose a plan to repay creditors over time. This plan will last 3 to 5 years or less, depending on individual income. As a general guideline, individuals whose income is below the state median income generally have 3-year plans or less, unless the Bankruptcy Court finds “just cause” to extend the period. Those whose income exceeds the state median income typically have 5-year plans. Essentially, a shorter-term plan repays less money over time, allowing for portions of the preexisting debt to be extinguished. A Chapter 13 petition proposes a plan to repay your creditors; the plan lists all of the creditors and how they will be repaid.

Once the petition and plan are filed, a confirmation hearing takes place. At the confirmation hearing, the court either approves or disapproves the consumer's repayment plan, depending on whether it meets the Bankruptcy Code's requirements for confirmation. Unlike a Chapter 7 case, the Chapter 13 consumer generally remains in possession of his or her assets. Payments are made to creditors through the trustee, based on predicted income over the life of the plan.

A Chapter 13 bankruptcy is not resolved in a matter of months like a Chapter 7 bankruptcy. Before a consumer can receive a discharge in a Chapter 13, he or she must make all of the payments in the plan. Once the plan is completed, the Chapter 13 discharge eliminates all personal liability for most debts. Long-term debts like mortgages are not necessarily eliminated in a Chapter 13 bankruptcy. The consumer is protected from lawsuits, garnishments, and other creditor actions while the plan is in effect. More kinds of debts are eliminated by the Chapter 13 discharge than the Chapter 7 discharge. This is because the Chapter 13 plan repays creditors, so certain types of judgments and other debts can be discharged. In most circumstances the Chapter 7 bankruptcy is the more advisable and attractive option because most individuals have limited assets. Make no mistake, all assets in retirement accounts are immune and not considered assets of the bankruptcy estate. Most people really only have three assets; the equity in their home which is usually protected, cars which are almost always underwater, and the cash and other commodities held in retirement accounts, which are completely protected from any creditor.

Chapter 11

Many consumers are unaware that they can use a Chapter 11 bankruptcy to reorganize their debts. Most people are aware of Chapter 11 as a means of reorganizing a corporation that is insolvent. Since the 2005 amendments to the Bankruptcy Code, individual Chapter 11 bankruptcies function much like Chapter 13 bankruptcies. If your secured debts exceed $1,081,400.00 or your unsecured debts exceed $360,475.00, you cannot file a Chapter 13 bankruptcy. [ii] For individuals whose debt exceeds these limits, a Chapter 11 bankruptcy can provide similar relief. Individuals can use their post-petition earnings to fund their plan; those earnings are protected as property of the bankruptcy estate. The bankruptcy estate is created when you file your petition and includes your assets. Post-petition earnings are money you earn after you file your Chapter 11 case. Since these funds came into existence after you filed, they are not subject to liquidation. Although most people think of Chapter 11 as being used solely by corporations, individuals who do not operate businesses can still use Chapter 11 for relief.

There are significant differences between a Chapter 13 and a Chapter 11. When an individual Chapter 11 is filed, a new entity is formed – the debtor in possession. The debtor in possession has all of the rights and powers of a Chapter 11 trustee, and must perform the duties of a Chapter 11 trustee. These duties include accounting for property, examining and objecting to claims, and filing informational reports as required by the court and the U.S. trustee or bankruptcy administrator, such as monthly operating reports. The debtor in possession also has many of the powers of a Chapter 11 trustee, such as employing, with the court’s approval, attorneys, accountants, appraisers and other professionals necessary to assist the debtor during its bankruptcy case. The debtor in possession must also file tax returns and any necessary or court-ordered reports, such as a final accounting. The Chapter 11 trustee oversees the debtor in possession’s compliance with the reporting requirements. All current funds and post-petition earnings are deposited into a special account. All insured assets (homes, cars, other property insurance) are changed to name the debtor in possession as the beneficiary. Also, depending on the amount of total disbursements under the plan, a quarterly fee must be paid to the U.S. Trustee’s office, as this is how the system is funded.

So why would you want to file an individual Chapter 11? Unlike a Chapter 13 filing, there are no limits on secured debts in a Chapter 11. A person who holds several investment properties may not qualify for relief under Chapter 13. A person who wishes to liquidate assets without losing control of the process may also want to file an individual Chapter 11. There are also more opportunities to cram down debt on assets like real property in a Chapter 11. While this bankruptcy remedy is not right for everyone, it may be a good option for an individual in the right financial situation.

The Automatic Stay

The automatic stay is one of the more powerful protections available to a person who has filed a bankruptcy. As soon as your case is filed, the automatic stay goes into effect. The automatic stay puts an immediate stop to any and all collection activity. This means that creditors cannot continue or begin lawsuits against you, cannot make collection calls, cannot repossess cars, cannot proceed with foreclosures, cannot continue to garnish your wages, and cannot continue to freeze your bank accounts. In general, the automatic stay remains in effect until a discharge is received.

Keith Simms, Aurora, Illinois: The Automatic Stay

Keith is a private high school teacher who lives in Aurora, Illinois. Keith has a PhD in Education, and has been teaching for 15 years. As a result, he makes in excess of $95,000 a year. Keith also has $45,000 in credit card debt, which was used to finance some unexpected expense throughout the years. He also has a second mortgage on his home that is no longer secured by the property’s value, meaning the first mortgage exceeds the current value of the home leaving the entire second mortgage completely unsecured. Although Keith makes the minimum payments on all of his credit cards each month, he has realized that he will never pay off the balances. After consulting with an attorney, Keith makes the informed decision to file a Chapter 13 bankruptcy to resolve his credit card debt and strip the second mortgage from his home, paying back only a portion of the credit card balances and the second mortgage. This is because all of Keith’s unsecured debt is treated the same way in a Chapter 13 bankruptcy. The amount of debt he repays is based on his disposable monthly income. At the end of the plan, Keith should have equity in the home that he wants to keep and he will have no credit card debt. The moment Keith files his bankruptcy case, the automatic stay goes into effect. Roughly two weeks after filing, one of Keith’s credit card companies begins calling him to demand that he make a full payment on his account balance, or face the account being closed. Keith notifies his bankruptcy lawyer of the phone calls. Keith’s attorney then files an adversary proceeding against the creditor, seeking damages for its violation of the automatic stay, the Fair Debt Collection Practices Act, and the Illinois Consumer Fraud and Unfair Practices Act.

There are some limits to the automatic stay’s protection that will vary from case to case. For example, while the automatic stay can put the brakes on a foreclosure lawsuit, if the house has already gone to sale and the sale has been confirmed, then the automatic stay may not provide much protection if the goal was to keep the home. A creditor in that situation will likely file a motion for relief from the stay and will generally win because these motions are rarely challenged. Also, if you filed a bankruptcy within the last year that was dismissed, the stay only lasts for 30 days. This shortened stay can be modified if there is good reason. If you filed two or more dismissed bankruptcies in the last year, then the stay will not apply until you obtain a court order extending the automatic stay. More informed attorneys are aware of this and will generally file a motion requesting the extension of the automatic stay when they file your bankruptcy petition.

The automatic stay does not protect you from criminal proceedings, child support/spousal support-related actions, actions that collect from property that is not included in the bankruptcy estate, and tax audits. If you have issues like these, you’ll want to consult with your attorney before you file to address how those liabilities will be handled. In some cases, it may be possible to work out a solution with the creditor. However, unless you disclose these concerns to your attorney as early as possible, the attorney’s ability to plan will be seriously limited.

The Bankruptcy Discharge

The goal of a successful bankruptcy filing is the discharge. It is the discharge order that truly puts you on the path towards securing financial freedom. It not only represents a fresh start, but it is also a powerful protection against your creditors. Once a debt is discharged, the creditor can never try to collect the debt again. The discharge is a court ordered injunction authored by a federal judge. This means that the Bankruptcy Court orders your creditors to cease collecting on your debts and considers them to be completely zeroed-out. Creditors who violate the protection of the discharge injunction can be sued for damages, much like with a violation of the automatic stay.

When you receive your discharge, the effect of the discharge order depends on which chapter you file under. For example, you can discharge more types of debt in a Chapter 13 bankruptcy than you can in a Chapter 7. This is because a Chapter 13 plan repays creditors over time; certain kinds of judgments and other debts can be discharged if they are partially repaid. For example, some debts related to fraud or personal injury judgments can be discharged in a Chapter 13 bankruptcy. [iii] However, a Chapter 7 discharge is generally obtained 45 to 60 days after the first meeting of the creditors. This meeting is also known as a 341 hearing and is discussed in depth below. In a Chapter 13, you will not receive your discharge until after you have completed your plan payments. This can take up to five years, but depending on your income, it can be accomplished in as little as three years, or even less depending on the strategy employed.

A discharge order utterly obliterates any and all personal obligations to repay a discharged debt. Once your debts are discharged, creditors are barred from attempting to collect the debt from you. Discharged debt must be reflected on your credit report as a $0 balance. Although creditors can inform the credit reporting agencies that the debt was discharged in bankruptcy, they cannot list the debt as “charged off,” “settled” or any other status. If a creditor violates the bankruptcy discharge, you can sue that creditor. If a creditor continues to attempt to collect a discharged debt, consult your bankruptcy attorney.

The Bankruptcy Process

Filing a bankruptcy is generally not something that you do overnight. In order to make sure that you fully benefit from a bankruptcy filing, your attorney needs to collect important information about your finances and long-term financial goals. A good attorney will examine your life goals and use his experience to help you achieve those goals. In some situations, you may wish to delay your filing to account for specific financial events that occurred before you decided to take advantage of this powerful consumer protection. This is why it is important to plan your bankruptcy around your goals and specific financial situation. A good attorney will also ask questions designed to identify potential issues before they become a problem. Like any other process, there is always a starting point.

Initial Steps of Filing for Bankruptcy Protection

Once you have decided to explore bankruptcy as an option, the first step is to contact a bankruptcy attorney and set up a consultation. At Sulaiman Law Group, our consultations can take an hour or longer. This is to ensure that we fully explain the various types of bankruptcy and what effect they will have on you achieving your goals. We also seek to obtain as much information as we can in order to help you make a more informed choice. Being a fiduciary for someone means that you would act in the manner described if you were your own client. We cannot advise a client on a course of action unless we know certain critical pieces of information regarding that client. The initial consultation is also a time for you to determine whether our firm is a good fit for you. Even if you are filing a Chapter 7 bankruptcy, which has a very short time line, you want to make sure that you trust and are comfortable with your attorney before deciding to file bankruptcy.

At the initial consultation, you will be given some documents to fill out. For instance, the initial intake form helps us prepare your bankruptcy petition and provides us with a snapshot of your financial situation. Some clients are candidates for both a Chapter 7 bankruptcy and a Chapter 13 bankruptcy. By attending the initial consultation and filling out the intake forms, you help us determine which type of bankruptcy best serves your long-term financial goals as well as your short-term financial goals. In order for bankruptcy to be a truly fresh start, it helps to make sure that you file under the right chapter and that filing sets you up for financial success in the future. We also need your financial information in order to determine whether you pass the means test. This is an essential part of filing a Chapter 7 bankruptcy and has implications for the other chapters as well.

We will also give you some discount codes for a few credit counseling agencies. Credit counseling teaches you how to manage credit, set a budget, and keep your debt under control. Credit counseling is now required by the Bankruptcy Code. This requirement went into effect with the 2005 amendments to the Code. The 2005 amendments to the Bankruptcy Code are also known as the Bankruptcy Abuse Prevention and Consumer Protection Act. Mandatory credit counseling was introduced to help prevent repeat filings. While the information provided in the counseling is rather remedial, taking the courses is now required by the law. The classes can be taken online via a computer and will take approximately 45 – 60 minutes to complete. If you do not take the pre-filing credit counseling, your case will be dismissed. If you do not take the pre-discharge credit counseling, you will not receive your discharge and you may have to pay an additional filing fee to reopen the case and get your discharge. Although it may seem boring or time consuming, credit counseling is a necessary step towards achieving your goal.

Choosing the Right Chapter

Whether you file a Chapter 7 or a Chapter 13 may depend on more than whether you pass the means test. For example, if you own a home and want to keep it, you aren’t automatically forced into a Chapter 13 filing. Here are some hypothetical clients and their results.

Sam Walker, Chicago, Illinois: Chapter 7

Sam earns $4,100 a month as a retail sales associate. He occasionally receives bonus checks from his employer, but his monthly income is never higher than $4,500 a month. Sam rents an apartment in the Lakeview neighborhood on Chicago’s North Side, owns a late-model Toyota, and has a rather large record collection. Sam has a 401k account through his employer with $75,000 in mutual fund assets, but does not own any stocks or other easily liquidated assets outside of his retirement accounts. Sam also has $50,000 in credit card debts. One of Sam’s credit card providers recently filed a lawsuit against him to collect the balance due on his account. Sam is a perfect candidate for a Chapter 7 bankruptcy. He is likely to pass the means test, and his personal possessions are protected by exemptions. Although Sam assigns a lot of value to his collection of obscure vinyl records, a Chapter 7 trustee likely will not. Filing a Chapter 7 bankruptcy will allow Sam to obliterate his credit card debts while keeping all of his belongings. It will also stop the pending lawsuit, preventing his creditor from obtaining a judgment against him and moving on to collection methods like wage garnishment. He will also only have to wait two years after his discharge to qualify for an FHA-sponsored home loan. He can reduce the two year waiting period to one year if he can show that he filed his bankruptcy due to extenuating circumstances beyond his control and that he has since exhibited a documented ability to manage his finances responsibly. [iv]

Dave Johnson, Riverside, Illinois: Chapter 7

Dave earns $5,000 a month and is an associate attorney at a family law firm located in Chicago. He is married and has one child. Dave’s wife is a stay-at-home mother and does not work outside the home. Dave and his wife own a house in Riverside, Illinois, a suburb located in Cook County. Unlike many home owners, Dave’s home is not underwater – he purchased it in 1999 and has always been current on his mortgage. His home has $50,000 in equity. In 2005, Dave was in a car accident. As a result of the accident, both of Dave’s legs were broken in several places, requiring two surgeries to repair them. Dave also underwent eighteen months of physical therapy. Although Dave’s savings covered his living expenses while he was in the hospital, his insurance did not cover all of the cost of his surgeries or his physical therapy.

Dave still owes $45,000 in medical bills. He also has amassed $25,000 in credit card debt, much of which was used to pay for his physical therapy. Dave and his wife own their cars free and clear, but both have high mileage and are worth less than $2,000 each. Like Sam, Dave is likely to pass the means test. Although it is possible that the Chapter 7 trustee could object to Dave’s Chapter 7 filing as abusive, Dave’s expenses and overall financial picture indicate that his case is likely to survive that challenge. Because the majority of Dave’s assets are protected by his exemptions and those of his wife, it is unlikely that the trustee will seek to liquidate his assets. Additionally, although Dave cannot exempt the entire value of his home’s equity, his $15,000 exemption and the closing costs associated with a property sale will likely make his home unattractive to the Chapter 7 trustee, whose goal is to quickly liquidate assets to repay creditors. A Chapter 7 filing will allow Dave to discharge his medical bills and credit card debt. It will also sever his personal liability on his home loan. So long as Dave continues to make his mortgage payments on time, his home is secure. If Dave is ever forced to default on his mortgage, and his home enters foreclosure, he will not be liable for a deficiency judgment. If the home is sold for less than the loan balance, Dave will not have to repay the difference.

Sarah Miller, Chicago, Illinois: Chapter 13 Lien Strip

Sarah earns $12,000 a month and is a commodities trader at the Chicago Board of Trade. Her house in Lincoln Park is worth $500,000, but is subject to two mortgages. The first mortgage is $500,000 and the second is $100,000. Sarah’s home is deeply underwater, but she is determined to keep her home. Sarah also has $10,000 in credit card debt. Sarah earns too much money to qualify for a Chapter 7 bankruptcy, and a Chapter 7 bankruptcy won’t allow her to recover any value in her home. On the other hand, a Chapter 13 bankruptcy can help Sarah eliminate her credit card debts and also partially restore some equity in her home. Since her first mortgage exceeds the value of her home, Sarah’s second mortgage can be treated as an unsecured asset. Depending on her allowable expenses, Sarah’s Chapter 13 plan will repay her creditors over five years, allocating all of her disposable income towards repaying her debts. Sarah’s goal is to come up with a plan that repays 10% of her debt over those five years. If successful, she will discharge her $10,000 in credit card debt for $1,000 and her second mortgage for $10,000. Throughout the plan, she will also continue making payments on her first mortgage. By removing the second mortgage, she may see her home return to positive equity over the term of her plan. At very least, Sarah will be at the break-even point, which is much better than being $100,000 underwater.

Nancy and Mike Smith, Naperville, Illinois: Chapter 13 Severance/Surrender

Nancy and Mike are a married couple with a household income of $100,000 a year. Their income exceeds the median income for their area, so they are unlikely to pass the means test, even after deducting their expenses. They purchased a home in Naperville, Illinois at the height of the real estate boom. Nancy and Mike love that they are within walking distance of the Riverwalk and Downtown Naperville. However, their home is now underwater by $200,000. They have two car loans, each with a balance of $15,000. The cars are three years old and have depreciated significantly. Both Nancy and Mike drive extensively for work and the mileage on their cars is the main factor in their reduced value. The couple also has several credit cards carrying a total balance of $30,000. Nancy and Mike feel that their mortgage and car payments are unsustainable investments. Although their car payments are current, they are two months behind on their mortgage payments.

A Chapter 13 bankruptcy provides powerful remedies for Nancy and Mike. If Nancy and Mike are willing to cut their losses and surrender their home to the lender, they can surrender the home in full satisfaction of the secured portion of their mortgage. While many lenders do not file a proof of claim for the unsecured portion (roughly $200,000 in this fact pattern), this is not a guarantee. If their mortgage lender manages to prove how much unsecured debt that Nancy and Mike owe, it can file a proof of claim, which means that Nancy and Mike would have to repay the unsecured portion as part of their Chapter 13 plan. Since they have had their cars for longer than 910 days, Nancy and Mike can also use their Chapter 13 to cram down their car loans to the current value of their cars. When they receive their discharge, they will own the cars free and clear of the loans, while only paying back a portion of the loan balances. This is an extremely attractive option for the informed.

Alex Richards, Montgomery, Illinois: Chapter 7 + Chapter 13 Lien Strip = Chapter 20

Alex filed a Chapter 7 bankruptcy ten months ago with a different attorney. He received a discharge and no longer has any personal liability on his mortgage. Since Alex already discharged his credit card debts and other debts in his Chapter 7 filing, it may seem that he cannot benefit from another bankruptcy filing. After all, he is not eligible for a discharge for another 4 years due to his recent Chapter 7 filing. However, Alex owns a home in Montgomery, Illinois. He is committed to keeping his home, even though his second mortgage puts him underwater by $100,000. He is currently four months behind on his mortgage, but his lender has not yet filed a foreclosure action. Alex is a good candidate for what is sometimes called a Chapter 20 bankruptcy.

Even though he cannot receive a discharge from a Chapter 13 filing, Alex can use the Chapter 13 filing for two main purposes: he can get his mortgage current and strip his second mortgage. Since he is only four months behind on his mortgage, and given that he will be attempting a 10% payback plan, Alex’s plan may be very short, depending on his disposable monthly income. At the end of the plan, he will be current on his mortgage and no longer underwater because his second lien will be stripped in the Chapter 13 bankruptcy.