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Bankruptcy and Its Impact

Timothy R. Hughes, Esq.
Hughes & Associates, P.L.L.C.

In the third and final part of our series on collections, we discuss bankruptcy and its impacts on debt collection.

The bankruptcy code has a major impact on collection these days and is a significant reason for initiating or proceeding with litigation. As such, it is critical to have an understanding of the basics.

Chapters 7, 11 and 13

A chapter 7 bankruptcy involves liquidation of the debtor’s non-exempt assets and a discharge of certain debts. Chapter 7 is available for individuals, partnerships, or corporations. In chapter 7 bankruptcies, the discharge is available only to individuals, not partnerships or corporations. Even for an individual, the discharge is not absolute as some debts may not be discharged.

By comparison, a chapter 11 bankruptcy involves a reorganization of a company, its assets, and its debts. The debtor files a plan to permit continued operation of a business and repayment of creditors. A business may receive the ability to reduce debts by paying a portion of its obligations and discharging others. In addition, a debtor may obtain the ability to terminate certain types of contracts. A chapter 13 bankruptcy involves only individuals. A corporation or partnership cannot file a chapter 13 bankruptcy. The chapter 13 bankruptcy is analogous to a chapter 11 corporate reorganization for an individual and permits an extended period for repayment of debts with court approval.

The Automatic Stay

Once a bankruptcy petition or application is filed, all parties
are stayed from commencing or continuing any judicial, administrative, or other action or proceeding against the debtor. All parties are also stayed from enforcing any judgment against the debtor or the property of the estate of the debtor. Further, no entity can create or perfect any lien against the property of the debtor to the extent the lien secures a claim arising before the commencement of the bankruptcy.

Some parties may be able to seek relief from the stay. Courts will sometimes permit the lender to have relief from the automatic stay to foreclose on property specifically securing the loan. Similarly, a landlord may be able to seek relief from the automatic stay to secure possession of the premises.


Homestead Exemptions

Different states have different rules with respect to exemptions of certain classes of assets from collection by creditors. For example, Florida has enacted an extremely broad homestead exemption which protects a Florida resident’s primary place of residence from collection by creditors.

Other states have extremely limited homestead exemptions. My home state of Virginia currently exempts only $5,000 of real or personal property from collection.

Secured Creditors and Unsecured Creditors

Secured creditors are creditors who have a properly documented security interest in the debtor’s property which secures repayment of a debt. One example of a secured creditor is a lender whose loan is secured by real property. In contrast, unsecured creditors are creditors who have no specific security interest. Credit card debts are a good example of unsecured debts. Generally speaking, monies owed on construction contracts and subcontracts tend to be unsecured debt.

Bankruptcies often involve the secured creditors exercising their rights against the property securing their debts. A business or individual often has little of value after this exercise. The unsecured creditors then may receive a pittance of the value of their unsecured debt before completion of the bankruptcy and discharge of debts.

The Impact

The automatic stay and discharge may make it extremely difficult for a creditor to recover anything close to full value on a debt, particularly if that debt is unsecured. This reality provides the backdrop of many settlement negotiations involving parties who are in financial crisis

Bankruptcy can be both a sword and a shield. Understanding these basic concepts both protects your from potential creditors, and to protect your ability to collect on debts that may be owed to your company.