The “B” Word: How to use Bankruptcy to your advantage
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As the COVID-19 pandemic continues on, more and more people are looking at a solution once thought unthinkable: bankruptcy. While bankruptcy has had a certain stigma attached to it for years, that stigma has lessened considerably in recent years as more people come to understand bankruptcy as a tool that, if used strategically, can help struggling individuals and business owners catch up or, in some cases, even get ahead.
In many cases, even the mere threat of bankruptcy can be used to your advantage, allowing you to renegotiate or restructure debts, leases, and other agreements. Before considering whether bankruptcy (or the threat of it) may benefit you, it’s important to understand what bankruptcy really is.
What is bankruptcy?
When people refer to “bankruptcy”, they’re actually referring to the United States Bankruptcy Code and six different chapters of that Code, each providing a separate type of relief. They are:
Chapter 7 Bankruptcy
Chapter 7 is the most commonly understood form of bankruptcy. Sometimes referred to as a “liquidation bankruptcy”, Chapter 7 allows individuals and businesses alike to shed, or “discharge”, most forms of debt, subject to a few limitations. For example, student loans are typically non dischargeable unless you can demonstrate that repayment of the student loans “will impose an undue hardship on you and your dependents.” Other non-dischargeable debt includes trust fund taxes and debts resulting from your causing a willful and malicious injury to another.
In a Chapter 7 Bankruptcy, the debtor transfers all of its assets — minus certain property that is exempt from the bankruptcy — into the bankruptcy trust, which the trustee then administers to pay the creditors according to their priority. Once the trust is exhausted, the remaining dischargeable debts are discharged, giving the debtor a fresh start.
Apart from the potential loss of assets, there are several other drawbacks to Chapter 7. For example, the debtor’s credit suffers greatly, often taking years to rehabilitate. Many lenders have strict requirements that a certain number of years pass since the Chapter 7 discharge before a debtor can borrow again. For example, FHA home loans have a two year “seasoning period”, while Fannie Mae and Freddie Mac typically have four year seasoning periods for Chapter 7 debtors.
Another drawback to Chapter 7 Bankruptcy is that not every debtor is eligible for it. In the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, Congress imposed a “Means Test” meant to prevent debtors from enjoying Chapter 7 Bankruptcy protections when they might otherwise have the financial means to pay their debts. While the bill may have been well-intentioned, the means testing has been widely criticized as detached from the reality of a debtor’s situation, often taking a high-level glance at a debtor’s income and without considering the real burden of their debt load and whether the repayment terms are uniquely onerous. The Means Test also gives preferential treatment to non-consumer debt, leaving consumers in a much harder position.
For debtors who fail the Means Test or otherwise do not qualify for Chapter 7, Chapter 13 Bankruptcy (discussed later) may be a viable alternative.
Chapter 13 Bankruptcy
Chapter 13 Bankruptcy, often called the “wage earner’s plan”, is a repayment plan in which the debtor makes payments to the bankruptcy trustee for a period of 3-5 years. The bankruptcy trustee, in turn, makes payments to the creditors during that period. Some (or all) debts may be paid in full during the Chapter 13 payment plan. Those that aren’t are typically — but not always — discharged at the end of the repayment period. A debtor is eligible for Chapter 13 Bankruptcy if their unsecured debts are less than $394,725 and their secured debts are less than $1,184,200, subject to a few other limitations.
Some downsides to a Chapter 13 Bankruptcy are fairly obvious. Whereas you can get a fresh start with a Chapter 7 Bankruptcy in as little as three months, Chapter 13 Bankruptcy is a process that can drag out for 3-5 years, with the complicated requirements for a Chapter 13 discharge providing much less certainty than in a quicker Chapter 7 proceeding.
One of the most enduring criticisms of Chapter 13 Bankruptcy — and of the Means Testing that forces many debtors into it — is that most debtors are already struggling financially when they enter into a Chapter 13 repayment plan, many without the consistent income needed to make payments for 3-5 years. Another valid criticism is that a 3-5 year repayment plan prevents a debtor from truly recovering during those years, as they must pay substantially all of their income towards the Chapter 13 plan.
Chapter 11 Bankruptcy
Chapter 11 Bankruptcy is often referred to as a “Chapter 11 Reorganization”. Chapter 11 Bankruptcy is most typically used by corporations, partnerships, and limited liability companies. Individual debtors can also make use of Chapter 11 if they are ineligible for Chapters 7 and 13.
Chapter 11 Reorganization gives debtors time to restructure their debts, along with the assistance of the court. The ideal end result of a Chapter 11 Reorganization is that the debtor and creditors agree on a reduction of debts owed and a new payment arrangement that will let the debtor continue operating. The drawback (for debtors) to a Chapter 11 Reorganization is that it requires a negotiation in which creditors have significant influence over the end result, whereas creditors have remarkably little say in a Chapter 7 Bankruptcy. This lengthy, drawn-out process also makes Chapter 11 Bankruptcy the most expensive bankruptcy to undertake. The advantage over Chapter 7 is that a Chapter 11 Reorganization, if successful, will let the debtor business emerge from bankruptcy in a stronger financial position, free of burdensome debts or onerous repayment terms, so that they can keep operating.?
How can bankruptcy work for me?
Bankruptcy can be a useful tool for debtors who need to shed or restructure their debt. However, one doesn’t necessarily need to declare bankruptcy to benefit from it.
For example, the mere threat of bankruptcy is enough to bring many creditors to the table and convince them to negotiate a reduction in the debt (often called a “haircut”), a lower interest rate, or a longer repayment term with lower installment payments — or some combination of the these.
Of course, this approach isn’t without its drawbacks. A renegotiated debt is often reported to the major credit bureaus and can have a negative impact on the debtor’s credit. A renegotiated debt might also require an agreement with the creditor that, if breached in some small way by the debtor, would cause the debt to revert to its original amount and terms.
Whether you’re considering bankruptcy or just looking to renegotiate some debt, it’s important to work with a qualified attorney or other capable professional to make sure you’re doing things right. Two of the biggest reasons Chapter 7 Bankruptcies fail is because the debtors either (i) fail to satisfy the highly complex filing requirements or (ii) fail to satisfy the Means Test. A good attorney can handle the paperwork and make sure you qualify before you file. This is especially important, as your credit is impacted as soon as you file, regardless of whether your debt is discharged. Remember: A little law now can save a lot later.
Similarly, if you’re looking to renegotiate some debt, it’s important to have an attorney on your side to look out for your interests, make sure the renegotiated agreements are fair, and explain your rights and obligations.