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Chapter 7 Bankruptcy in Detail

Chapter 7 Overview

A Chapter 7 bankruptcy 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. Most people do not have the kinds of assets that a trustee is interested in liquidating. Trustees are interested in liquidating things like cash, stocks, bonds, and precious metals. Assets that are difficult to value or sell are not as attractive. Assets that cost money to liquidate are not as attractive.

In many cases, there may not be an actual liquidation of the consumer's assets. This is because there is little or no nonexempt property. These cases are called "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.

In most Chapter 7 cases, individual consumers receive a discharge that releases them from personal liability for 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 such a consumer’s income is in excess of certain thresholds, the consumer may not be eligible for Chapter 7 relief.

Chapter 7 Eligibility – The Means Test and Abuse

The 2005 amendments to the U.S. Bankruptcy Code established a means test to determine an individual’s eligibility for filing a Chapter 7 bankruptcy. The means test is designed to prevent abuses of the Bankruptcy Code, although many attorneys find that it has done very little to prevent people from filing bankruptcies, and even less to prevent abuse of the system. The means test looks at the median income for a specific family size in a specific geographic area. For instance, the median income for a three person family in the 60618 zip code, which includes Chicago’s North Center and Ravenswood neighborhoods, was $66,758 a year in December of 2011. If your family’s income meets or falls below the median, you may be eligible to file a Chapter 7 bankruptcy. If it exceeds the median, a presumption of abuse arises. This presumption can be rebutted, in particular if you can demonstrate that special circumstances and expenses make your actual income lower than your paystubs may indicate. In fact, people who make more than the median income for their area can qualify for Chapter 7 protection.

Keep in mind that passing the means test is not necessarily a guarantee that you are eligible for a Chapter 7 bankruptcy. If your income suddenly changes or if it appears that you have a significant amount of net income, a bankruptcy judge can apply what is known as the “totality of the circumstances” test and determine that a Chapter 7 filing is abusive. If abuse is found, the case is either converted to a Chapter 13 or it is dismissed. How you have conducted your financial affairs prior to filing your bankruptcy can also have an effect on this analysis. For example, spending large amounts of money on luxury items in the months preceding your bankruptcy filing is generally considered abusive. This is why it is especially important that you disclose all of your financial affairs to your attorney. In some cases, it may be wise to postpone a bankruptcy filing.

Post-Holiday Filing Issues

The winter holiday season is a time when people generally spend money on gifts for friends and family. Many people also take advantage of the sales retailers offer to obtain new creature comforts for their homes. If you use your credit cards to purchase gifts and non-essential consumer goods during the holiday season and file for bankruptcy at the beginning of the year, it may appear to be an abuse of the Bankruptcy Code. This can be overcome by waiting to file your bankruptcy petition. When a person runs up a large amount of credit card debt on luxury items and then immediately files for bankruptcy, it appears abusive. By waiting to file and attempting to pay down some of the balances, you can avoid this appearance of abuse.

Ron Pullman, Chicago, Illinois: An Example of A Bad Faith Filing

Ron lives in Chicago, Illinois. He is a librarian at a nearby public library. Instead of being laid off, Ron chose to take a salary cut when the library’s budget was slashed. With his $45,000 salary, Ron qualifies for a Chapter 7 bankruptcy, but only has one credit card, which he uses to purchase gas. Ron pays this account monthly and has a great credit score. Ron also wishes he could afford to transform his condo into a true “man cave,” with leather recliners, flat-screen TV’s, a premium sound system, and other creature comforts. Ron applies for several credit cards with high limits. He then proceeds to outfit his man cave to his heart’s content. Once he is finished with his shopping spree, Ron realizes that he cannot possibly pay off his new debts. Ron decides to file a Chapter 7 bankruptcy. Ron’s creditors object to their debts being discharged as an abuse of the Bankruptcy Code. After a hearing on his creditors’ objections, Ron is granted a discharge, but none of the objecting creditors’ debts are included in the discharge. Ron is now on the hook for all of the debt he just incurred. Ron could have withdrawn his filing as well to avoid the uncertainty of fighting the creditors’ objections. An experienced attorney would not have let Ron file on these facts.

The Chapter 7 Process

A Chapter 7 case begins when you file a petition with the bankruptcy court. Before you file, it is important that you have assembled all of the documents that you will need in order to file your petition. For example, you will need to provide your last two tax returns as well as your last six months of pay stubs. If you are self-employed, you will need to provide your bank statements for the past six months. You must also complete the pre-filing credit counseling and provide your attorney with a certificate indicating that you completed the course.

In order to complete the forms that make up the petition, statement of financial affairs, and schedules, you must provide the following information:

1. A list of all creditors and the amount and nature of their claims;
2. The source, amount, and frequency of the your income;
3. A list of all of your property; and
4. A detailed list of your monthly living expenses, i.e., food, clothing, shelter, utilities, taxes, transportation, medicine, etc.

Your attorney will work with you to gather this information. It is very important that you list all of your creditors. Not every creditor will necessarily report your debts to the various credit reporting agencies, so simply providing a copy of your credit report may not be sufficient. Anyone to whom you owe money qualifies as a creditor. If your Aunt Sally lent you $30,000 as a down payment on your house, and you have a plan to pay her back, she is one of your creditors.

Married individuals must gather this information for their spouse regardless of whether they are filing a joint petition, separate individual petitions, or even if only one spouse is filing. If only one spouse files, the income and expenses of the non-filing spouse are required so that the court, the trustee and creditors can evaluate the household's financial position. All of your financial information is organized into “schedules.” These schedules are lists of your assets and debts that are organized by type.

Among the schedules that an individual will file is a schedule of "exempt" property. The Bankruptcy Code allows an individual to protect some property from the claims of creditors because it is exempt under federal bankruptcy law or under the laws of the consumer's home state. If you have recently moved from another state, inform your bankruptcy attorney as you may be eligible to use your prior state’s exemptions. Since exemptions vary from state to state, you may discover that your old state’s exemptions cover more or less than the Illinois exemptions. If your old state’s exemptions provide you more protection, you may want to file before you are no longer eligible to use them. For example, if the Illinois exemptions provide you with more protection, you may want to wait to file until you are eligible to use the Illinois exemptions.

Filing a petition under chapter 7 creates an "automatic stay" that stops most collection actions against you and your property. The stay arises by operation of law and requires no judicial action. This means that as soon as you file, with a few exceptions, the stay goes into effect immediately. As long as the stay is in effect, creditors generally may not initiate or continue lawsuits, wage garnishments, or even telephone calls demanding payments. The bankruptcy clerk gives notice of the bankruptcy case to all creditors whose names and addresses are provided by the consumer. If you have specific creditors who are about to move forward with a lawsuit, your attorney should also directly notify those creditors and their counsel of your bankruptcy filing. For example, if you file a bankruptcy petition on a Friday and your home is scheduled for a sheriff’s sale the following Tuesday, you or your attorney should provide notice to that creditor. The extra layer of documentation may make the difference between a successful stay violation claim and an unsuccessful one.

This extra layer of documentation is exceptionally powerful. When you have taken extra steps to provide notice of your bankruptcy filing, creditors who violate the automatic stay expose themselves to significant legal liability. The law makes a distinction between an “inadvertent” or “accidental” violation of the stay and a “willful” or “knowing” violation of the stay. If a creditor did not have proper notice of the bankruptcy filing, then the relief available to you is limited to actual damages and attorney’s fees. However, if the creditor has been provided with added notices, it is easier to categorize a violation of the stay as willful or knowing. These types of violations can entitle you to punitive damages, which are a powerful remedy designed to punish willful violations of the automatic stay.

Between 20 and 40 days after you file your petition, the bankruptcy trustee will hold a meeting of creditors. This is also referred to as the 341 meeting. 341 refers to the section of the Bankruptcy Code which requires that the meeting be held. During this meeting, you are put under oath, and both the trustee and creditors may ask questions. You must attend the meeting and answer questions regarding your financial affairs and property. Failing to attend your 341 meeting can result in your case being dismissed. If a husband and wife have filed a joint petition, they both must attend the creditors' meeting and answer questions. These meetings are generally very short and last typically no more than 5 to 15 minutes. There is a set of general questions that the trustee will ask. These questions are primarily designed to ensure that you listed all of your assets and debts in your petition. A set of sample 341 meeting questions can be found in Appendix 1. Within 10 days of the creditors' meeting, the U.S. trustee will report to the court whether the case should be presumed to be an abuse under the means test described here. It is very important that you cooperate with the trustee and provide any financial records or documents that the trustee requests.

The Bankruptcy Code requires the trustee to ask questions at the meeting of creditors to ensure that you are aware of the potential consequences of seeking a discharge in bankruptcy, the ability to file a petition under a different chapter, the effect of receiving a discharge, and the effect of reaffirming a debt. Some trustees provide written information on these topics at or before the meeting to ensure that you are aware of this information. If this is the case, be sure you have read the information before your 341 meeting begins.

Who Is The Trustee? What Does A Trustee Do?

When a Chapter 7 petition is filed, an impartial case trustee is appointed to administer the case and liquidate your nonexempt assets. A trustee is generally an attorney, although non-attorneys may qualify to serve as a Chapter 7 trustee if they meet the requirements set forth in the Code of Federal Regulations. [i] Your specific trustee is randomly assigned to your case when it is filed. Sometimes a trustee will be substituted for another trustee if a scheduling conflict or other conflict arises. For example, if your first cousin is a Chapter 7 trustee, and is assigned to your case, you will be assigned a new trustee.

If all of your assets are exempt or subject to valid liens, the trustee will normally file a "no asset" report with the court, and there will be no distribution to unsecured creditors. Most Chapter 7 cases involving individual consumers are no asset cases. You may be surprised to learn that even though your personal belongings have sentimental value, it is very rare that they have any true resale value. Trustees are concerned with assets that can be easily sold. Precious metals, cash, stocks, bonds, houses and vehicles are most attractive to trustees. Trustees are paid a flat fee for each case they handle. They also receive a percentage of the value of any liquidated assets. If an asset is difficult to sell, then a trustee likely won’t be interested in it. If the trustee is interested in a specific asset, it is possible to purchase those assets back from the trustee.

If the case appears to be an "asset" case at the outset, unsecured creditors must file their claims with the court within 90 days after the meeting of creditors. A typical claim establishes the amount owed and provides documentation to support the claim. In some situations, your attorney may want to object to the claim if it is improperly filed or if it is otherwise defective. A governmental unit, like the IRS, has 180 days from the date the case is filed to file a claim. In the typical no asset Chapter 7 case, creditors do not file proofs of claim because there will be no distribution, meaning that there are no assets to liquidate. If the trustee later recovers assets for distribution to unsecured creditors, the Bankruptcy Court will provide notice to creditors and will allow additional time to file proofs of claim. This rarely occurs in practice and can be prevented by fully disclosing your financial affairs to your attorney. Before filing a case, your attorney will already know if yours is an “asset” case or a “no asset” case. Typically, this is disclosed at the time of filing.

When you file your bankruptcy case, it creates an "estate." The estate technically becomes the temporary legal owner of all of your property. It consists of all legal or equitable interests you have in property at the time of filing; this includes property in which you share ownership. Your creditors are paid from non-exempt property of the estate. If the Chapter 7 trustee determines that yours is an asset case, the trustee’s job is to liquidate your nonexempt assets. The trustee will sell your nonexempt property and distribute that money to your unsecured creditors.

The trustee also has the power to “look back” and try to recover money or property you may have spent or transferred 90 days prior to filing your case. If you paid some creditors and not others within the 90 days before you filed, the trustee can attempt to recover that money. This is called a “preference.” A good example is money paid to a family member to settle an outstanding debt while other creditors go unpaid. Remember Aunt Sally? If you paid back her $30,000 loan shortly before filing bankruptcy, odds are that your trustee would expect her to return those funds to the bankruptcy estate for distribution to all of your unsecured creditors.

The trustee can also undo transactions where you borrowed money against your assets prior to filing. A good example would be a consumer that took out a home equity line of credit prior to filing bankruptcy. The trustee also has the power to undo sales or other transfers of property. For example, if you have a boat and a “weekend driver” car and sell those to your friend prior to filing for a Chapter 7 bankruptcy, the trustee can undo that sale, bringing the property back into the bankruptcy estate.

What Happens When My Case Is Discharged?

A discharge releases you from personal liability for most debts and prevents the creditors owed those debts from taking any collection actions against you. This powerful injunction provides you with absolute personal protection from your creditors. Creditors who violate the discharge injunction can be sued and you may be able to recover damages from them. In most Chapter 7 cases, the Bankruptcy Court will issue a discharge order relatively early in the case. This is usually 60 to 90 days after the meeting of creditors.

The court may deny you a discharge if it finds that you failed to keep or produce adequate financial records; did not explain, satisfactorily, any loss of assets; committed a bankruptcy crime like perjury; failed to obey a lawful order of the bankruptcy court; fraudulently transferred, concealed, or destroyed property; or failed to complete an approved instructional course concerning financial management. These situations rarely occur, but they highlight the importance of full disclosure to both your attorney and the bankruptcy court.

Secured vs. Unsecured Debt

Unsecured debt, like credit cards, is generally paid from your bankruptcy estate. If your case is an asset case, the assets will be sold to pay these debts. Secured debt is tied to a piece of property. The most common secured debts are mortgages and automobile loans. Real estate is known as real property. Cars, boats, paintings, etc. are known as personal property.

Secured creditors may retain some rights to seize property even after a discharge is granted. This is because the discharge only removes your personal liability for your debts. Debts tied to property will still be tied to the property. For example, if you have a mortgage on your home, even though your personal obligation to pay your debt is discharged, the bank can still take your home to satisfy the debt. This is because your bankruptcy discharges your personal obligation to repay the money lent to you. This obligation is described in the promissory note you signed at the real estate closing. The mortgage on your home is a separate obligation that ties the physical property to the debt. The Chapter 7 discharge cannot remove this obligation because it is not your personal obligation, but one that is linked to the property itself. If you stop making your mortgage payments, then the lender can proceed forward with a foreclosure. However, if you continue to make your payments, it is likely that the lender will happily accept them.

Reaffirming Debts

It is possible to “reaffirm” debts. Reaffirming a debt involves an agreement between you and your secured creditor. You agree to pay all or a part of your debt; the creditor agrees to not take back the property as long as you continue to make payments. Before you reaffirm any debts, you should consider your ability to make the payments required by your agreement.

Before deciding to reaffirm a debt, discuss it with your attorney first. You should never enter into a reaffirmation agreement before consulting with your attorney. If, after talking to your attorney, you decide to reaffirm a debt, you will be required to file a signed reaffirmation agreement with the court. Your reaffirmation agreement must include disclosures. These disclosures are required by the Bankruptcy Code. Among other things, the disclosures must advise you of the amount of the debt being reaffirmed, how it is calculated, and that reaffirmation means that your personal liability for that debt will not be discharged in the bankruptcy. It is highly unlikely that a competent attorney would ever advise a client to reaffirm a debt on an underwater asset because there is no financial benefit to the client.

You are also required to file a signed statement of your current income and expenses. The statement must show that you can afford to pay the reaffirmed debt. If your statement shows that you cannot afford to pay the debt, the court may presume that the debt is an undue hardship. In that case, it would deny the reaffirmation agreement.

If you are represented by an attorney in connection with the reaffirmation agreement, your attorney must certify in writing that he or she advised you of the legal effect and consequences of the agreement, including the result of defaults under the agreement. Your attorney must also certify that you gave informed consent to the debt and that repaying it will not be an undue hardship on you or your dependents. Even if you don’t have a reaffirmation agreement, you may repay a debt voluntarily without reestablishing personal liability for the debt. This is almost always a better position than reaffirming.

In general, it is a bad idea to reaffirm debts as part of your Chapter 7 bankruptcy, especially on underwater assets. Reaffirmation agreements generally contain clauses that force you to accept personal liability for the reaffirmed debt. This means that your discharge will not apply to the reaffirmed debt. If your goal was to obtain a fresh start with absolute freedom from your debts, reaffirming a debt defeats the purpose of filing a bankruptcy in the first place. Remember, a discharge represents absolute freedom from your existing dischargeable debts.

Your Chapter 7 Discharge

Once your debts are discharged in your Chapter 7 bankruptcy, your creditors cannot initiate or continue any attempts to collect the discharged debts from you. Some debts cannot be discharged in a Chapter 7 bankruptcy.

They include:

• Alimony and child support
• Certain tax obligations, although it may be possible to discharge tax obligations that are greater than 3 years old.
• Student loans, unless you can demonstrate that repaying the loan would be an undue hardship on you and your dependents.
• Personal injury judgments
• Debts related to DUI or DWI damages
• Criminal restitution orders such as an order to pay restitution to the victim of a battery you committed.

If these types of debts are not paid as part of your Chapter 7 bankruptcy, you will still be personally liable for them.

It is very important that your filing be 100% truthful. The bankruptcy court may revoke your Chapter 7 discharge if the trustee, a creditor or the U.S. trustee requests it and demonstrates a valid basis for revoking the discharge. The request will be granted if the discharge was obtained through fraud, if you acquired property that is property of the estate and knowingly and fraudulently failed to report or to surrender it to the trustee, or if you made a material misstatement or failed to provide documents or other information in connection with an audit of your case.

Sam Jackson, Schaumburg, Illinois: A Revoked Discharge

When Sam filed his Chapter 7 bankruptcy petition, his wealthy Uncle Larry was terminally ill. A week before Sam was to attend the 341 meeting of the creditors, his uncle passed away. Uncle Larry’s will stated that Sam would receive a cash inheritance of $500,000.00. At the 341 meeting, the Chapter 7 trustee asked Sam if he had acquired any new assets since he filed his bankruptcy case. Sam said that he had not. The Chapter 7 trustee declares Sam’s case to be a no-asset case and recommends discharge. Sam is granted his discharge, and begins to spend his inheritance. One of Sam’s creditors discovers Sam’s inheritance and files a motion to revoke the discharge. Given that Sam lied to the trustee during the 341 meeting, and given that he failed to disclose the inheritance as required by the Bankruptcy Code, the Bankruptcy Court grants the motion to revoke Sam’s discharge. He may have also exposed himself to liability for bankruptcy fraud. If Sam’s uncle died months after the completion of his bankruptcy, this would have not been a problem. Assets acquired after a discharge is received are the property of the individual, not the bankruptcy estate. Again, the underlying principal behind the Bankruptcy Code is a fresh start, allowing people like Sam to spend and invest money again.