The Bankruptcy Process

The rights of debtors and creditors has undergone constant evolution throughout history. Today, failing to pay debts is generally not a crime. Debtor's prisons were abolished centuries ago. Creditors' legal tools to force payment today are generally limited to taking and selling the debtor's non-exempt property (overview here), and there are procedural protections for all parties to make sure it is done fairly (overview here).

Despite the limitations, creditor's rights are substantial. Any debtor who has failed to pay debts for a long time knows that the phones ring constantly, letters and threats of lawsuits come, and if the matter is left alone long enough, repossessions, garnishments, and executions happen.

Typically, there are only three ways a debtor can legally force the creditor to discharge the debt: (1) pay it off, (2) die, or (3) file bankruptcy. Any other process typically requires agreement (some exceptions). But in any event, whatever the debtor's or creditor's negotiation strategy may be, all strategies should include an understanding of what bankruptcy laws will and will not do to force creditors to hold their debts discharged.

The basic idea of bankruptcy

The United States Congress created the process that we now call chapter 7 bankruptcy in 1898 (some earlier versions of bankruptcy existed for limited times, but this one lasted). Although the law has undergone occasional changes, and undoubtedly will continue to change, the basic idea of every kind of bankruptcy is the same: Grant the debtor a discharge of debts in exchange for a performance by the debtor.

There are a few different types of bankruptcy (the most typical are chapters 7, 11, and 13), but all involve the debtor making some performance in exchange for getting a discharge. The chapter 7 bankruptcy, which is the subject of this article, requires the debtor to completely disclose and give up all non-exempt property. A trustee is appointed by the court to investigate and decide what of the debtor's property to take and sell on behalf of the creditors.

The debtor's goal: the discharge order

Every bankruptcy case starts with a petition, and the debtor's goal is to obtain a discharge order. The discharge order is a permanent injunction, ordering the debtor's creditors to hold the debts discharged and forever cease collection activities. Any person who has notice of the discharge order and does anything that is considered a collection activity on a discharged debt can be held in contempt of the bankruptcy court and punished for the violation. Since bankruptcy judges are known for imposing stiff fines for such violations, wise creditors are very concerned about not doing anything that might violate the final discharge injunction of a bankruptcy court, and should always get competent legal advice before having any communication or contact with a bankruptcy debtor.

As long as the debtor does what is required, the debtor will get the discharge order. There are situations in which the discharge order will be denied -- usually when the debtor has done something dishonest -- and there are situations when the discharge will not apply to certain creditors.

There are rules about how the debtor's property is distributed and which creditors' claims are discharged, based on a mix of basic property rights and specialized bankruptcy law (overview here).

The automatic stay

The bankruptcy court is sometimes called the most powerful court in the nation. The primary reason for this is that as soon as bankruptcy is filed, all court proceedings involving the debtor (with a few exceptions) come to a grinding halt, because of the "automatic stay".

As soon as a debtor files bankruptcy (or in an involuntary bankruptcy, as soon as the "order for relief" enters) the "automatic stay" goes into effect. The automatic stay is very much like the discharge order, except it is a temporary injunction instead of a permanent one, and it orders creditors to cease all collection activities immediately. As soon as a person has notice that a debtor has filed bankruptcy, that person may be punished for violating the automatic stay. Bankruptcy judges enforce the automatic stay just as zealously as the discharge order, and wise creditors should beware of it, and should always get competent legal advice before having any communication or contact with a debtor who has filed bankruptcy.

The Chapter 7 (Liquidation) Process

The Chapter 13 (Reorganization) Process

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