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Managing Bankruptcy and Insolvency Issues Chapter 13

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Presentation on theme: "Managing Bankruptcy and Insolvency Issues Chapter 13"— Presentation transcript:

1 Managing Bankruptcy and Insolvency Issues Chapter 13
EBD-301 Accounting & Finance for Entrepreneurs

2 General Comment
Bankruptcy law is federal statutory law contained in Title 11 of the United States Code. Congress passed the Bankruptcy Code under its Constitutional grant of authority to "establish... uniform laws on the subject of Bankruptcy throughout the United States." See U.S. Constitution Article I, Section 8. 

3 Bankruptcy Law States may not regulate bankruptcy though they may pass laws that govern other aspects of the debtor-creditor relationship. See Debtor-Creditor A number of sections of Title 11 incorporate the debtor-creditor law of the individual states. A person or business is bankrupt when it cannot pay the debts owed to creditors Bankruptcy is imposed by court order

4 Federal Bankruptcy Code - Title 11 of the U. S. Code
Federal Bankruptcy Code - Title 11 of the U.S. Code. Title 11 is currently subdivided into nine chapters: Chapter 1. General Provisions, Definitions and Rules of Construction Chapter 3. Case Administration Chapter 5. Creditors, the Debtor, and the Estate Chapter 7. Liquidation Chapter 9. Adjustment of the Debts of Municipality Chapter 11. Reorganization Chapter 12. Adjustment of the Debts of a Family Farmer with Regular Annual Income Chapter 13. Adjustment of the Debts of An Individual With Regular Income Chapter 15: Ancillary and other Cross-Border cases

5 Bankruptcy Code Title 11 of the U.S. Code
Chapter 1: General Provisions, Definitions and Rules of Construction Chapter 3: Case Administration Chapter 5: Creditors, the Debtor, and the Estate Chapter 7: Liquidation Chapter 9: Adjustment of the Debts of Municipality

6 Bankruptcy Code Chapter 11: Reorganization
Chapter 12: Adjustment of the Debts of a Family Farmer with Regular Annual Income Chapter 13: Adjustment of the Debts of an Individual with Regular Income Chapter 15: Ancillary and other Cross-Border cases

7 Bankruptcy Code The three chapters most relevant to the distressed business seeking protection under the bankruptcy code are Chapter 11 (Reorganization) Chapter 7 (Liquidation) Chapter 5 (Creditors, The Debtor, and the Estate) Rule of Absolute Priority The bankruptcy process begins with the Chapter 11 filing

8 Definitions of Failure
Defining Business Failure A business unable to meet its maturing obligations is deemed to be technically insolvent A business with debts that exceed the value of its assets is said to be technically bankrupt. In the worst case – the business is liquidated

9 Alternatives to Bankruptcy
Composition with Creditors Financially stressed business may reach an agreement with creditors to accept less (which is better than nothing at all) There must be a mutual assent between the debtor and the creditors before the composition can be created Those creditors who do not participate are not bound by it.

10 Alternatives to Bankruptcy
Necessary conditions for a viable composition The creditor be a good moral risk. Debtor must demonstrate the ability to make a recovery Economic conditions must be favorable creditor’s committee may assume temporary management of the business A composition with creditors is a contract and must be supported by consideration to be enforceable

11 Chapter 7 Liquidation If per chance the bankruptcy court, on the advice of the trustee, determines that there is no viable means for the business to return to financial health, then a liquidation of assets is ordered under procedures outlined in Chapter 7 Settlement with creditors is accomplished in accordance with Chapter 5, Section 507 of Title 11 U.S. Code (as amended in 2006) Satisfaction by assignment of assets or cash

12 Bankruptcy Proceedings for Individuals
Individuals may file for reorganization of debts under Chapter 13 Allows individuals with a regular income and limited debt to undergo a reorganization of their debts under the supervision of the federal bankruptcy court (repay over 3 to 5 years) Individuals may also file for bankruptcy and the elimination of most debts under Chapter 7

13 Pros When you file bankruptcy, it stops all collection actions by creditors, including foreclosures, repossessions, and garnishments• Most states allow you to exempt your home, car and other essentials, so you will not wind up homeless and unable to get around. Declaring bankruptcy now can get you started sooner on rebuilding your credit and your life. If there is another disaster, you may be able to amend your existing Chapter 13 plan to accommodate it. While nothing will get rid of student loan debt, at least bankruptcy will prevent your lenders from aggressive collection action.

14 Pros So is being sued for bad debts, having your car repossessed or your home foreclosed on. If your creditors sue you, your name will be in court records and may appear in the newspaper. Both judges and trustees have heard far worse stories than yours. Credit cards helped you get into this mess. They can get you into another one just as quickly.

15 Cons You will lose all your credit cards (unless you pay them off before filing.) You may also have to give up some luxury possessions. • A recent bankruptcy makes it nearly impossible to get a mortgage (although you should be able to do so within about five years). • A bankruptcy stays on your credit report for 10 years, making it difficult to acquire credit, buy a home or car, get life insurance, or sometimes get a job.

16 Cons Not all debts may be "discharged" in a bankruptcy. Student loans and back taxes (within 3 years) are prime examples. Bankruptcy is an admission of defeat, an embarrassment. If I declare bankruptcy, my name will be in court records and may appear in the newspaper. You will have to explain to a judge or trustee how you got into a financial mess. It will be a long time before you are able to get credit cards again.

17 Bankruptcy: Which Flavor is Best?
There are two types of personal bankruptcy. You will need to choose which one suits your circumstances. Chapter 13 - Reorganization If you have a regular income and limited debt, you may keep property, such as a mortgaged house or car that you otherwise might lose. In Chapter 13, the court approves a repayment plan that allows you to pay off a default during a period of three to five years, rather than surrender any property.

18 Bankruptcy: Which Flavor is Best?
Chapter 7 - Discharge of Debt Involves liquidating all assets that are not exempt. Exempt property may include cars, work-related tools and basic household furnishings. Some property may be sold by a court-appointed official a trustee or turned over to creditors. You can receive a discharge of your debts under Chapter 7 only once every six years.

19 The Process Chapter 7 The initial filing is the first step. You or your agent will file several forms with the bankruptcy court listing income and expenses, assets, debts and property transactions for the past two years. Be honest. Be sure to list everything you owe. The fee for this filing is $200. It may be waived for people who receive public assistance or live below the poverty level. A court-appointed trustee is assigned to oversee your case. About a month after filing, you must attend a "meeting of creditors" where the trustee reviews your forms and asks any questions. Despite the name, creditors rarely attend. At this meeting, you must declare any nonexempt property and give it (or its value in cash) to the trustee. Normally, this meeting lasts about five minutes. Three to six months later, you receive a notice from the court that "all debts that qualified for discharge were discharged." Your case is then over. Then your case is over.

20 The Process Chapter 13 You file the same forms as above plus a proposed repayment plan, in which you describe how you intend to repay your debts over the next three, or in some cases five, years. The filing fee is $185 and, unlike the Chapter 7 fee, cannot be waived. A trustee is assigned to oversee the case. As in Chapter 7, you attend the meeting of creditors. Often one or two creditors attend this meeting, especially if they don't like something in your plan. After the meeting of the creditors, you attend a hearing before a bankruptcy judge who either confirms or denies your plan. If your plan is confirmed, and you make all the payments called for under your plan, you often receive a discharge of any balance owed at the end of your case.

A. Economic Failure; revenues do not cover expenses. B. Business Failure; termination resulting in loss to creditors, C. Technical Insolvency: firm cannot meet maturing obligations, D. Technical Bankruptcy: Value of assets < value of liabilities,

E. Out-of-Court Remedies; 1. Necessary conditions; a. Debtor is good moral risk. b. Debtor must show ability to make a recovery. c. General business conditions must be favorable. 2. Extension; postpone due date. 3. Composition; creditors agree to take less. 4. Creditor committees; lenders assume management. 5. Assignment; Requires agreement as to liquidation values, and priority.

23 CAUSES OF FAILURE A. Managerial Incompetence.
The most frequently cited cause of failure is managerial incompetence. This definition covers a wide assortment of management blunders; poor investments, poor controls, inadequate planning, unresponsiveness to market requirements, etc.

24 FEDERAL BANKRUPTCY US Code, Title 11 (Jan-2-2006)
B. Chapter 11; Reorganization Firm's debt is restructured to allow the orderly payment of creditors while the company regains its financial health. 1. Reorganization of repayment schedules; lengthen maturities 2. Some debt may be permanently dismissed. 3. Debt frequently has interest rates lowered. 4. Evaluates current management. 5. Determine if merger with healthy firm is best.

25 FEDERAL BANKRUPTCY US Code, Title 11 (Jan-2-2006)
A. Chapter 7; Liquidation; When company cannot reasonably be expected to be made a going concern again, the court generally orders a liquidating of assets. The proceeds are used to pay off the creditors (by Rule of Absolute Priority – See Chap. 5). 1. Provides safeguards against fraud. 2. Provide equitable distribution of assets. 3. Discharge all obligations: debtors can restart without burden of former debt.

26 FEDERAL BANKRUPTCY US Code, Title 11 (Jan-2-2006)
C. The Rule of Absolute Priority; Chapter 5, Section 507 1. Secured creditors; mortgage bondholders. 2. Administrative expenses allowed under section 503 (b) . 3. Third, unsecured claims allowed under section 502 (f) of this title . 4. Allowed unsecured claims, but only to the extent of $10,000 earned within 180 days of filing. 5. Allowed unsecured claims for contributions to an employee benefit plan…services rendered with 180 days of filing .

27 The Rule of Absolute Priority
Allowed unsecured claims of persons but only to the extent of $4,925 for each such individual. Allowed unsecured claims of individuals, to the extent of $2,225 for each such individual, arising from the deposit Allowed unsecured claims of governmental units, only to the extent that such claims are for taxes for a taxable year on or before the date of filing the petition.

28 The Rule of Absolute Priority
Allowed unsecured claims based upon any commitment by the debtor to a Federal depository institutions regulatory agency . Allowed claims for death or personal injury resulting from the operation of a motor vehicle or vessel if such operation was unlawful because the debtor was intoxicated from using alcohol, a drug, or another substance D. Satisfaction of Creditor Claims 1. Assignment of assets 2. Cash payments

29 Individual Bankruptcy Summary
Both Chapters 7 and 13 may get rid of unsecured debts and stop foreclosures, repossessions, garnishments, utility shut-offs, and debt collection activities Personal bankruptcy usually does not erase child support, alimony, fines, taxes, and some student loan obligations bankruptcy usually does not allow you to keep property when your creditor has an unpaid mortgage or lien on it

30 IRS Publication 4681 A Cautionary Tale
IRS Publication 4681 explains the effects of canceled debts, foreclosures, repossessions, and abandonments on your taxable income. “Generally, if you owe a debt to someone else and they cancel or forgive that debt for less than its full amount, you are treated for income tax purposes as having income and may have to pay tax on this income.”

31 IRS Publication 4681 A Cautionary Tale
If your lender sends you a Form 1099-C, it means the adjudication of the balance owed (and forgiven or reduced) has been reported to the IRS. The important point to remember is that the cancellation of debt is does not always result in a totally clean slate - There may be significant tax liabilities created as a result of bankruptcy proceedings

32 Homework Questions When is a person or business considered bankrupt?
Where do we file for bankruptcy? How do we define business failure? What conditions are necessary for an out-of-court settlement? Individuals may file for a Chapter 7 or Chapter 11. How do these two chapters differ?

33 Homework Questions Discuss at least 3 major pros and 3 major cons of declaring bankruptcy. What are some of the guidelines for avoiding a second bankruptcy? What important information is contained in IRS Publication 4681 regarding debt cancelled in a bankruptcy proceeding?

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