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Rights of Creditors and Debtors in Bankruptcy

In order to understand what happens inside a bankruptcy, you must understand what happens outside of bankruptcy. For an overview of how debtor-creditor rights work outside of bankruptcy, click here. The more you understand about the details of this process outside of bankruptcy, the more you understand inside of bankruptcy.

A chapter 7 bankruptcy is made essentially to mimic the situation outside of bankruptcy where (1) all the creditors get a judgment against the debtor at once, (2) all the creditors give their execution/garnishment powers to the trustee, (3) the trustee who does one single massive execution/garnishment on all of the debtor's property, and then (4) forgives the remaining amounts of the judgments that were not paid off by the massive execution/garnishment. This may not seem meaningful to you, but using this model answers most of your questions about bankruptcy. Some rules in bankruptcy differ slightly from this hypothetical situation, but I find it useful to treat those as exceptions and treat this situation as the general rule.

The Date of Filing Rule

The first rule to understand is the date of filing rule. The rule is basically that the hypothetical massive execution/garnishment occurs on the date of filing of bankruptcy (even though the actual discharge order and property distributions happen later).

The date of filing rule answers the questions about what property gets distributed. Generally, all property that the debtor owned on the date of filing gets to be distributed to creditors, and all property that the debtor acquires or earns after the date of filing does not get distributed to creditors (there are exceptions to this rule, but this is the general rule).

The date of filing rule also answers the questions about what debt gets discharged. Debts that the debtor owed on the date of filing get discharged, and debts that the debtor incurs after the date of filing do not get discharged (again, with some exceptions).

Because of the date of filing rule, timing the date of filing may be very important to the debtor.

Secured creditors either get to keep their lien or its value

The next rule to understand is the rule about secured creditors and their property rights. The most common secured creditors in bankruptcy are home mortgages, car loans, and installment purchases of furniture and other household items. The next most common are business loans securing business property. Other than that, most creditors are simple unsecured creditors.

The main difference between a secured and unsecured creditor is that the secured creditor actually owns a property right in the debtor's property (usually called a "lien"). Oustide of bankruptcy, secured creditors have a superior right to their collateral to all unsecured creditors. As long as the secured creditors have preserved their claims properly, unsecured creditors who take and sell the debtors' property using garnishment or execution have to either use the proceeds of the sale to pay the secured creditors off or else whoever gets the property still owes the money to the secured creditor. In other words, secured creditors either get to keep their lien or its value.

The general rule still applies inside of bankruptcy. If some of the debtor's property has a lien on it, the trustee must respect that lien just the same as a creditor executing or garnishing the property must respect that lien.

The debtor's options with secured creditors

In order to preserve the secured creditors' rights, the bankruptcy gives the debtor four options for each secured creditor -- surrender, reaffirm, redeem, or do nothing. Each option is discussed in turn.

The first option -- surrendering the property -- means returning it to the creditor. Surrendering may make the most sense to the debtor if the debtor owes more on the property than it is worth and does not want to keep paying on it after bankruptcy.

The second option -- reaffirming the debt -- means agreeing to continue to be personally liable after bankruptcy. This gives the creditor something that the creditor cannot get without the debtor's agreement. Reaffirming is the usual option if the debtor wants to keep the property.

The third option -- redeeming the property -- is a powerful option that only exists inside bankruptcy, and only for certain personal property. Normally, a debtor must either surrender, reaffirm, or do nothing, but for certain property, the debtor can make a motion to redeem. With this motion, the debtor can force a creditor to accept only the value of the property, keep the property

The fourth option -- doing nothing -- may have various consequences depending on the facts. If the debtor is not current on payments, normally the creditor may get relief from the automatic stay from the court, then go ahead and exercise its state law remedies to take the collateral. If the debtor is current on payments, the situation is interesting. The law seems to say that the debtor must surrender the property if the debtor does not reaffirm the debt or redeem the property, but it is not clear that the creditor can force the debtor to surrender if the debtor is current on payments. For this reason, some debtors choose to do nothing and keep paying, and call this the "pay through and retain lien" option.

There is a fifth option that sometimes applies to second mortgages or liens: having the lien declared unsecured. This option only applies where the first mortgage or lien covers the entire value of the property. In this case, the debtor can make a motion to the court to hold that the second mortgage or lien is completely unsecured. This can be very powerful in the case of homes, where property have dropped below the amount of the first mortgage.

What property the trustee will sell

Outside of bankruptcy, creditors normally pick and choose which property of the debtor they want to sell. There is some property that is exempt by law that the creditors can't sell even if they want to, and there is some property that is not exempt, but is worth so little that creditors don't want to sell it even though they can.

The same analysis applies to the trustee in bankruptcy. The trustee has a duty to take and sell all of the debtor's property except property that is exempt or property that is worth so little that it would be burdensome to pay the costs of sale on the property. A wise debtor will evaluate his or her situation before filing so that the debtor will know what property the trustee cannot sell and guess what property the trustee probably will not sell, before making intelligent decisions regarding bankruptcy.

If after looking at the debtor's statements and schedules the trustee finds that all of the assets are either exempt or not worth enough to sell, the trustee will issue a "no asset" report. If that occurs, the unsecured creditors will get nothing. If, on the other hand, there are assets that the trustee decides to take and sell, the trustee will move to liquidating and distributing assets.

Distributing Assets

If there are assets for the trustee to sell, the trustee will first demand the debtor to turn them over, then attempt to convert them into money (i.e. sell them, unless the assets are already money). Once the trustee has a total sum of money, the trustee will distribute it as follows:

1. First, to priority unsecured creditors (such as child support, alimony, taxes, and others) in the order prescribed by law.
2. Second, to all the other unsecured creditors pro-rata based on the size of their claims.

There are some other rules to distribution. Creditors may wish to seek the advice of a lawyer to determine how much of the property they will get and whether they should file any motions to determine whether they have priority or not.

Nondischargeable Debts

Certain types of debts will not be discharged in bankruptcy. Some creditors' claims are automatically considered nondischargeable, while others have to sue the debtor within the bankruptcy to be determined to be nondischargeable. The question of whether they need to sue the debtor may depend in some cases on how the debtor lists them in the debtor's schedules.

Debts that are nondischargeable include taxes, student loans, criminal restitution payments, debts based on fraud, debts based on willful and malicious injuries, and others.

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