SIMPLE DEFINITIONS OF TEN BANKRUPTCY TERMS

                                                          Ten Bankruptcy Terms

                                                                     by Frank J. Kokoszka, Esq.

                                                                          Kokoszka & Janczur

            Almost every attorney, whether he/she be a litigator, corporate attorney or real estate practitioner, will be confronted with bankruptcy issues.  The following are ten (very simple) bankruptcy definitions or "terms of art," that every attorney should master, to know just enough about bankruptcy to be considered "dangerous."

1.          Adversary Proceedings:   An adversary proceeding or "adversary" is a lawsuit filed in or within a bankruptcy case (think of it as a "battle" within the "war").  Adversary proceedings are governed generally by Part VII of the Bankruptcy Rules (Rules 7001- 7087), which incorporate most of the Federal Rules of Civil Procedure.  Bankruptcy Rule 7001 lists what type of matters or disputes must be "fought" as an adversary;  i.e., commenced by the filing of a complaint.  Most issues in a bankruptcy case are not adversary proceedings, but are "contested matters" (defined below).

2.         Applicable Law:  Bankruptcy is governed by the Bankruptcy Code which is Title 11 of the United States Code, the Federal Rules of Bankruptcy Procedure (the "Bankruptcy Rules"), Local Rules, and to a great, great, extent, case law.  As one of my bankruptcy mentors, a prominent bankruptcy attorney, once taught me, "some bankruptcy judges feel compelled to publish every decision they enter."  Bankruptcy law is constantly being shaped by new case law and the skilled bankruptcy practitioner must keep abreast of recent decisions.  Please note that state law does come into play in some instances, such as determining whether something is a valid security interest.

3.          Automatic Stay:  Generally, the automatic stay commences immediately with the filing of a voluntary bankruptcy petition and the entering of an order of relief in an involuntary case.[1] There are exceptions where an entity has filed for bankruptcy within certain time periods. The automatic stay operates as an injunction prohibiting any collection action against a debtor outside of the bankruptcy court.  See Bankruptcy Code Section 362.  This includes collection letters, telephone calls, repossessions or lawsuits against the debtor.  There are exceptions to the automatic stay, and situations in which a party can seek to have the automatic stay modified or "lifted."  The purpose of the automatic stay is to allow the bankruptcy to go forward in an orderly fashion.  Willful violations of the automatic stay can subject the violator to punitive damages.  Even innocent violations of the automatic stay (such as a repossession by a creditor who did not know of the bankruptcy) are void, and must be corrected (for example, by returning the repossessed collateral).

4.         Contested Matters:   When the resolution of a disputed matter in a bankruptcy case does not have to be brought as an adversary proceeding, then it is a "contested matter."  Contested matters are usually resolved by filing a motion and the opportunity for a hearing.  See Bankruptcy Rules 7001 (to determine whether something is an adversary proceeding), 9014, and 2002 (dealing with notice requirements).  For example, a creditor seeking relief from the automatic stay would file a motion, since such is considered a contested matter.

5.         Discharge:  A discharge is a permanent injunction against any action to collect a debt incurred before the bankruptcy filing, unless the debt was either (1) reaffirmed; or (2) excepted from discharge.  A bankruptcy discharge frees the debtor from the legal obligation to pay the debts which existed prior to the bankruptcy and provides the debtor with a "fresh start."  See Bankruptcy Code Sections 523 and 524.

            There are exceptions to discharge.  Corporations and other legal entities (non-individuals) do not get a discharge when they are liquidated in a chapter 7 case.  There are time limits to how often a Debtor can obtain another discharge.  Debtors who have committed illegal acts in connection with the bankruptcy or business debtors who cannot (or will not) explain their financial affairs and produce supporting records are also denied a discharge (See, pervious K & J Law blog entry: “Business Debtors Beware!”).  The Denial of Discharge requires the commencement of an adversary proceeding objecting to discharge.

            Second, some debts may not be included in a general discharge.  Some type of claims automatically are deemed "non-dischargeable."  For example, in general, most (but not all ) taxes, child support obligations and student loans are not discharged.  Additionally, the Bankruptcy Code and Bankruptcy Rules (and of course, case law) provide grounds for objecting to the dischargeability of a particular debt.  In order to do this, a creditor must commence an adversary proceeding.  Thus, a debtor may receive a general discharge but, an individual creditor may object to the specific dischargeability of the creditor's claim.

6.         Disposable Income: In a chapter 13 case, which is a repayment plan for individuals with "regular income," the debtor and the chapter 13 trustee negotiate a budget in order to determine how much the debtor can afford to set aside each month to pay creditors. The amount of the debtor's income above necessary expenses is known as "disposable income."  The trustee receives the debtor's disposable income (often through payroll withholding), and distributes it to creditors per a chapter 13 plan approved by the bankruptcy court.  See Bankruptcy Code Section 1322.

7.         Exempt Property:  Just as certain property is "exempt" from judgment and collection by garnishment or citation, certain property of the debtor is "exempt" from turnover to the trustee in a chapter 7 case. While the Bankruptcy Code lists certain exemptions, the Code allows each state to choose whether its debtors will use the federal exemptions or state exemptions.  See Bankruptcy Code Section 522.  In Illinois, a debtor must use the state exemptions.  These exemptions are set forth in the Illinois Code of Civil Procedure at 735 ILCS 5/12-1001 et seq. (exemptions of personal property) and  735 ILCS 5/12-901 (homestead exemption), and include the following: necessary wearing apparel, up to $15,000 in value in a homestead property, up to $2,400 in value in one car, and $4,000 worth of other personal property (sometimes referred to as the "wild-card" exemption).  Only an individual and not a corporation can claim exemptions. 

8.         Preference:   A preference is a payment (or other "interest") made for an antecedent debt to a creditor while the debtor is insolvent.  See Bankruptcy Code Section 547.  An insolvent debtor is one who cannot pay all of its creditors, so if it pays some creditors, it is "preferring" them to the other creditors.  Every preference reduces the amount of assets available to pay the other, non-preferred, creditors.  The Bankruptcy Code presumes that most payments made by a debtor within 90 days of a bankruptcy filing are preferences which may be avoided (recovered by the bankruptcy estate), although there are defenses.  For payments benefiting "insiders," (relatives, partners, stockholders, officers, etc.) the 90 day period is extended to one year. 

            Preference law is also aimed to discourage extremely aggressive collection methods (such as repossessions, levys and garnishments) against debtors who are on the verge of bankruptcy.  This consideration sometimes restrains non-trade creditors, such as banks and mortgagees, and makes it easier to work out many situations. 

9.         Proof of Claim:  A proof of claim is an official form (Official Form #10) which creditors must file to share in any payments the trustee makes to creditors.  There are deadlines for filing proofs of claims, which are usually stated in the bankruptcy notices sent by the clerk of the bankruptcy court, (known as the "bar date.")

            Most consumer chapter 7 cases are "no asset" cases.  A creditor may get a notice stating that "at this time there appear to be no assets available from which payment may be made to unsecured creditors."  If so, unless the creditor receives a follow-up notice, there will be no payments to unsecured creditors by the bankruptcy trustee, and there is no need to file a proof of claim. 

            10.        Reaffirmation:  A reaffirmation is a promise by the debtor to pay a debt despite the discharge. There are two usual reasons why a debtor would enter into a reaffirmation: (i) there is collateral for the debt which the debtor wants to keep; or (ii) the debt may not be dischargeable and by saving the creditor the expense of an adversary proceeding, a debtor can usually get a compromise as to the amount of the debt, and/or a structured repayment plan, and also avoid the embarrassment of an adversary proceeding on the public record.  A reaffirmation agreement cannot place an undue hardship upon the debtor.

            Some big consumer creditors, like credit card issuers and department stores, routinely ask for reaffirmations of the entire pre-petition debt, even though there is no reason in the world why the debtors should agree.  They usually talk about maintaining "good credit" -- a foolish notion, considering that people with a recent bankruptcy don't have "good credit."    

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[1] Creditors can file an involuntary bankruptcy petition against an entity.  In an involuntary case, the entity that the creditors put into bankruptcy is called the "alleged debtor."  The alleged debtor has time to respond to the involuntary bankruptcy filing. If the court determines or the parties agree that the alleged debtor should remain in bankruptcy, then an order for relief is entered.

Business Debtors- How Are Your Business Records?

Business Debtors Beware!

Author: Mark D. Liston, Kokoszka & Janczur, P.C.

Editor: Frank J. Kokoszka, Kokoszka & Janczur, P.C.

            The prime feature of a chapter 7 bankruptcy for most individual debtors is the discharge. However, there are exceptions to the discharge and these exceptions fall into two major categories. The exception of a particular debt from discharge and the denial of the debtor’s discharge entirely. These two exceptions serve different purposes. As for the first (provided for by Section 523 of the Bankruptcy Code), certain debts are deemed particularly important, so these debts cannot be dischargeable. Examples include generally child support, taxes, and student loans (this does not mean that taxes and student loans are always non-discharageable) . Additionally, debts incurred by criminal, immoral, or otherwise improper conduct cannot be discharged. Examples include theft, fraud, deliberate injury to person or property, and debts arising from drunk-driving accidents. The principle is that if you owe someone a debt because you wronged them, you do not deserve a discharge of that debt.

            With respect to denial of the discharge entirely (provided by Section 727 of the Bankruptcy Code), the policy is that a debtor who does something dishonest or knowingly improper within the bankruptcy process itself should not receive a discharge of any debts. Examples include transferring or concealing assets, failure to fully disclose the information required on the bankruptcy forms, testifying falsely, and refusing to obey a court order. Conversely, the general rule embodied in Section 727 is essentially that the “honest but unfortunate debtor” who cooperates with the trustee and the court should receive a discharge.

            However, one glaring exception to that general rule can be found in Section 727(a)(3), which provides for the denial of discharge where “the debtor has concealed, destroyed, mutilated, falsified, or failed to keep or preserve any recorded information, including books, documents, records, and papers, from which the debtor’s financial condition or business transactions might be ascertained, unless such act or failure to act was justified under all of the circumstances of the case.” (Emphasis added.) Concealing, destroying, mutilating, and falsifying obviously involve a dishonest or wrongful motive, but that is not necessarily true of the mere failure to keep or preserve records. Indeed, the debtor’s intent is simply not a factor in determining whether they have failed to keep or preserve adequate business records. Instead, “[t]he statute places an affirmative duty on the debtor to create books and records accurately documenting her financial affairs.” In re Lindemann, 375 B.R. 450, 467 (Bankr. N.D. Ill. 2007). If the debtor has not done so, then her discharge must be denied unless she can show that her failure to create and maintain records was “justified,” a standard that is usually not satisfied by the debtor’s after-the-fact explanations. This is true regardless of whether the failure to keep records stemmed from any improper motive.

            Additionally, the records must be “comprehensible,” in that they clearly and intelligibly reflect the debtor’s business transactions. In re Juzwiak, 89 F.3d 424, 429 (7^th Cir. 1996). Records are only adequate if they are organized and “provide the trustee or creditors with enough information to ascertain the debtor's financial condition and track his financial dealings with substantial completeness and accuracy for a reasonable period past to present." Lindemann, 375 B.R. at 468. And whether they are adequate is a question of quality, not quantity, so merely producing a large volume of confusing, incomplete, or unorganized records is insufficient. Courts have repeatedly stated that they should not have to sift through reams of complicated and poorly organized documents in order to reconstruct the flow of the debtor’s assets or financial situation. It has even been said that “‘too many’ is just as bad as ‘not enough.’” In re Vandewoestyne, 174 B.R. 518, 522 (Bankr. C.D. Ill. 1994).

            There are no types of records specifically required in every case, and what is adequate has to be decided based on the particular facts of the debtor’s case, such as the type, size, and complexity of the business. Nonetheless, something like a “morass of checks and bank statements” will likely be insufficient. Union Planters Bank, N.A. v. Connors, 283 F.3d 896, 899 (7^th Cir. 2002). As for the period of time prior to the bankruptcy filing the records must cover, some courts have found two years to be sufficient, though it may be longer if warranted by the particular facts of the debtor’s case.

            It should be noted that the failure-to-keep-or-preserve prong of this exception is generally not implicated in consumer bankruptcies. In re Scott, 172 F.3d 959, 970 (7^th Cir. 1999). Instead, its principal application is to business debtors. This tempers the harshness of the rule, but it will still come as a surprise to many business debtors to learn that they may be denied a discharge solely because they had been sloppy or careless in their recordkeeping. After all, the average business debtor had no intention of filing for bankruptcy before his business began failing or he suffered a sudden financial catastrophe, and therefore he didn't knowingly disregard the duty imposed on him by bankruptcy law to keep adequate records. Additionally many debtors are in bankruptcy because of their poor—yet not dishonest—handling of their finances, including poor record-keeping. To find out the very reason for their bankruptcy is also the reason they are denied a discharge will strike them as draconian, especially since the trustee will still liquidate all their non-exempt assets.  

            Courts have considered the seeming harshness of this rule and have tailored the application of the law accordingly, so that the education, experience, and sophistication of debtors are taken into consideration when determining the adequacy of their records. Lindemann, 375 B.R. at 468. So, for example, a bricklayer will not be held to the same standard as a lawyer or accountant. Nonetheless, there is still the potential for a simple, honest debtor to do his best to cooperate with the trustee and disclose fully but still walk away without a discharge because the trustee or a disgruntled creditor files an adversary proceeding and is able to show that the debtor’s business records are unsatisfactory.

            Under the statute, it is possible for a debtor to show that their failure to keep or preserve records was “justified under all of the circumstances of the case,” though it does not give clues as to when the failure is justified. In cases where courts have found a failure to keep or preserve adequate records, it is very rare that the debtor has been able to justify that failure. Explanations that documents were destroyed by flooding; destroyed by a landlord after an eviction; eaten by mice, and in the possession of a third party have all been rejected. In re Hansen, 325 B.R. 746, 762 (Bankr. N.D. Ill. 2005); In re Wasserman, 332 B.R. 325, 333 (Bankr. N.D. Ill. 2005); In re Costello, 299 B.R. 882, 889 (Bankr. N.D. Ill. 2003); In re Fink, 351 B.R. 511, 524 (Bankr. N.D. Ill. 2006).

            One argument in support of this exception to discharge is that creditors, the trustee, and the court have the right to know the financial condition of the debtor and how that condition came about, but the debtor’s failure to keep adequate business records effectively deprives them of that right. Additionally, the trustee and court may not be able to fully ascertain whether the debtor is truly “honest but unfortunate” if he did not maintain records of his business transactions sufficient to track his recent financial history. Others would respond that a discharge should only be denied on the basis of the failure to keep or preserve business records if there is some evidence that such failure was the product of a dishonest intent.

            At any rate, it is essential that individuals who owe primarily business-related debts and their attorneys do their best to ensure adequate records exist before filing for bankruptcy under Chapter 7.

            If you have any questions, either because you are considering filing for bankruptcy or you are a creditor of a business debtor, please contact Mark Liston or Frank Kokoszka at 312-443-9600.