Bankruptcy for Smarties # 1
I don't want to be sued for violating a trademark, and I assume most of my readers are not dummies, thus the above title.
Given that I've spent 40 years in bankruptcy and workouts, I thought I'd write a piece summarizing the subject in two posts.
The term bankruptcy itself stems from the Italian Banca Rotta, or "broken bench." In the Middle Ages when a merchant could not pay his debts, his bench in the marketplace was broken and his assets were sold to pay creditors. The idea of a discharge or forgiveness of the remaining unpaid debts is a concept that came centuries later.
In America there currently are five basic flavors of bankruptcy: Chapter 7, Chapter 9, Chapter 11, Chapter 12, and Chapter 13, which I will deal with in a somewhat different order.
Chapter 7 is what most people think of when they hear the word "bankruptcy." In Chapter 7 a trustee is appointed to take charge of the debtor's (person or company that is in bankruptcy) assets. The trustee sells the assets and pays debts according to certain priorities. In general, selected support obligations take precedence; taxes are next, and the poor general creditors come last. Secured creditors, with a lien on property, get paid out of a sale of their collateral. Most secured creditors usually take back their collateral unless they are over-secured, or the property is worth more than they are owed.
Chapter 7's can be filed voluntarily by persons or business entities such as corporations, partnerships or limited liability companies. Chapter 7's also can be filed involuntarily against people or business entities by unsecured (or under-secured) creditors, provided the amounts they are owed are fixed and not subject to dispute. In general, creditors will join an involuntary petition only if they have a court judgment.
Chapter 11 is a reorganization, although it is often used as a liquidation. The common notion is that a business entity files a Chapter 11 to screw its creditors. That is not the case generally. In business cases, the entity may be solvent (have a positive net worth), but not have the cash to make current payments to bondholders or creditors. It also might have a negative net worth, but have a profitable business operation. An example of the latter would be a corporation owing $100m to its bondholders and generating a profit of $2m a year (before debt service). In this case a Chapter 11 is filed to reduce the amount of debt and keep the core business running. The catch, which most lay people don't understand, is that in such a situation the equity holders (stockholders) don't retain their equity. They either get wiped out, with the bondholders exchanging some of their debt for equity in the reorganization, or can buy back their equity or some percentage with fresh cash from the outside. Creditors need to approve a Chapter 11 plan filed by creditors or the debtor. Individuals can also file for Chapter 11 relief and do so either to delay the inevitable or simply stretch out payments on maturing debt out of future earnings. Chapter 11’s can be filed voluntarily or involuntarily, the latter by creditors wanting to preserve value in a company going downhill.
Only Individuals can file Chapter 13’s. In general, a Chapter 13 debtor must pay the full value of his secured debt plus his disposable income for 3-5 years. A change a decade ago in the law forced many poor consumers into Chapter 13.
Chapter 9 is a municipal corporation reorganization where a city or other entity can't pay its bonded debt.
Chapter 12 is sort of Chapter 11 for small farmers.
One important thing about any filing: The filing of a case under any chapter acts as an automatic stay against any civil legal proceeding except certain domestic cases. Thus, many people file voluntarily to stop cases against them in hopes that they are delayed, or the underlying cause of action is resolved in the case itself. Business entities file sometimes because they have multiple cases filed against them and need to stop the legal bleeding.
I know my fellow lawyers will critique my summary, and they are invited to supplement my descriptions in the comments. However, my summary should give one an idea of bankruptcy flavors. In my next post, I'll deal with what happens to debt that is wiped out and what kind of debts can be wiped out, with the ultimate question: Could Donald Trump file a Chapter 11 and wipe out his debt to his accusers?