Chapter Choice is Vitally Important. The following discussion applies only to individuals (not corporations, LLCs, partnerships or other artificial business entities).  Determining whether to file for bankruptcy, and the chapter under which the bankruptcy case should be filed, varies drastically between cases filed by individuals and cases filed by corporations, LLCs, partnerships or other artificial business entities.  See, Small Business Bankruptcy, for a discussion of bankruptcy filing by corporations and artificial entities.

The chapter choice (the decision to file under Chapter 7, 11, 12 or 13) is the most important initial decision in a small business or consumer  bankruptcy filing. Certain goals can be achieved under Chapter 7 which can not be done in a Chapter 11 or 13 case, and vice versa. The choice of whether to file under Chapter 7, 11, 12 or 13 should be made only after consulting with a qualified attorney.

Chapter 7. Chapter 7 allows the debtor to discharge debt, but does not permit the debtor to reorganize or change the terms of any loans or contracts. It is normally the proper option if you are current (or almost current) on all secured debts (such as home mortgages and vehicle loans) and have an unmanageably large amount of unsecured debt such as:

► credit card debt;

► medical bills;

► unsecured consumer or business loans (except student loans);

► deficiency claims on repossessed vehicles or foreclosed land;

► federal income tax claims for tax years more than 3 years old, but only if the tax returns for those tax years were filed.

House & Vehicles. You can either: (a) keep houses, cars or other collateral for secured debts by continuing to make the normal contract payments; or surrender the collateral, and discharge and further liability on the loan.  You can not reorganize or alter the terms of a secured loan under Chapter 7.  This can only be done under Chapter 11 or 13.

Abuse Test. A debtor will not qualify under Chapter 7 if:

(1) most of the debts are consumer debts (debts incurred by an individual primarily for a personal, family, or household purposes); and

(2) the debtor can afford to repay a significant portion of the debt he wants to discharge in bankruptcy.

The bankruptcy trustee can seek dismissal of the case as an abuse of the bankruptcy process if the debtor can afford to repay a significant portion of the unsecured debt.  This rule is designed to encourage debtors to file under Chapter 13 if they can afford to repay a significant portion of the debt.

Therefore, if the problem debts are unsecured consumer debts, consider filing under Chapter 11 or 13 only if you can not demonstrate an inability to repay any of it.  The rules for determining whether a debtor can afford to repay the debts are very complex and were significantly affected by the bankruptcy reform legislation effective for all cases filed after October 2005.  The debtor must pass a complex "means test" to establish a right to a Chapter 7 discharge if he/she earns income above the median family income.

The abuse test only apples if most of the debt is consumer debt. If most of the debt is business related, the debtor may file under Chapter 7 even if he can afford to repay some or all of it.

Chapter 11.  Chapter 11 is available to individuals, corporations and other artificial entities.  It permits individuals to reorganize their debt by proposing a plan which modifies or rejects the provisions of some loans (except for home mortgages) and contracts.  The main advantage of filing under Chapter 11 rather than Chapter 13 is that the debtor is not required to file or perform under a bankruptcy plan for between 4 to 6 months (or perhaps longer).  Individuals who need a significant period of time to catch their breath financially, and need time before they can propose or make payments under a repayment plan, will want to consider filing under chapter 11.

There are no debt limits for filing a case under Chapter 11.  However, Chapter 13 cases can only be filed if total secured debt is less $1,010,650 and unsecured debts are less than $336,900.  Chapter 11 will be the only bankruptcy option for individuals that desire to reorganize secured debt by keeping collateral and paying less than the full amount due, lowering the interest rate, or reorganizing other a small business obligations. 

A significant disadvantage to Chapter 11 is that it is very expensive and time consuming.  The legal fees and court costs involved in filing a Chapter 11 filing can be more than 5 time as expensive than Chapter 13 cases.  The debtor will also need to devote a substantial amount of time dealing with his attorney, obtaining documents and complying with court requirements and procedures.

Chapter 12.  Chapter 12 is available to individuals, corporations and partnerships engaged in farming and fishing activities. It is limited to:

(1) farmers with:

(a) total secured and unsecured debt of less than $3,544,525; and

(b) at least 50 percent of the total debt (except for mortgage debts for a principal residence) must arises out of farming activities.

(2) fisherman with:

(a) total secured and unsecured debt of less than $1,642,500; and

(b) at least 80 percent of total debt (except for mortgage debts for a principal residence) must arise out of commercial fishing activities.

Chapter 12 largely mirrors the pre-reform (pre-BAPCPA) provisions of Chapter 13. Like Chapter 13, it permits a debtor to reorganize his debt by proposing a plan which modifies or rejects the provisions of loans and contracts.

The main difference between Chapter 12 and 13 (other than the requirement that a Chapter 12 can only be filed by a farmer or fisherman) is that Chapter 12 permits unlimited cram down and modification of secured debts on real and personal property, including home mortgages, and vehicle, equipment and boat loans. For example, under Chapter 12, a debtor can modify the provisions of a mortgage related to a home mortgage. Bankruptcy courts are not permitted to modify the terms of home mortgages in Chapter 13 cases.

Chapter 13. Chapter 13 is the proper option if you fall behind on the payments to secured debts and want to keep the property, or want to alter unfavorable terms of a loan agreement.

Arrearages on Home Mortgages and Vehicle Loans. If you fall behind on a home mortgage or vehicle payments, you can stop the foreclosure and repay the arrearage in a bankruptcy plan over 3 to 5 years.

Cram Down. A significant feature of Chapter 13 is “cram down.” For most secured debts (except home mortgages and vehicle loans less than 2 & 1/2 years old), you can repay the lesser of the value of the property or the payoff amount due on the loan.  You can also drastically reduce the interest rate on the loan.  For example, assume you have a vehicle loan more than 2 & 1/2 years old.  The payoff amount due is $20,000.  The contract interest rate is 18 percent.  The market value of the vehicle is $10,000.  You can propose a bankruptcy plan which pays $10,000 at 7.25 percent interest (as of 4/2008).  The only issue subject to argument is the market value of the property.  The creditor must transfer the title free and clear of the lien when all plan payments have been completed.

Selective Repayment of Debt. You can retain certain property and repay the debt in installments, and surrender other property without paying for it.  For example, if you have a home mortgage and two car loans, you can keep the house and one car, and surrender the second car without payment.  If you have several leases or contracts, you can reject some contracts or leases, surrender the property, pay nothing on the rejected contracts, and assume other contract or leases and maintain the contract payments.

Small Business Reorganization.  You can also use Chapter 13 to reorganize a small business.  All of the benefits available in a consumer filing are available to reorganize a small business.  In business cases, a debtor can repay debts (or arrearages on loan payments) in installments over 3 to 5 years.  A small business owner may also use the "cram down" provisions of the bankruptcy laws to reduce installment payments and the interest rate paid on secured debts.  A small business owner can also use Chapter 13 to selectively reject unfavorable contracts or unexpired leases.

A significant limitation on small business cases is that the small business must be organized as a sole proprietorship. Only an individual may file bankruptcy under Chapter 13. Corporations, partnerships or other business entities are not allowed to file under Chapter 13, and can  reorganize only by filing under Chapter 11.  Chapter 11 cases are much more complicated than Chapter 13 cases. Even a simple Chapter 11 filing will usually cost a minimum of at least $15,000 to $50,000 in attorney fees.

Super Discharge. The rules concerning the discharge of debts in bankruptcy are much more liberal in Chapter 13 cases. A Chapter 13 discharge is commonly known as a "super discharge" because certain debts can be discharged in a Chapter 13 case that can not be discharged in Chapter 7. In Chapter 13 cases the following debts can be discharged: (1) malicious injury to another person or his property; (2) civil fines and penalties; (3) debts incurred in connection with a divorce decree.  These debts can never be discharged in a Chapter 7 case.

William D. Weber

Board Certified,

Consumer Bankruptcy Law,

Texas Board of Legal Specialization

►

►

►

►

►

6666 Harwin Drive, Suite 220

Houston, TX   77036

Phone: (713) 789-3300

Fax: (713) 893-6004