Prior to 1833, right here in America you could be thrown in jail if you failed to pay your debts. It would not matter who you were. Robert Morris, financier of the American Revolution and signer of the Declaration of Independence, was hounded by creditors in his later years and endured three years in prison. He was only liberated in 1801 after the passage of the first federal bankruptcy act, one that was quickly repealed in 1803. On good report, the debtor's jail in Annapolis, Maryland was so miserable that it was considered a living hell.
How foreign and quaintly Dickensian all that sounds to us now. We are a people comfortably married to debt and credit. From Congress to Wall Street to family budgets, our culture is widely tolerant of red ink. Underlying the abolition of debtors' prison in 1833 and the many advances in bankruptcy law that have since followed is the deeply rooted notion that a person should be able to rehabilitate himself and receive absolution for non-venal sins. That concept is ingrained in the U.S. Bankruptcy Code, the current version of which was enacted by Congress in 1978 and extensively amended in 1994.
Bankruptcy law and its practitioners have received increasing public attention with the sensational Chapter 11 filings of corporations such as Enron and MCI. Yet the public's fixation on the scandalous nature of these cases has done little to help people understand what a bankruptcy case is usually all about for the debtors: a road to a fresh start. More worrisome to readers of this newspaper is that attorneys are sometimes lacking in basic knowledge of bankruptcy proceedings.
Whether you practice family law, corporate law, or litigation, clients, sooner or later, are likely to raise concerns that relate directly to the concentration. You should be prepared to respond knowledgeably. Over the next several weeks this column will address the basics of bankruptcy law and some of the important issues facing debtors and creditors.
There are some common misconceptions about bankruptcy, some of which you may have encountered in your practice. Here are a few of them:
1. An individual or a corporation must be insolvent to file a bankruptcy case. The Bankruptcy Code does not require that you be insolvent before voluntarily filing a case. For example, when creditors combine together and force a person or business into an involuntary bankruptcy case, they do not have to prove that the person or business is insolvent. Rather, the test is whether that person or business is paying debts as they mature in the ordinary course. In some instances the Court will dismiss a case if it is filed for an improper or abusive purpose.
2. Bankruptcy lawyers are horned creatures with no feelings. Actually, none have horns and many have feelings.
3. When you file for bankruptcy, a trustee will take all of your assets and sell them. True or false? It depends. In an individual's Chapter 7 bankruptcy case a trustee is appointed, but that trustee will only liquidate an individual's non-exempt assets (in a corporate Chapter 7, there are no exemptions and all assets are liquidated). According to the U.S. Bankruptcy Code, trustees must comply with relevant state exemption statues, which will protect many key assets.
For instance, in Maryland a spouse who only has individual debts (as opposed to joint debts) and owns his home as tenants-by-the-entirety, will not lose that home no matter how much that property is worth and no matter how much equity is in that property. That's because the house in this case is considered exempt by Maryland law. Thus, the debtor could go through a bankruptcy, discharge all his debts, and still retain his valuable house. On the other hand, if he had a house titled in his own name with substantial equity in it, a trustee would sell the house for the benefit of his creditors.
4. By trickery and abuse of the bankruptcy process a debtor can leave all of his creditors high and dry without ever losing any assets. Not surprisingly, this last misconception is also not absolutely right or wrong in all cases. Because of the non-exemptions statutes, some debtors' assets will be protected in their entirety from creditors. Most Chapter 7 bankruptcy cases are deemed "no asset" cases, in which the Trustee liquidates nothing. Most consumers who file possess few or no non-exempt assets, let alone any non-exempt assets with enough value to make their liquidation a fruitful exercise.
The above clarifications are just the beginning. Clients may also be unfamiliar with the basic structure of the bankruptcy judicial system. Bankruptcy Courts are strictly federal and are adjuncts to the District Courts. There are 94 separate Bankruptcy Courts, one for each Division within the various Federal District Courts. Because bankruptcy judges are not Article III judges (i.e., not provided for under the U.S. Constitution), jurisdiction over bankruptcy cases is technically within each District Court. That technicality aside, when you file a bankruptcy case, you do so in the Bankruptcy Court.
In addition to the courts, a division of the Justice Department known as the Office of the United States Trustee has been created and given express standing by statute to monitor cases within every district. The U.S. Trustee acts as an administrator of the bankruptcy process (as opposed to the judicial role imparted to each bankruptcy judge). In a Chapter 7 case, the U.S. Trustee's office helps with the assignment and monitoring of trustees; in a Chapter 11 case, the office assists in the formation of a Committee of Unsecured Creditors.
Many clients are also likely to be ignorant of the differences between the various types of bankruptcy. The Bankruptcy Code is comprised of four major operative chapters: Chapter 7 (the liquidation of assets), Chapter 9 (municipality bankruptcy), Chapter 11 (business and individual reorganization), and Chapter 13 (individual reorganization/payment plans).
We won't be unraveling here all the intricacies of these four realms. As with any area of the law, there are attorneys who make careers doing that. Even if you are not among that lucky group, though, you will find it helpful to be able to talk their language to some extent. In coming installments, we'll explore further the fundamentals of bankruptcy cases.