Is Bankruptcy the Answer?
By Michael B. Katz, Esq.
One thing I’ve learned in my 45 years practicing bankruptcy law is that most individuals who wind up taking this course of action are good people who have found themselves in bad and unexpected circumstances, most often caused by things that were beyond their control.
People get sick, get divorced, lose employment, and have accidents. Likewise, businesses can be adversely affected by events over which they have no meaningful control. Outbreaks of disease, oil shortages, breaks in the supply chain, changing technology, interruption of their workforce, and many other factors can all cause a business or individual to be unable to stay financially afloat.
“It is important that you not let your pride prevent you from finding the best and most effective solution for your personal or business cash-flow problems.”
Which brings us the COVID-19 pandemic. It represents the epitome of unexpected circumstances and matters beyond our control. Indeed, in an effort to slow the spread the spread of the virus, the state has shuttered all non-essential businesses, leading to unemployment levels not seen since the Great Depression.
In these precarious times, individuals and businesses are finding themselves in dire financial circumstances they could not have foreseen, nor done anything to prevent. Given their predicament, some might be looking at bankruptcy as a possible recourse.
In order to help honest but financially burdened individuals make a fresh financial start, Congress has passed a number of bankruptcy laws. Here are the key types:
This is the type of bankruptcy proceeding that allows certain qualifying individuals to eliminate most of their unsecured debts (those without mortgages) and to make a fresh financial start.
In order to qualify for Chapter 7, a person cannot have filed Chapter 7 bankruptcy within the prior eight years. The person filing, known as a debtor, must also pass a test which limits how much earned income the debtor had earned in the prior year. This is called the means test, and it varies based on the state in which the debtor resides, the number of dependents in the family, and whether there is any earned income generated by the debtor’s spouse.
For example, for a Massachusetts resident, the limitation is $67,119 for a single person, $84,125 for a couple (combined gross income), and then increases in different amounts for additional dependents. These limitations became effective as of April 1, 2020 and are subject to periodic adjustment. Similarly, in Connecticut, the individual cutoff is $66,689, and $88,594 for a couple.
While most unsecured debts can be eliminated in Chapter 7, there are some types of debts that cannot, including income taxes owed from the past three years, alimony and child support, student loans, and debts incurred due to an accident while driving under the influence.
One of the major benefits of Chapter 7 for an individual obtaining a discharge is that not only are the debts — such as most credit cards, personal loans, foreclosure and repossession deficiency balances, and medical bills — totally wiped out, they are eliminated without incurring any phantom income, on which both federal and state income taxes would be owed.
Compare this to either making a direct settlement with a lender or credit-card company, or going through a non-judicial, multi-year debt-settlement plan, where anything that is settled with the creditors results in the person receiving a 1099 from the creditor and having to pay taxes on the forgiven portion of the debts. In Chapter 7, Congress has decreed that all discharged debts are tax-free, and therefore no hidden taxes are incurred.
The key aspect of Chapter 7 is that the Bankruptcy Court is trying to help an honest debtor make a fresh financial start. In regard to secured debts — for example, those debts that are secured by a lien or mortgage, most often vehicle loans or a home mortgage — in Chapter 7, the debtor gets to select whether they wish to keep the item and continue making the payments, or to surrender the item and wipe out any shortfall amount that might exist after the secured party sells the item after repossession or foreclosure sale.
While a corporate entity can also elect to file Chapter 7 and have the Bankruptcy Court liquidate its assets and distribute the proceeds to its creditors, it does not get to carry on its business affairs after filing. Only an individual qualifies for a discharge, so a corporate entity must cease all business after it files Chapter 7.
In this type of proceeding, an individual is given an option to repay all or a portion of the debt, if approved by the Bankruptcy Court and Chapter 13 trustee, through a plan of reorganization that generally lasts for a period of three to no more than five years. There is no need to pass the means test to qualify for Chapter 13, and, unlike the restrictions in Chapter 7 that allow it to include only unsecured debts, Chapter 13 can also affect secured debts.
The most common application in Chapter 13 is to use it to stop a foreclosure sale of a debtor’s home or automobile, and it allows the debtor to pay the outstanding past-due amounts over the life of the plan, in addition to requiring the debtor to make the full current payment each month.
For example, if a lender is owed $60,000 in back mortgage payments, requiring the borrower to pay it in full in order to prevent a foreclosure sale, in a Chapter 13, the debtor could propose to pay $1,000 per month for the 60 months of its Chapter 13 plan, plus pay the current mortgage amount each month so that debtor does not fall further behind.
These are simplified examples, and the details of a Chapter 13 plan are more complex and would require you to consult with a qualified attorney for more specific advice.
A Chapter 11 reorganization can be filed by an individual who owns a business and operates as a ‘DBA,’ but due to its complexity and expense, it is most often filed by a corporate entity.
The idea of a Chapter 11 is to grant the business a ‘time out’ and give it some element of time to figure out a plan of reorganization to allow it to continue in business. Under 11 USC 362(d), all lawsuits and claims against the debtor’s business are enjoined from proceeding, and the debtor gets time to meet with its creditors and to seek to formulate a formal plan of reorganization.
That plan may propose to pay unsecured creditors a percentage on the dollar, which must be found to be a greater percentage than the creditors would receive in an immediate liquidation of the business and its assets. In some cases, mortgage debts can be reduced to the actual value of the assets that secure the mortgage, so that if the debtor owes a lender $750,000 on a building that can be proven to be worth only $500,000, the debtor can seek to ‘cram down’ the mortgage to a reduced amount of $500,000, and the additional $250,000 gets treated as an unsecured debt, and paid at the same percentage on the dollar as the other unsecured debts.
This is a very simplified version of a Chapter 11, as there are many other requirements that must be fulfilled by a Chapter 11 debtor, and the cases are necessarily complex and sometimes expensive. However, the overall savings to the debtor can be substantial, and they are often the key to a business’ survival.
The court in a Chapter 11 is seeking to be fair to both the debtor and its creditors, as well as preserving the jobs of the employees of a business.
There are sometimes options for a business to consider without the need to file a formal insolvency proceeding. They require a skilled and knowledgeable attorney to know how to handle these matters, and they include utilization under Massachusetts state law of an assignment for the benefit of creditors, trust mortgage, or sometimes just using a skilled negotiator to try to convince creditors to accept an informal settlement of their debt, rather than forcing the debtor to use funds to pay for a formal bankruptcy proceeding, when those same funds could be paid toward a voluntary settlement with the creditors.
In reality, these voluntary settlements are often difficult to finalize because you need to negotiate with multiple parties, who sometimes will not agree to the same terms. In a Chapter 11, the creditors are legally required to accept whatever settlement is approved by the bankruptcy judge, after a plan is voted on and approved by the Bankruptcy Court.
It is important that you not let your pride prevent you from finding the best and most effective solution for your personal or business cash-flow problems. You cannot make an informed decision until you know and understand all of your options, as well as the positives and negatives of each option.
During this pandemic, many fraudulent parties are preying on people, so make sure to do your homework to get the name of a qualified person to advise you or your business. Contact the Hampden County Bar Assoc. Lawyer Referral Service, call your accountant, or do a Google search to find an experienced person to help you or your business.
Working together, we can all find ways get through these uncharted waters. v
Michael Katz is the chairperson of the Bankruptcy & Creditors Rights department of the law firm Bacon Wilson, P.C., with offices in Springfield, Northampton, Amherst, Hadley, and Westfield; (413) 781-0560.