I. Business Chapter 7
If a business files for Chapter 7 bankruptcy protection, the Chapter 7 Trustee assigned to the case seizes all of the business’s assets and liquidates them. As part of the liquidation the Trustee pays off all encumbrances against the assets — e.g., mortgages against real property — pays the cost of selling the assets, takes the statutory cut found in 11 U.S.C. § 326(a), and distributes the remaining proceeds to the creditors according to the priority rules found in 11 U.S.C. §§ 507(a) and 726(a).
When the smoke all clears the debtor ceases to exist, which is why a business is ineligible for a Chapter 7 discharge pursuant to 11 U.S.C. § 727(a)(1).
II. Personal Chapter 7
I am pleased to report that although the title of Chapter 7 in the Bankruptcy Code is “Liquidation,” no individual debtors are liquidated in a Chapter 7 bankruptcy. However, there can be a liquidation component to the case.
A. Exempting Assets
I have already written about exempting assets many times — see, e.g., the September 16, 2011 post. Therefore, I won’t discuss that topic here; other than to say that in a personal Chapter 7 bankruptcy the debtor keeps the exempt assets, while the Chapter 7 Trustee seizes and liquidates the nonexempt assets for the benefit of creditors.
B. The Liquidation
When faced with a nonexempt asset, a Trustee must answer a question: Is it worth the time, effort, and expense to do the liquidation? Here is the analysis the Trustee will do:
1. How much is the asset worth?
Although the debtor provides an estimated value in the bankruptcy papers, this estimate does not bind the Trustee — even if the estimate was a professional appraisal of the property. The only way to really determine the value of the asset is to put it on the market because an asset is only worth what the market will pay for it. Of course, a professional appraisal may dissuade the Trustee from taking further action because the appraisal may indicate the futility of selling the asset due to the required payout discussed below.
2. How Much Is Owed On The Asset?
As part of the sale, the Trustee must pay the creditors who have legitimate recorded liens on the asset. Therefore, if the asset is underwater — i.e., the liens total more than the sale price — the Trustee will abandon it, with one possible exception. If the Trustee can convince a creditor whose lien is secured by the asset to accept less than full payment, thus leaving money left over to pay the unsecured creditors, the Trustee will proceed with the sale.
For example, suppose there is an IRS tax lien against the property based on a nondischargeable income tax debt. Suppose further that tax lien is the reason the property is underwater. Then the Trustee may be able to convince the IRS to release the lien in exchange for some payment after the sale, since the remaining unpaid tax debt will not be discharged in the bankruptcy.
3. How Much Will It Cost To Sell The Property?
As with any economic transaction, the sale of a nonexempt asset is not free. For example, if the asset is real estate, the Trustee will have to pay a real estate agent, pay for advertising, and pay to get the Court’s permission do the liquidation and the ultimate distribution of the proceeds. If these costs exceed the equity in the asset, the Trustee will abandon it.
C. The Payout
Once the Trustee determines that there will be a dividend to the creditors, the Court will send a notice of dividend to each of the creditors the debtor scheduled in the bankruptcy papers. A creditor wishing to participate in the eventual payout must file a proof of claim with the Court by the date listed on the notice of dividend, stating the amount owed and providing proof of the legitimacy of the debt. Otherwise, that creditor will not be paid.
11 U.S.C. § 726(a) contains the order of payout.
1. Paying The Debtor The Exemption Amount
The Trustee will then write a check to the debtor for the exemption amount. This amount cannot be surcharged by the Trustee to cover expenses. See Law v. Siegel, 134 S.Ct. 1188 (2014). Therefore, the only ways the Trustee can end up paying the debtor less than the original exemption amount claimed in the schedules are by: (1) successfully challenging the legitimacy of the exemption by filing an action in the bankruptcy court no later than thirty days after the conclusion of the 341 meeting of creditors (see Fed. R. Bankr. Proc. 4003(b)(2)); or (2) convincing the debtor to accept less than the original exemption amount.
You might wonder why a debtor would agree to payment of less than the full exemption amount. One way I have seen this happen is when the debtor has equity in a home that is approximately the exemption amount, and is facing a foreclosure. If the debtor has insufficient income to cure the default in a Chapter 13 repayment plan, the debtor will eventually lose the house. If the debtor insists on being paid the entire exemption amount, the Trustee will abandon the asset. However, if the debtor is willing to accept sufficiently less than the exemption amount, then the Trustee will sell the property and the debtor will at least get the reduced exemption amount. Otherwise, the debtor loses the house and gets nothing.
2. Paying The Secured Creditors
If the asset was encumbered, then those creditors who had liens against the asset are paid first, with the understanding that they are paid in the order they recorded their liens. Thus, the oldest lien is paid first, then the second oldest, etc. The slogan used here is: “First in time is first in right.”
3. Paying The Unsecured Priority Creditors
In the taxonomy of debt there is a hierarchy of priority, which is detailed in 11 U.S.C. § 507(a). The first priority is domestic support — i.e., child support and alimony. Therefore, these claims are paid before any other unsecured claimants are paid. If there is money left over after the domestic support claims are paid in full, then administrative claims are paid. After that, there are eight other priority classes — so there are ten in all. No one in a class gets paid anything until the members of the next higher class are paid in full. Take a look at § 507(a) to see the order of payout. You might be surprised to see that priority tax debts have seven priority classes ahead of them.
4. Paying The General Unsecured Creditors
After all of the priority debts have been paid, if there is anything left it goes to the unsecured nonpriority creditors — usually referred to as general unsecured creditors.
5. Paying The Debtor
If after everyone else has been paid there is still money left over — a rare occurrence — the debtor gets it pursuant to 11 U.S.C. § 726(a)(6).
D. The Trustee’s Compensation
As you may have picked up from the discussion, the Trustee has a fair amount to do in a Chapter 7 case where there are assets to be liquidated for the benefit of creditors. What does the Trustee get? A hearty handshake and the thanks of the creditors? Not quite.
To set the stage for my answer, let me recount a famous story about the great defense attorney of old, Mr. Clarence Darrow. Mr. Darrow had successfully defended his client, who then asked, “Mr. Darrow, how can I ever thank you?” To which the redoubtable Mr. Darrow replied, “Madame, ever since the Phoenicians invented money, there has only been one satisfactory answer to that question.”
So the Trustee gets money. How much? For each Chapter 7 case the Trustee gets $60, plus a cut of the funds to be distributed to the creditors. That cut is calculated using the formula found in 11 U.S.C. § 326(a):
In a case under chapter 7 or 11, the court may allow reasonable compensation under section 330 of this title of the trustee for the trustee’s services, payable after the trustee renders such services, not to exceed 25 percent on the first $5,000 or less, 10 percent on any amount in excess of $5,000 but not in excess of $50,000, 5 percent on any amount in excess of $50,000 but not in excess of $1,000,000, and reasonable compensation not to exceed 3 percent of such moneys in excess of $1,000,000, upon all moneys disbursed or turned over in the case by the trustee to parties in interest, excluding the debtor, but including holders of secured claims.
III. Prebankruptcy Planning
I hope I have not only answered the question posed at the beginning of this post — a question I get with surprising frequency — but have also implicitly adumbrated the need for prebankruptcy planning.
Unfortunately, there are sloppy bankruptcy mills who fail to do careful prebankruptcy planning, which results in their clients unnecessarily having their rights prejudiced. See, e.g., DeLuca v. Seare, BAP No. NV-13-1196-KiTaJu (B.A.P. 9th Cir. Aug. 25, 2014).
And while I understand the desire for a cheap bankruptcy — no one wants to pay more than absolutely necessary for any service — the consequences of pinching pennies can be catastrophic. There is a lot of truth to the old maxim, “You get what you pay for.” In general, two types of services are worth paying a bit more for: good medical services, and good legal services.
If you’re a debtor and need bankruptcy protection, contact an extremely knowledgeable and highly skilled bankruptcy attorney to guide you through the process.