Bankruptcy

Worth more at work

Sold off, the property would have brought at most $35,000. Kept at work, it was worth an estimated $162,876. It was the equipment, vehicles, inventory, and office supplies of Whiting Pools, a company that sold, installed, and serviced swimming pools. In January 1981 the Internal Revenue Service seized all of it to collect about $92,000 in unpaid payroll taxes, and the next day Whiting filed for bankruptcy under Chapter 11.

Those two numbers set up the choice at the center of this activity. When a debtor cannot pay, should its property be sold now and the money divided among its creditors, or kept at work while the debtor pays them over time? The Bankruptcy Code gives both answers, in different chapters, to different debtors. Each fact pattern in the activity fits one of those chapters, and you work out why, and what follows for the debtor and the creditors.

The Constitution gives Congress the power to pass uniform bankruptcy laws, and Title 11 of the United States Code, the Bankruptcy Code, is the result. A bankruptcy case is a federal case, filed in a federal bankruptcy court. A debtor in Volusia County files in the Middle District of Florida (opens in a new tab). Still, the Code leaves some questions to the states, among them what an individual debtor gets to keep.

The day of filing

Filing a petition sets two things in motion, and neither waits for a judge. The first is the automatic stay. Under section 362 (opens in a new tab), the filing itself stops nearly every effort to collect from the debtor or the debtor’s property: lawsuits, garnishments, foreclosures, repossessions, even phone calls demanding payment. Some proceedings go on, such as a criminal case against the debtor or a suit to set child support. A creditor that wants the stay lifted has to ask the court, and a common ground is that the creditor’s interest in its collateral is not adequately protected.

The second is the bankruptcy estate. Section 541 (opens in a new tab) gathers into it every legal and equitable interest the debtor holds in property when the case begins, wherever the property is. The estate is what the case works with: what a trustee sells in Chapter 7, and what a business keeps using while it reorganizes.

Whiting’s property was not in Whiting’s hands when its case began. The IRS had it and meant to sell it. The government asked the bankruptcy court to rule that the stay did not reach the IRS, or else to lift the stay. The court refused, found that Whiting needed the property to reorganize, and ordered it returned. The case reached the Supreme Court (United States v. Whiting Pools, Inc., 462 U.S. 198 (1983) (opens in a new tab)). The estate includes property a creditor seized before the petition was filed, the Court held, so the IRS had to turn it over.

The IRS kept its lien, and with it a right to adequate protection: payments or other safeguards against losing value while Whiting used the property. The bankruptcy judge had set terms of that kind: $20,000 before the property came back, then $1,000 a month until the taxes were paid. If Whiting missed a payment, the stay would end. The court of appeals later sent those terms back for a closer look. In other words, bankruptcy can take a secured creditor’s collateral out of its hands, and the law protects the value of its interest instead.

The estate is not all for the creditors. An individual debtor may claim some property as exempt and keep it. The Code has its own list of exemptions, but it lets a state require its residents to use the state’s list instead. Florida does: section 222.20, Florida Statutes (opens in a new tab), bars its residents from the federal list, apart from a few benefits such as Social Security (section 222.201).

One item on Florida’s list has no dollar limit. The Florida Constitution (opens in a new tab) protects a homestead from forced sale however much it is worth. The limit is on size: half an acre inside a city or town, 160 acres outside one. The statutes add other items, such as up to $5,000 of a debtor’s interest in one vehicle (section 222.25).

The homestead protection has limits of its own. It yields to taxes on the home and to debts for buying, improving, or repairing it. It also does not stop a lender from foreclosing a mortgage the owner signed. And a debtor cannot move to Florida and claim its list right away. The Code generally applies the exemptions of the state where the debtor had a permanent home for the 730 days before filing (section 522 (opens in a new tab)). The Code is the same in every state, and the results are not. A home a trustee could sell elsewhere may be beyond the trustee’s reach in Florida.

Who is paid, and in what order

Creditors do not stand in one line. A secured creditor holds a lien on particular property: a mortgage on a house, a security interest in a machine shop’s lathes, the tax lien the IRS held on everything Whiting owned. Its claim is secured up to the value of that property, and any part of the debt above that value is unsecured (section 506). A lender that never perfected its security interest, the risk the last activity traced, can lose it to the trustee and join the unsecured creditors.

Unsecured creditors share what is left, and not equally. Section 507 ranks some unsecured claims ahead of the rest. Domestic support obligations, such as child support, come first, then the costs of administering the case. Further down come, among others, recent wages owed to employees and certain taxes. In a Chapter 7 case each rank is paid in full before the next receives anything, and creditors within a rank share in proportion to their claims (section 726). Credit card lenders, hospitals, and suppliers usually hold ordinary unsecured claims, which wait behind all of those.

Often there is nothing to share. The federal courts’ guide to Chapter 7 (opens in a new tab) reports that most Chapter 7 cases filed by individuals are no-asset cases. Everything the debtor owns is exempt or covered by liens, and the unsecured creditors receive nothing.

Starting over

Chapter 7 is the Code’s most common answer. A trustee collects the nonexempt property, sells it, and pays creditors in the order just described. For a business, that is the end. Section 727 (opens in a new tab) grants a discharge only to an individual, so a business that liquidates keeps its unpaid debts and has nothing left to pay them.

An individual whose debts are mainly consumer debts meets a gate first: the means test in section 707(b). It compares the debtor’s average monthly income over the six months before filing with the median income (opens in a new tab) for a household of the same size in the debtor’s state. A debtor at or below the median cannot be challenged under the test. Above it, a formula based on the income left after allowed expenses decides whether abuse is presumed, which steers a debtor who could fund a repayment plan toward Chapter 13.

For an individual, the point of Chapter 7 is the discharge. According to the federal courts, individual debtors receive one in more than 99 percent of Chapter 7 cases that are not dismissed or converted. It usually comes within a few months of filing. It ends the debtor’s personal liability for the debts it covers, and section 524 turns it into an injunction against any effort to collect them from the debtor personally.

The idea is older than the Code. On September 17, 1930, a man named Hunt borrowed $300 from Local Loan Company and, as security, assigned it part of the wages he would earn in the future. He filed for bankruptcy in Illinois the next March and received his discharge on October 10, 1932. Eight days later, the lender sued his employer in Chicago to collect from the wages Hunt had earned since the bankruptcy.

The bankruptcy court stopped the suit, and the Supreme Court agreed (Local Loan Co. v. Hunt, 292 U.S. 234 (1934) (opens in a new tab)). Bankruptcy gives “the honest but unfortunate debtor” a new start, the Court said, free of the weight of old debts. That start would mean little to a wage earner who had to spend much of his future pay on debts from before the bankruptcy. The Court decided Hunt under the Bankruptcy Act of 1898, which the Code replaced, and it has repeated the phrase (opens in a new tab) under the Code.

The word honest matters. Section 727 denies a discharge to a debtor who, among other things, hid or destroyed property or lied under oath in the case. And section 523 (opens in a new tab) leaves certain debts in place even after a discharge: domestic support, most student loans, certain taxes, and debts a court finds came from fraud.

A discharge also leaves liens where they were, as a farm owner named Johnson learned. Johnson had given Home State Bank a mortgage on his farm to secure notes of about $470,000, and when he defaulted, the bank began to foreclose. He filed under Chapter 7 and was discharged from personal liability on the notes. The mortgage survived. Once the bankruptcy court lifted the stay, the bank went back to state court and won a judgment against the farm itself of about $200,000.

The Supreme Court described the rule in two parts (Johnson v. Home State Bank, 501 U.S. 78 (1991) (opens in a new tab)). A discharge ends one way of collecting a debt, a suit against the debtor personally, and leaves the other, an action against the property itself. So Chapter 7 can erase what a homeowner owes on the note and still leave the house open to foreclosure.

Paying over time

Johnson’s case did not end there. Before the foreclosure sale, he filed again, this time under Chapter 13, and proposed to pay the bank the value of its judgment in installments. The Supreme Court held that the mortgage the discharge left behind was still a claim that a Chapter 13 plan could reschedule. It left the bank’s other objections to his plan for the lower courts.

Chapter 13 is reorganization for an individual. A debtor with regular income and debts under the limits in section 109(e) proposes a plan that pays creditors from future income. The plan usually runs three years when the debtor’s income is below the state median and five when it is above, and never longer than five. The debtor keeps the property, including property Chapter 7 would have sold. In exchange, the plan must give unsecured creditors at least what they would have received in a Chapter 7 liquidation.

For a homeowner behind on a mortgage, Chapter 13 offers what Chapter 7 does not. The stay halts the foreclosure, and the plan can cure the default within a reasonable time while the debtor keeps making the regular payments (section 1322 (opens in a new tab)). The cure is available until the home is sold at a foreclosure sale, so the timing of the filing matters. Beyond curing the default, a plan generally may not change the terms of a mortgage secured only by the debtor’s principal residence.

Whiting took the other road. In Chapter 11, a business usually stays in charge of its own case as the debtor in possession, with a trustee’s powers, and keeps operating. With the court’s approval, it can reject contracts and leases that no longer pay their way, such as the lease on a warehouse it has stopped using (section 365). Then it proposes a plan that sorts the claims into classes and says how each class will be paid.

Creditors whose rights the plan changes vote by class. A class accepts when creditors holding at least two-thirds of the amount and more than half the number of the claims voted say yes (section 1126). Even then, a creditor that does not accept the plan must receive at least what it would get if the business were liquidated under Chapter 7 (section 1129 (opens in a new tab)). A court can also confirm a plan over a class that votes no if, among other things, the plan is fair and equitable to that class and does not discriminate unfairly against it.

Whiting’s two numbers show why the Chapter 7 comparison can leave room for a plan. Congress presumed, the Court explained, that a debtor’s assets are worth more in a rehabilitated business than “sold for scrap.”

Small businesses have a faster route. Since 2020, a business whose debts fall under the limit in section 1182 can choose Subchapter V. Only the debtor may propose a plan, and a trustee helps it reach one. The court can confirm the plan even if no class votes yes, provided, among other things, that the debtor pays its projected disposable income into the plan for three to five years (section 1191).

Three debtors, one question

The activity gives you three debtors and four prompts for each. The Issue Spotter asks the questions this reading has followed: which chapter applies, which creditors are secured, what the stay stops, and how the debtor comes out. The Analyst then puts your prediction in front of a judge. Ground each answer in a section of the Code, and check it against the courts’ Bankruptcy Basics (opens in a new tab) before you trust the AI’s version. The fact patterns are on the activity page.

For each one, start with the question Whiting’s two numbers raised. Is what this debtor has worth more sold now, or kept at work while the creditors are paid over time?