Bankruptcy, Part One

This is the first part of a two-part article on the effect of a bankruptcy filing on the title and closing process.

Introduction

The filing for bankruptcy will affect many aspects of a pending real estate transaction, including the ability (1) to provide title insurance to prospective purchasers and lenders and (2) to close the transaction. For example, the customary time frames to close a transaction may be lengthened to allow for court orders to be obtained, and the usual forms of title insurance policy that are issued may exclude coverage for a claim brought by the bankruptcy trustee to set aside the transaction on the basis that it constitutes a fraudulent or preferential transfer under federal bankruptcy, state insolvency, or similar creditors’ rights laws.

These issues will be discussed in more detail in next month’s article. In this Part 1 we will look briefly at some important aspects of the Bankruptcy Code. Clearly this is a very large and important area of the law and it is the intention to provide a brief outline. You are strongly advised to seek the advice of an attorney for a full understanding of this complex process.

The Code (found at Title 11 of the United States Code) is federal law; a bankruptcy court is a unit of the U.S. district court.

The Code recognizes two forms of relief for the debtor, namely liquidation and reorganization. Within this general division there are several different types of relief available to the debtor, commonly known by the name of the chapter of the Code under which the bankruptcy filing is made. This article will refer to petitions filed under Chapters 7, 11 and 13. Chapter 9 is limited to municipalities, and Chapter 12 is limited to family farmers and fisherman. Of interest is that the Code (except for Chapter 13), without many differences, applies to bankruptcy filings by the poorest individual and the largest corporations in the United States.

The type of bankruptcy filed by the debtor will determine, to a large extent, the requirements a title company will impose in order to close and insure a real estate transaction.

The bankruptcy process begins

The bankruptcy process begins when the petition for bankruptcy is filed.

Either the debtor can file for bankruptcy (a “voluntary petition”) or a creditor can file for a debtor’s bankruptcy (an “involuntary petition”).

Once the petition is filed, a bankruptcy estate is created. This estate is a separate legal entity from the debtor, and it holds title to the debtor’s pre-bankruptcy assets. The property of the estate generally includes all of the debtor’s legal and equitable interests in property at the time the bankruptcy was filed. In a Chapter 11 individual case or Chapter 13 case, estate property will also include post-petition earnings received and property acquired by the debtor while the plan is pending. The Code allows for individual debtors to claim various exemptions of property from the estate under state or federal law. The debtor can retain the exempt property free of the claims of creditors, with the intention that this will form the basis of the “fresh start” for the debtor. A common example is the homestead exemption allowed under Colorado state law.

The estate’s interest in the property within the bankruptcy estate is subject to the same limitations and encumbrances affecting the debtor’s interest (which is subject to the right of the trustee to avoid or void certain liens and other interests).

Chapter 7

Chapter 7 provides for the liquidation of the debtor’s non-exempt assets for the benefit of creditors and the discharge of the debtor’s debts.

Chapter 7 applies to individuals, businesses, stockbrokers, commodity brokers and partnerships. Individual consumers must prove that they have obtained credit counseling, or be excused from it, in order to file under Chapter 7. Individuals may be prevented from filing by reason of having taken certain actions in a prior bankruptcy filing.

In all cases, the debtor must be a person who resides, or has a domicile, place of business, or property in the United States.

The U.S. Trustee will appoint a trustee to act on behalf of the estate, to take control and collect all assets and to distribute any assets left, after administration of the estate, to the creditors based on a statutory scheme of priority in the Code.

Chapter 11

Chapter 11 provides for the reorganization of the debtor’s finances through a plan that will provide for the continuation, retention or disposal of the debtor’s assets. This plan must be confirmed by the bankruptcy court.

Any individual or entity eligible for relief under Chapter 7 is eligible for relief under Chapter 11. Individual debtors must complete a course on credit counseling.

Unlike in a Chapter 7 case, the debtor automatically remains in control of all assets after the commencement of the Chapter 11 bankruptcy, the “debtor in possession.” The debtor, as debtor in possession, has the authority to continue to operate the ordinary course of business of the debtor, without court order, and can exercise many of the considerable powers given to a trustee, but must act in accordance with the duties and obligations of the trustee. Court approval is required for any act outside of the ordinary course of business.

On confirmation of the plan, the assets of the debtor’s estate are vested in the debtor (as reorganized) and the debtor receives a discharge of debts which arose prior to confirmation of the plan, in accordance with the terms of the plan. There is no limit on the duration of a Chapter 11 plan, but, typically, plans are approved for a period of three to five years, but extended periods can be approved.

Chapter 13

Chapter 13, similar to a Chapter 11 plan of reorganization, provides for an individual debtor to reorganize their finances through a repayment plan and to obtain a discharge of debts. This chapter is limited to (1) an individual with a regular income who owes, on the date of the filing of the petition, non-contingent, liquidated, unsecured debts of less than $250,000 and non-contingent, liquidated, secured debts of less than $750,000, or (2) an individual with regular income and such individual’s spouse, who owe, on the date of the filing of the petition, non-contingent, liquidated, unsecured debts that aggregate less than $250,000 and non-contingent, liquidated, secured debts of less than $750,000.

Individual debtors must complete a course on credit counseling. Under a Chapter 13 plan, the debtor undertakes to repay all or portion of the individual’s debt from assets or future earnings. The debtor must commit to a plan with a duration of at least three years, but not more than five years, generally based on the income of the debtor.

Unlike a Chapter 11 bankruptcy, a Chapter 13 trustee is appointed to administer the case, investigate the debtor’s financial affairs, account for the assets, collect and disburse payments made under the plan. Failure of the debtor to comply with the plan may result in the dismissal of the Chapter 13 case, or conversion to a Chapter 7 case. On completion of the plan, the debtor will obtain a discharge of debts.