Consumer Bankruptcy Basics Part III: Chapter 7

So you've read my last two posts and have decided that the benefits of filing bankruptcy outweigh the drawbacks. Now you have to decide what chapter to file under. For the average consumer debtor, your choices will be between filing under Chapter 7 or Chapter 13 (Chapter 11 is usually reserved for business bankruptcies and individuals with complex debt). Chapter 7 is commonly referred to as liquidation bankruptcy and Chapter 13 is known as wage earner's plan.

A future post will focus more closely on the process of filing for bankruptcy protection--right now, we are just talking about what you can expect from a Chapter 7 filing.  As noted above, Chapter 7 is known as the liquidation chapter.  The basic idea of Chapter 7 is to collect the assets of a debtor, sell them, and distribute the proceeds to the debtor's creditors.

Once a debtor files a Chapter 7 petition, a Trustee will be appointed.  The Chapter 7 Trustee's job in a nutshell is to look out for the best interests of unsecured creditors and to liquidate and distribute the debtor's assets.  Lets say, hypothetically, that a debtor has $200,000 in assets, and $600,000 in unsecured (non-mortgage) debts--$200,000 owed to creditor A and $400,000 owed to creditor B.  The Trustee will sell the debtor's assets and distribute the proceeds on a pro rata basis.  In our example, this means that creditor A will get $66,666.67 and creditor B will get $133,333.33.  Remember from Part I that the debts will be discharged, so this is all the creditors will ever get paid--one-third of the amount actually owed to them.

This is obviously an over-simplified version of how the process works.  First of all, the bankruptcy process itself generates certain expenses that usually come off the top--attorneys' fees, the Trustee's commission, and the like.  Second, certain types of debts, such as child support and taxes, get paid in full before any other type of debt gets paid.  Third, assets will almost never fetch their market value when sold by a Trustee--just as with a home foreclosure, there is basically a discount because of the bankruptcy and because the debtor is not a willing seller.  In addition, recall from Part II that the debtor can exempt certain assets from the reach of the trustee.

Finally, remember that secured assets are often treated differently throughout the bankruptcy process. Secured assets usually include cars and real estate.  The bank has a mortgage on them, which may be foreclosed.  If a debtor has a house worth $300,000 (assume for the moment, that the house is not exempted, even though it often may be), and $270,000 is owed on the mortgage, the Trustee may sell the house, but must give the first $270,000 to the bank on account of the mortgage.  Factor in the fact that the house will not fetch its fair market value at a bankruptcy auction and the costs of the auction itself, the chances of a Trustee getting any benefit for unsecured creditors from liquidating such a house are slim at best. 

Speaking very generally, the average consumer debtor in a Chapter 7 case, assuming no shenanigans (see the upcoming Part VIII for a description of the shenanigans I'm talking about), can often get through a Chapter 7 without having to give much up, if anything, to the Trustee.  This is because most of a family's assets are often either exempt or encumbered/mortgaged.

Stay tuned for next week when we discuss the Chapter 13.