When thinking of personal bankruptcy, envision it as an adult's version of a child's "do over." Though the drafters of the modern Bankruptcy Code hoped that filing bankruptcy would not become habit-forming, the process enables people to wipe out debt and start accumulating new debt all over again.
Put that way, personal bankruptcy sounds fairly attractive to a struggling debtor, yet the process carries with it a social stigma partly attributable to misunderstanding. Bankruptcy isn't a punishment, but a second chance, a legal means of unloading personal liability for unpaid debts. Attorneys, particularly those engaged in family law or representing small businesses and start-ups, should be familiar with how the system can work in a particular client's favor.
Though most personal bankruptcy filers are seeking relief from runaway credit card balances, the procedure is not restricted to this kind of debt. To give honest debtors a fresh start, the Bankruptcy Code allows a variety of "claims" against a person to be discharged. As such, the term claim covers a creditor's right to payment (as well as equitable remedies), regardless of whether that right is reduced to judgment, liquidated, fixed, contingent, matured, disputed, legal, equitable, or secured.
That said, not all debts are dischargeable. For public policy reasons, some obligations won't be forgiven. To sort out what's dischargeable and what isn't, let's consider claims commonly included in a personal, as opposed to a business, Chapter 7 proceeding.
Creditor's claims are generally either secured or unsecured. Secured claims are based upon a debt that is supported by collateral. For example, you buy a house, and the lender retains an interest in the purchase as security. If you fail to make your mortgage payments, the creditor can take possession of the house and sell it. The proceeds will be used to pay off the debt, but if they don't cover your obligation, the creditor can sue you for the difference.
A bankruptcy filing can help a debtor avoid that situation. Yet even if the debt is discharged, the debtor won't escape the creditor completely. A secured creditor's lien rights, which include the right to take and sell the car or house, remain intact. Even after a discharge, the creditor can take and sell that car or house if the debtor is in default. Remember, a discharge only relieves a debtor of his personal liability for the debt, which means the secured creditor can't sue the debtor for the deficiency not satisfied by the sale of the collateral.
Unsecured debt is unsupported by collateral, such as credit card debt and medical bills, both of which are commonly discharged in personal Chapter 7 cases. Some unsecured debt, particularly that tied to obligations to the government, are less likely to be discharged.
Government-guaranteed student loans, for example, cannot be forgiven unless a debtor can prove repayment will impose undue hardship. To prove undue hardship, the debtor must establish (1) that he cannot maintain a minimal standard of living for himself and his dependents, based upon his current income and expenses; (2) that his inability to maintain a minimal standard of living is likely to exist for a significant portion of the repayment period; and (3) that he has made good faith efforts to repay the loans.
Unpaid personal income taxes are also tricky to have discharged. A debtor's income tax liability generally won't be discharged except in the limited instances where (1) the tax claim arises from a return due more than three years before the debtor filed his bankruptcy petition, and (2) the debtor has timely filed a return with the IRS reporting the tax liabilities in question. Old tax liabilities reported in untimely filed returns, however, are dischargeable only if the late returns were filed two or more years before the debtor filed bankruptcy.
Debtors usually cannot avoid liability for alimony and child support. Child support is never dischargeable-the kids take priority over the debtor. Alimony isn't dischargeable either if it truly constitutes payments for maintenance and support. In some cases, though, the court will examine the separation agreement and determine that the spouses intended the alimony to be a property settlement and not for maintenance and support. In that instance, payments will be discharged.
Monetary awards in divorce cases are dischargeable unless the debtor's former spouse can show (1) that the debtor has the ability to pay the award and (2) that a discharge's detrimental consequences to the debtor's former spouse or child would outweigh any benefits to the debtor.
Money judgments for punitive and compensatory damages are also typically listed in a bankruptcy. A discharge can void these judgments, but in some cases this relief will be limited. Under Maryland law, for instance, a recorded money judgment constitutes a lien on the debtor's interest in land located in the county in which the judgment was rendered. After a debtor receives his discharge, a judgment creditor can still foreclose on its lien against the real property. And when a money judgment stemmed from fraudulent conduct or a willful and malicious injury, the bankruptcy court may rule that the judgment can't be discharged.
Of interest to clients facing litigation is that personal liability claims can also be discharged. A debtor can file bankruptcy to seek relief from personal liability in a lawsuit that has not yet been filed, or has been filed but not yet reduced to a judgment. A discharge operates as a permanent injunction against the commencement or continuation of the lawsuit, as well as the act of attempting to recover or offset any such debt.
All told, a debtor can have many types of creditor claims (we haven't discussed all here) discharged through a Chapter 7 proceeding. The story is far more problematic when the debtor's conduct is not to the court's liking. Next week, we'll take a look at the impact questionable behavior on a personal bankruptcy case.