AMERICAN BANKRUPTCY LAW: Meaning of Chapter 7 and 11 by Adeyemi Oshunrinade


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Recently the entire nation became aware of the news of American Airline filing for bankruptcy. Fliers around the world and soon to be passengers are gripped with fear and anger caused by the uncertainty around what would become of their planned trips and whether they would ever be able to recover money paid for tickets and trips. The reason for such fear may be attributed to the fact that those concerned, lack the knowledge of what American bankruptcy law is or what it means to file for Chapter 11 under the bankruptcy statute.

The aim here is to explain the meaning of bankruptcy under the bankruptcy code and what it means to file for Chapter 7 and Chapter 11 as it applies to private individual and business organizations respectively.

Bankruptcy law is Federal law. Under Article I of the United States Constitution, Congress has the power to establish uniform laws as it relates to bankruptcies throughout the United States. For most of the 20th century, bankruptcy law was the Bankruptcy Act of 1898; this is commonly referred to as the “Bankruptcy Act.” In 1978 it was replaced by a law commonly referred to as the “Bankruptcy Reform Act of 1978” or the “Bankruptcy Code;” which was amended in 2005. (See David G. Epstein, Principle of Bankruptcy Law unit 1 p. 2 (2007).

Though Bankruptcy law is Federal law, it is also in large part state law. This does not mean State are allowed to enact bankruptcy laws, since the Supremacy Clause preclude State Legislatures from making Bankruptcy laws. Rather, what this means is that the Bankruptcy Code incorporates State law and sometimes, courts applying the Bankruptcy Code, look to State law to find answers to questions involving the property rights of debtor and the claims of the creditor to such property.

Most bankruptcy case involves the filing of either Chapter 7 or 11. Chapter 7 is the most common form of bankruptcy; it provides for the independent sale of the debtor’s assets accumulated and owned at the time of the bankruptcy proceeding. This is usually followed by the distribution of the proceeds of the sale to creditors according to statutory rules. On the other hand, Chapter 11 permits but does not require the sale of assets. The idea is to allow the debtor to keep his assets and then generate earning from such assets to help fund a plan of creditor payments that has been negotiated by creditors and approved by the court. In other words, Chapter 11 is about restructuring rather than total assets’ liquidation.

In any bankruptcy case, the individual debtor or business entity, begins the proceeding by first filing a bankruptcy petition; most bankruptcy petitions about 99% are filed by the person seeking bankruptcy relief (the debtor) usually “voluntary” and less than 1% are filed by the creditor against a debtor which is “involuntary.” Under the Bankruptcy Code Section 301 and 303, the case for bankruptcy is “commenced” when a petition is filed by or against an eligible debtor. (See David G. Epstein, Principle of Bankruptcy ibid; unit 4 P.40)

Under section 109 of the Bankruptcy Code, questions are raised as to: (1) whether the person filing for bankruptcy is eligible to be a debtor? (2) Whether such person is eligible to be a debtor under that particular section of the Code?

Before filing for bankruptcy, the individual petitioning must first go for credit counseling. This is known as pre-bankruptcy counseling; section 109(h) of the Bankruptcy Act makes an individual ineligible to file for bankruptcy under any of the chapters unless within 180 days before filing the individual received credit counseling from an agency approved by the U.S. Trustee.

Besides the credit counseling, the petitioner must also declare their assets (property) and what they owe (claims).The debtor pays a filing fee but sometimes, this is waived by the court for poor petitioners. The debtor must also present the certificate of credit counseling earlier discussed, tax return for the most recent year, and statement of net income as well as anticipated income.

As soon as an individual debtor files for bankruptcy, there are three legal consequences: (1) the property of the debtor immediately becomes property of the estate, (2) the property of the estate and the debtor are brought under ‘automatic stay’ which helps to shield the estate property from the collection efforts by the creditors and (3) the date of filing the petition for bankruptcy becomes the date of the commencement of bankruptcy proceedings. In Chapter 7 cases, a trustee will take possession of all estate property and all of the debtor’s interests in such property, becomes the property of the estate.

The role of the bankruptcy trustee is to sell the property of the estate in most Chapter 7 cases. The proceeds of such sale are then distributed to the holders of unsecured or general claims. Some property are turned over to the debtor if they are exempt property as stated in section 522; some are transferred to third parties as in section 549 and some are subject to liens valid in bankruptcy.

In most Chapter 7 cases, the benefit of a bankruptcy petition to the debtor is the discharge and the costs to the creditors as well, is the discharge. A debtor, who has filed for bankruptcy and received a discharge, is protected from any further liability on the discharged debts. As soon as the discharge issues, creditors can no longer sue the debtor for the debts and they are prohibited from even calling the debtor about the discharged debts.

Section 525 of the Code suggests that the debtor is protected from discriminatory treatment however, a store may refuse to give credit to one based on bankruptcy history or a bank may refuse to give a loan based on bankruptcy status. In Chapter 7 cases, corporations and business entities are not allowed discharge; such a discharge is only open to human petitioners.

In Chapter 11 cases involving business entities, corporations, partnerships and limited liability companies, a discharge will only issue after the court has approved the reorganization and restructuring plan. A business entity will only receive a discharge when the court confirms there is a plan in place for the orderly payment of creditors. However, in Chapter 11 cases filed by individual debtors, a discharge does not take effect until payments under the plan have been made.

Important to note in a Chapter 7 case is that property of the estate is taken by the trustee and sold; the proceeds are then distributed among the creditors. This means that in a Chapter 7, the debtor loses the property of the estate as his only cost, while the benefit to the creditor is the receipt of the proceeds of sale. On the other hand in a Chapter 11 case, the debtor retains possession of estate property. However, use of such property is subject to supervision by the bankruptcy court.

These may help explain what happened in the case of American Airlines; since the company filed for Chapter 11, it retains possession of its assets which enables it to restructure and reorganize itself by following a court approved plan that allows it to pay its creditors accordingly without liquidating all its assets.

Some properties enjoy protection and are not considered property of the estate for bankruptcy purposes. For example, funds placed in an educational retirement account at least 365 days before the petition for bankruptcy are excluded. This is within the limit established by the Internal Revenue Code; as long as the funds are for the benefits of the debtor’s children or grandchildren, they are excluded from the estate with a $5,000 limit on funds contributed between one and two years before filing. (See section 541(b) (5) as added in 2005). Even though, no mention of it is made in section 541 (c) (2) of the code, ERISA accounts and spendthrift trusts are considered excluded.

Among debts not offered discharge in Chapter 7 bankruptcy are those acquired after a petition for bankruptcy, is filed. Domestic support obligations and student loans lack discharge exceptions due to the nature of such loans. Under section 523 (a) (8) which denies the exception for student loans, to obtain relief, the debtor must prove “undue hardship” to have the student loan discharged. Also in the category denied exception are taxes, credit card debts, and illegally incurred obligations.

In essence bankruptcy focuses on claims, the ultimate goal of a bankruptcy petition is to have such claims discharged to enable the debtor obtain relief and have a “fresh start” free from his debt obligations. In Chapter 7 bankruptcy, property of the estate is taken by the trustee and liquidated to pay the creditors whereas, in Chapter 11, the plan provides for reorganization and distribution to valid holders of claims.

Dr. Adeyemi Oshunrinade [E. JD] is an expert in general law, foreign relations and the United Nations. He is the author of ‘Murder of Diplomacy’ (2010) and ‘Wills Law and Contests’ (2011).

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Categories: LAW

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4 replies

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