The last resort: what happens when your borrower files bankruptcy?

RMA Journal, The, Sept, 2003 by J. Tol Broome, Jr.

Take a few moments to review this overview of the ramifications of bankruptcy, the procedures to follow, and the lender's rights and remedies. The author cautions that this article in no way is intended to be an all-inclusive discussion of bankruptcy and urges bankers to consult an attorney and/or the institution's bankruptcy department when a borrower files.

Bankruptcy. The mere mention of the word makes you cringe, doesn't it? Yet the act itself has become commonplace. Whereas consumers and businesses alike once dreaded the lasting stigma attached to bankruptcy--making it a last resort only after all other remedies had failed--the rate of filings has increased dramatically over the past 20 years and the stigma has disappeared rather quickly.

According to the American Bankruptcy Institute, in 1983 there were only 348,880 filings in the U.S. By 1996 new filings had tripled and exceeded the million mark for the first time reaching 1,178,555 bankruptcies. And in 2002 a new high was reached with 1,577,601 total filings. While some economists will tell us to take heart in a diminishing rate of increase, others tell us we could be in for a brand-new round. Either way, we must be prepared.

The Federal Bankruptcy Code

If not for the Bankruptcy Code, each state would be left to make its own laws and to conduct its own proceedings. However, the Code supersedes all state laws when a bankruptcy is involved.

First and foremost of numerous provisions is that all creditors must cease direct contact with the debtor once a bankruptcy petition has been filed. In most cases, once the petition is filed, a trustee is appointed who becomes the liaison between the debtor and its creditors.

The sections of the Bankruptcy Code most frequently used by individuals and small business owners are Chapter 7, Chapter 11, and Chapter 13. A Chapter 7 is a full liquidation of all nonexempt assets. A Chapter 11 is a reorganization, whereby a business attempts to repay as many debts as possible while continuing to function. In a Chapter 11, the business owner operates the business as debtor-in-possession without a trustee. A Chapter 13 is for individuals and proprietorships and is similar to a Chapter 11 in that the debtor makes an effort to repay as many creditors as possible, but uses personal cash flow rather than liquidation of assets.

Chapter 7

A Chapter 7 bankruptcy is the quickest of the three and usually is fully resolved within about six months. However, a Chapter 7 should be filed only if the business owner sees no way to stay in business or if the individual cannot meet monthly obligations, even on a partial-pay basis. If your borrower files a Chapter 7, you will likely receive nothing if you are an unsecured creditor. Even if secured, you might not receive full payment of the debt owed.

There is a seven-step process for a Chapter 7 bankruptcy:

1. Petition filed by debtor Creditors are given an automatic stay, which means they cannot contact the debtor; taxes, child support, and alimony are not stayed; an interim trustee is appointed; and the first meeting of the creditors is scheduled.

2. Financial disclosure. At the time of filing or shortly thereafter, the debtor must provide a complete list of assets, debts, sources of income, and expenses.

3. 341 meeting. The first meeting of the creditors, known as the 341 meeting, usually is held within 30 days of the bankruptcy filing; a permanent trustee is elected by the creditors.

4. Proof of claim. Creditors have approximately 180 days to file a proof of claim, which provides details to the trustee regarding the debt owed. A proof of claim must be filed for the creditor to collect anything from the liquidation of assets.

5. Exemptions. The debtor provides a list of exempted assets (those that will not he sold) to the trustee.

6. Order of claims. The trustee approves the order in which claims will be paid, ranging from the best secured to unsecured. Secured claims are to be paid from the liquidation of the specific collateral pledged for that debt; deficiencies on secured claims and unsecured claims are paid from what is left over--usually little or nothing.

7. Sale of assets. The trustee sells all nonexempt assets and pays claims in order of priority.

Exempt property in a Chapter 7. As mentioned, the debtor is allowed to exempt certain property from a Chapter 7 liquidation. This provision keeps debtors from becoming completely destitute after a bankruptcy is filed. Exempt property claims are one area in which each state is allowed its own laws and amounts You should consult an attorney or an up-to-date bankruptcy exempt property list in your home state to find out what assets and amounts are exempt in Chapter 7.

Federal law also provides for exemptions in Section 522(d). There is a provision that allows states to opt out of the federal exemptions and establish their own. The federal exemptions are:

* Equity in a primary residence of up to $17,425 (known as the Homestead Exemption).