BUSN Chapter 20 Creditors Rights & Bankruptcy

Judicial Liens

A creditor can bring a legal action against a debtor to collect a past-due debt. If the creditor is successful, the court awards the creditor a judgment against a debtor (usually for the amount of the debt plus any interest and legal costs incurred). Frequently, however, the creditor is unable to collect the awarded amount. To ensure that a judgment will be collectible, the creditor can request that certain nonexempt property of the debtor be seized to satisfy the debt A court's order to seize the debtor's property is known as a writ of attachment if it is issued before a judgment. If the court's order is issued after a judgment, it is referred to as a writ of execution.

Preferences

A debtor is not permitted to make a property transfer or a payment that favors—or gives a preference to—one creditor over others. The trustee is allowed to recover payments made both voluntarily and involuntarily to one creditor in preference over another. To have made a preferential payment that can be recovered, an insolvent debtor generally must have transferred property, for a preexisting debt, during the ninety days before the filing of the petition in bankruptcy. The transfer must have given the creditor more than the creditor would have received as a result of the bankruptcy proceedings. The Code presumes that the debtor is insolvent during the ninety-day period before filing a petition. If a preferred creditor (one who has received a preferential transfer from the debtor) has sold the property to an innocent third party, the trustee cannot recover the property from the innocent party. The trustee can generally force the preferred creditor to pay the value of the property, however.

The Basic Formula

A debtor wishing to file for bankruptcy must complete the means test to determine whether she or he qualifies for Chapter 7. The debtor's average monthly income in recent months is compared with the median income in the geographic area in which the person lives. (The U.S. Trustee Program provides these data at its Web site.) If the debtor's income is below the median income, the debtor usually is allowed to file for Chapter 7 bankruptcy, as there is no presumption of bankruptcy abuse.

Fixed-Rate Mortgages

A fixed-rate mortgage has a fixed, or unchanging, rate of interest, so the payments remain the same for the duration of the loan. Lenders determine the interest rate for a standard fixed-rate mortgage loan based on a variety of factors, including the borrower's credit history, credit score, income, and debts. For a borrower to qualify, lenders typically require that the monthly mortgage payment (including principal, interest, taxes, and insurance) not exceed 28 percent of the person's monthly gross income.

Liens

A lien is an encumbrance on (claim against) property to satisfy a debt or protect a claim for the payment of a debt. Creditors' liens may arise under the common law or under statutory law. Creditors' liens may arise under the common law or under statutory law. Mechanic's liens are statutory liens, whereas artisan's liens were recognized by common law. Judicial liens arise when a creditor attempts to collect on a debt before or after a judgment is entered by a court. Mechanic's and artisan's liens can be an important tool for creditors because these liens normally take priority over perfected security interests unless a statute provides otherwise. Other types of liens can also be useful because a lien creditor generally has priority over an unperfected secured party. In other words, if a creditor obtains a lien before another party perfects a security interest in the same property, the lienholder has priority. If the lien is not obtained until after another's security interest in the property is perfected, the perfected security interest has priority.

The Reorganization Plan

A reorganization plan is established to conserve and administer the debtor's assets in the hope of an eventual return to successful operation and solvency. The plan must be fair and equitable and must do the following: 1. Designate classes of claims and interests. 2. Specify the treatment to be afforded the classes. (The plan must provide the same treatment for all claims in a particular class.) 3. Provide an adequate means for execution. (Individual debtors must utilize postpetition assets as necessary to execute the plan.) 4. Provide for payment of tax claims over a five-year period.

The Repayment Plan

A repayment plan must provide for the following: 1.Turning over the debtor's future earnings or income to the trustee as necessary for execution of the plan. 2.Full payment through deferred cash payments of all claims entitled to priority, such as taxes 3.Identical treatment of all claims within a particular class. (The Code permits the debtor to list co-debtors, such as guarantors or sureties, as a separate class.) The repayment plan may provide for payment of all obligations in full or for payment of a lesser amount. The debtor must begin making payments under the proposed plan within thirty days after the plan has been filed and must continue to make "timely" payments from her or his disposable income. If the debtor fails to make timely payments or does not commence payments within the thirty-day period, the court can convert the case to a liquidation bankruptcy or dismiss the petition. In putting together a repayment plan, a debtor must apply the means test to identify the amount of disposable income that will be available to repay creditors. The debtor is allowed to deduct certain expenses from monthly income to arrive at this amount.

Limitations on the Automatic Stay

A secured creditor or other party in interest can petition the bankruptcy court for relief from the automatic stay. If a creditor or other party requests relief from the stay, the stay will automatically terminate sixty days after the request, unless the court grants an extension or the parties agree otherwise. Also, the automatic stay on secured debts normally will terminate thirty days after the petition is filed if the debtor had filed a bankruptcy petition that was dismissed within the prior year. If the debtor had two or more bankruptcy petitions dismissed during the prior year, the Code presumes bad faith, and the automatic stay does not go into effect until the court determines that the petition was filed in good faith. In addition, the automatic stay on secured property terminates forty-five days after the creditors' meeting (discussed shortly) unless the debtor redeems or reaffirms certain debts. In other words, the debtor cannot keep the secured property (such as a financed automobile), even if she or he continues to make payments on it, without reinstating the rights of the secured party to collect on the debt.

Fraudulent Transfers

A trustee can avoid (set aside or cancel) fraudulent transfers or obligations if 1. they were made within two years of the filing of the petition or 2. they were made with actual intent to hinder, delay, or defraud a creditor.

Voidable Rights

A trustee steps into the shoes of the debtor. Thus, any reason that a debtor can use to obtain the return of his or her property can be used by the trustee as well. The grounds for recovery include fraud, duress, incapacity, and mutual mistake.

Discharge

From the debtor's point of view, the primary purpose of liquidation is to obtain a fresh start through the discharge of debts. A discharge voids, or sets aside, any judgment on a discharged debt and prevents any action to collect it. Certain debts, however, are not dischargeable in bankruptcy. Also, certain debtors may not qualify to have all debts discharged in bankruptcy. These situations are discussed next.

Procedures

Garnishment can be a prejudgment remedy, requiring a hearing before a court, but it is most often a postjudgment remedy. State law governs garnishment, so the procedure varies. In some states, the creditor needs to obtain only one order of garnishment, which will then apply continuously to the debtor's wages until the entire debt is paid. In other states, the judgment creditor must go back to court for a separate order of garnishment for each pay period.

Garnishment

Garnishment occurs when a creditor is permitted to collect a debt by seizing property of the debtor (such as wages or funds in a bank account) that is being held by a third party. As a result of a garnishment proceeding, the debtor's employer may be ordered by the court to turn over a portion of the debtor's wages to pay the debt.

Liability Arises When Debtor Defaults

The guarantor can be required to pay the obligation only after the principal debtor defaults, and default usually takes place only after the creditor has made an attempt to collect from the debtor. The guaranty contract terms determine the extent and time of the guarantor's liability

Filing the Petition

A Chapter 13 repayment plan case can be initiated only by the filing of a voluntary petition by the debtor or by the conversion of a Chapter 7 petition (because of a finding of substantial abuse under the means test, for instance). Certain liquidation and reorganization cases may be converted to Chapter 13 with the consent of the debtor On the filing of a repayment plan petition, an automatic stay takes effect, just as with a Chapter 7 filing. The stay applies to all or part of the debtor's consumer debt, but it does not apply to any business debt incurred by the debtor or to any domestic-support obligations. A trustee, who will make payments under the plan, is appointed.

Special Treatment of Consumer-Debtors

A consumer-debtor is a debtor whose debts result primarily from the purchase of goods for personal, family, or household use. The Bankruptcy Code requires that the clerk of the court give all consumer-debtors written notice of the general purpose, benefits, and costs of each chapter of bankruptcy under which they may proceed. In addition, the clerk must provide consumer-debtors with information on the types of services available from credit counseling agencies.

Surety

A contract of strict suretyship is a promise made by a third person to be responsible for the debtor's obligation. It is an express contract between the surety (the third party) and the creditor. The surety in the strictest sense is primarily liable for the debt of the principal. The creditor need not exhaust all legal remedies against the principal debtor before holding the surety responsible for payment. The creditor can demand payment from the surety from the moment the debt is due.

Discharge

After the completion of all payments under the plan, the court grants a discharge of the debts provided for by the plan. All debts are dischargeable except claims not provided for by the plan, certain long-term debts provided for by the plan, certain tax claims, payments on retirement accounts, and claims for domestic-support obligations. In addition, under current law, debts related to injury or property damage caused while driving under the influence of alcohol or drugs are not dischargeable. Certain student loan debts can be discharged under Chapter 13, but only if the court finds that payment of the debts would constitute an undue hardship for the debtor. Furthermore, a discharge can be revoked if it is discovered that the debtor acted fraudulently or dishonestly.

Confirmation of the Plan

After the plan is filed, the court holds a confirmation hearing, at which interested parties (such as creditors) may object to the plan. The hearing must be held at least twenty days, but no more than forty-five days, after the meeting of the creditors. The debtor must have filed all prepetition tax returns and paid all postpetition domestic-support obligations before a court will confirm any plan. The court will confirm a plan with respect to each claim of a secured creditor under any of the following circumstances: 1.If the secured creditors have accepted the plan. 2.If the plan provides that secured creditors retain their liens until there is payment in full or until the debtor receives a discharge. 3. If the debtor surrenders the property securing the claims to the creditors.

Reaffirmation of Debt

An agreement to pay a debt dischargeable in bankruptcy is called a reaffirmation agreement. A debtor may wish to pay a debt—for example, a debt owed to a family member, physician, bank, or some other creditor—even though the debt could be discharged in bankruptcy. Also, as noted previously, a debtor cannot retain secured property while continuing to pay without entering into a reaffirmation agreement.

Involuntary Bankruptcy

An involuntary bankruptcy occurs when the debtor's creditors force the debtor into bankruptcy proceedings. An involuntary case cannot be filed against a farmer or a charitable institution. For an involuntary action to be filed against other debtors, the following requirements must be met: 1. If the debtor has twelve or more creditors, three or more of those creditors having unsecured claims totaling at least $14,425 must join in the petition. 2. If a debtor has fewer than twelve creditors, one or more creditors having a claim of $14,425 or more may file. If the debtor challenges the involuntary petition, a hearing will be held. The debtor's challenge will fail if the bankruptcy court finds either of the following: 1. The debtor generally is not paying debts as they become due. 2.A general receiver, assignee, or custodian took possession of, or was appointed to take charge of, substantially all of the debtor's property within 120 days before the filing of the involuntary petition If the court allows the bankruptcy to proceed, the debtor will be required to supply the same information in the bankruptcy schedules as in a voluntary bankruptcy. An involuntary petition should not be used as an everyday debt-collection device, and the Code provides penalties for the filing of frivolous (unjustified) petitions against debtors. If the court dismisses an involuntary petition, the petitioning creditors may be required to pay the costs and attorneys' fees incurred by the debtor in defending against the petition. If the petition was filed in bad faith, damages can be awarded for injury to the debtor's reputation. Punitive damages may also be awarded.

Additional Grounds for Dismissal

As noted, a debtor's voluntary petition for Chapter 7 relief may be dismissed for substantial abuse or for failing to provide the necessary documents (such as schedules and tax returns) within the specified time. In addition, a motion to dismiss a Chapter 7 filing may be granted in two other situations. First, if the debtor has been convicted of a violent crime or a drug-trafficking offense, the victim can file a motion to dismiss the voluntary petition. Second, if the debtor fails to pay postpetition domestic-support obligations (which include child and spousal support), the court may dismiss the debtor's Chapter 7 petition.

Creditors' Committees

As soon as practicable after the entry of the order for relief, a committee of unsecured creditors is appointed. The committee may consult with the trustee or the debtor concerning the administration of the case or the formulation of the plan. Additional creditors' committees may be appointed to represent special interest creditors, and a court may order the trustee to change a committee's membership as needed to ensure adequate representation of the creditors. Generally, no orders affecting the estate will be entered without the consent of the committee or a hearing in which the judge is informed of the position of the committee. As mentioned earlier, businesses with debts of less than $2.19 million that do not own or manage real estate can avoid creditors' committees. In these fast-track proceedings, orders can be entered without a committee's consent. In addition, if the debtor has filed a plan accepted by the creditors, the trustee may decide not to call a meeting of the creditors.

Distribution to Unsecured Creditors

Bankruptcy law establishes an order of priority for classes of debts owed to unsecured creditors, and they are paid in the order of their priority. Each class must be fully paid before the next class is entitled to any of the remaining proceeds. If there are insufficient proceeds to pay the full amount to all the creditors in a class, the proceeds are distributed proportionately to the creditors in that class, and classes lower in priority receive nothing. In almost all Chapter 7 bankruptcies, the funds will be insufficient to pay all creditors. Note that claims for domestic-support obligations, such as child support and alimony, have the highest priority among unsecured claims, so these debts must be paid first. If any amount remains after the creditors have been satisfied, it is turned over to the debtor.

Bankruptcy Law

Bankruptcy law in the United States has two goals: 1.To protect a debtor by giving him or her a fresh start, free from creditors' claims. 2. To ensure equitable treatment to creditors who are competing for the debtor's assets. Bankruptcy law is federal law, but state laws on secured transactions, liens, judgments, and exemptions also play a role in federal bankruptcy proceedings. Bankruptcy law before 2005 was based on the Bankruptcy Reform Act of 1978, as amended (called the Bankruptcy Code, or simply, the Code). In 2005, Congress enacted bankruptcy reform legislation that significantly overhauled certain provisions of the Bankruptcy Code for the first time in twenty-five years. One of the major goals of this legislation was to require consumers to pay as many of their debts as they possibly could instead of having those debts fully discharged in bankruptcy. Before the reforms, the vast majority of bankruptcies were filed under Chapter 7 of the Code, which permits debtors, with some exceptions, to have all of their debts discharged (extinguished) in bankruptcy. Under the 2005 legislation, however, more debtors have to file for bankruptcy under Chapter 13, which will be discussed later in this chapter.

Bankruptcy Courts

Bankruptcy proceedings are held in federal bankruptcy courts, which are under the authority of U.S. district courts. Rulings by bankruptcy courts can be appealed to the district courts. The bankruptcy court holds proceedings dealing with the procedures required to administer the debtor's estate in bankruptcy

Actions That Release the Surety and Guarantor

Basically, the same actions release a surety or a guarantor from an obligation. In general, the same rules apply to both sureties and guarantors. For simplicity, the remainder of our discussion of suretyship and guaranty refers just to sureties, but it applies to both. If a material modification is made in the terms of the original contract between the principal debtor and the creditor—without the surety's consent—the surety's obligation will be discharged. (The extent to which the surety is discharged depends on whether he or she was compensated and the amount of the loss suffered as a result of the modification.) Similarly, if a debt is secured by collateral and the creditor surrenders the collateral to the debtor or impairs the collateral without the surety's consent, these acts can reduce the surety's obligation Naturally, any payment of the principal obligation by the debtor or by another person on the debtor's behalf will discharge the surety from the obligation. Even if the creditor refused to accept payment of the principal debt when it was tendered, the surety's obligation can be discharged

Limitations

Both federal and state laws limit the amount that can be taken from a debtor's weekly take-home pay through garnishment proceedings. Federal law provides a framework to protect debtors from suffering unduly when paying judgment debts. For example, the federal Consumer Credit Protection Act of 1968 provides that a debtor can retain either 75 percent of disposable earnings per week or a sum equivalent to thirty hours of work paid at federal minimum-wage rates, whichever is greater. State laws also provide dollar exemptions, and these amounts are often larger than those provided by federal law. Under federal law, an employer cannot dismiss an employee because his or her wages are being garnished.

Laws Assisting Creditors

Both the common law and statutory laws other than Article 9 of the Uniform Commercial Code (UCC) create various rights and remedies for creditors

Chapter 13—Individuals' Repayment Plan

Chapter 13 of the Bankruptcy Code provides for the "Adjustment of Debts of an Individual with Regular Income." Individuals (not partnerships or corporations) with regular income who owe fixed unsecured debts of less than $383,175 or fixed secured debts of less than $1,149,525 may take advantage of bankruptcy repayment plans. Many small-business debtors have a choice of filing under either Chapter 11 or Chapter 13. Repayment plans offer some advantages because they are typically less expensive and less complicated than reorganization or liquidation proceedings.

Include Contract Provisions

Creditors also include provisions in the mortgage contract that are aimed at protecting their investment. For instance, many lenders include a prepayment penalty clause, which requires the borrower to pay a penalty if the mortgage is repaid in full within a certain period. A prepayment penalty helps to protect the lender should the borrower refinance within a short time after obtaining a mortgage. Creditors frequently also require the debtor to maintain homeowner's insurance on the mortgaged property.

Creditors' Composition Agreements

Creditors may contract with the debtor for discharge of the debtor's liquidated debts (debts that are definite, or fixed, in amount) on payment of a sum less than that owed. These agreements are called creditors' composition agreements, or simply composition agreements, and usually are held to be enforceable.

Redemption Rights

Every state allows a defaulting borrower to redeem the property before the foreclosure sale by paying the full amount of the debt, plus any interest and costs that have accrued. This is known as the right of redemption. The idea behind this right is that it is only fair for the borrower to have a chance to regain possession after default. Some states even allow a borrower to repurchase property after a judicial foreclosure—called a statutory right of redemption. Generally, the borrower may exercise this right for up to one year from the time the house is sold at a foreclosure sale. The borrower may retain possession of the property after the foreclosure sale until the statutory redemption period ends. If the borrower does not exercise the right of redemption, the new buyer receives title to and possession of the property.

Defenses of the Surety and the Guarantor

Generally, the surety can also assert any of the defenses available to a principal debtor to avoid liability on the obligation to the creditor. A few exceptions do exist, however. The surety cannot assert the principal debtor's incapacity or bankruptcy as a defense, nor can the surety assert the statute of limitations as a defense. Obviously, a surety may also have her or his own defenses—for example, her or his own incapacity or bankruptcy. If the creditor fraudulently induced the surety to guarantee the debt of the debtor, the surety can assert fraud as a defense. In most states, the creditor has a legal duty to inform the surety, before the formation of the suretyship contract, of material facts known by the creditor that would substantially increase the surety's risk. Failure to so inform may constitute fraud and renders the suretyship obligation voidable.

Foreclosure Procedure

If all efforts to find another solution fail, the lender will proceed to foreclosure. The lender must strictly comply with the state statute governing foreclosures. Many problems arose in the last ten years because lenders, facing a record number of foreclosures during the recession, had difficulty complying with the required statutory formalities. To bring a foreclosure action, a bank must have standing to sue

Applying the Means Test to Future Disposable Income

If the debtor's income is above the median income, then further calculations must be made to determine whether the person will have sufficient disposable income in the future to repay at least some of his or her unsecured debts. Disposable income is calculated by subtracting living expenses and interest payments on secured debt, such as mortgage payments, from monthly income. In making this calculation, the court presumes that the debtor's recent monthly income will continue for the next sixty months. Living expenses are the amounts allowed under formulas used by the Internal Revenue Service (IRS). The IRS allowances include modest allocations for food, clothing, housing, utilities, transportation (including car payments), health care, and other necessities. (The U.S. Trustee Program's Web site also provides these amounts.) The allowances do not include expenditures for items such as cell phones and cable television service.

Mortgage Foreclosure

If the homeowner defaults, or fails to make the mortgage payments, the lender has the right to foreclose on the mortgaged property. Foreclosure is the legal process by which the lender repossesses and auctions off the property that has secured the loan. Generally, two types of foreclosure are used in the United States: judicial foreclosure and power of sale foreclosure. In a judicial foreclosure, which is available in most states, a court supervises the process. In a power of sale foreclosure, the lender is allowed to foreclose on and sell the property without judicial supervision Foreclosure is expensive and time consuming, though. It generally benefits neither the borrowers, who lose their homes, nor the lenders, which face the prospect of losses on their loans. Therefore, both lenders and borrowers are motivated to avoid foreclosure proceedings if possible.

Order for Relief

If the voluntary petition for bankruptcy is found to be proper, the filing of the petition will itself constitute an order for relief. (An order for relief is the court's grant of assistance to a debtor.) Once a consumer-debtor's voluntary petition has been filed, the clerk of the court (or other appointee) must give the trustee and creditors notice of the order for relief by mail not more than twenty days after the entry of the order.

Chapter 12—Family Farmers and Fishermen

In 1986, to help relieve economic pressure on small farmers, Congress created Chapter 12 of the Bankruptcy Code. In 2005, Congress extended this protection to family fishermen, modified its provisions somewhat, and made it a permanent chapter in the Bankruptcy Code (previously, it had to be periodically renewed by Congress). For purposes of Chapter 12, a family farmer is one whose gross income is at least 50 percent farm dependent and whose debts are at least 50 percent farm related. The total debt must not exceed $4,031,575. A partnership or a close corporation that is at least 50 percent owned by the farm family can also qualify as a family farmer. A family fisherman is one whose gross income is at least 50 percent dependent on commercial fishing operations and whose debts are at least 80 percent related to commercial fishing. The total debt for a family fisherman must not exceed $1,868,200. As with family farmers, a partnership or close corporation can also qualify.

Limitations

In a few states, statutes allow the homestead exemption only if the judgment debtor has a family. If a judgment debtor does not have a family, a creditor may be entitled to collect the full amount realized from the sale of the debtor's home. In addition, the homestead exemption interacts with other areas of law and can sometimes operate to cancel out a portion of a lien on a debtor's real property.

Objections to Discharge

In addition to the exceptions to discharge previously listed, a bankruptcy court may deny discharge to the debtor for reasons relating to the debtor's conduct and not to the debt. The situations in which a court can deny discharge include the following: 1.The debtor's concealment or destruction of property with the intent to hinder, delay, or defraud a creditor. 2.The debtor's fraudulent concealment or destruction of financial records. 3. The granting of a discharge to the debtor within eight years prior to the filing of the petition. 4.The debtor's failure to complete the required consumer education course (unless such a course was not available). 5.Proceedings in which the debtor could be found guilty of a felony. (Basically, a court may not discharge any debt until the completion of the felony proceedings against the debtor.) When a discharge is denied under these circumstances, the debtor's assets are still distributed to the creditors. After the bankruptcy proceeding, however, the debtor remains liable for the unpaid portions of all claims. A discharge may be revoked (taken back) within one year if it is discovered that the debtor acted fraudulently or dishonestly during the bankruptcy proceeding. If that occurs, a creditor whose claim was not satisfied in the distribution of the debtor's property can proceed with his or her claim against the debtor.

Tax Returns during Bankruptcy

In addition, a debtor may be required to file a tax return at the end of each tax year while the case is pending and to provide a copy to the court. This may be done at the request of the court or of the U.S. trustee—a government official who performs administrative tasks that a bankruptcy judge would otherwise have to perform, including supervising the work of the bankruptcy trustee. Any party in interest (a party, such as a creditor, who has a valid interest in the outcome of the proceedings) may make this request as well. Debtors may also be required to file tax returns during Chapter 11 and 13 bankruptcies.

Workouts

In some instances, to avoid bankruptcy proceedings, creditors may prefer a private, negotiated adjustment of creditor-debtor relations, also known as a workout. Often, these out-of-court workouts are much more flexible and thus conducive to a speedy settlement. Speed is critical because delay is one of the most costly elements in any bankruptcy proceeding. Another advantage of workouts is that they avoid the various administrative costs of bankruptcy proceedings.

Laws Assisting Debtors

The law protects debtors as well as creditors. Certain property of the debtor, for example, is exempt from creditors' actions. Of course, bankruptcy laws are designed specifically to assist debtors. In most states, certain types of real and personal property are exempt from execution or attachment. State exemption statutes usually include both real and personal property.

Writ of Attachment

In the context of judicial liens, attachment is a court-ordered seizure of property before a judgment is secured for a past-due debt. Attachment rights are created by state statutes. Normally, attachment is a prejudgment remedy occurring either at the time a lawsuit is filed or immediately afterward. The due process clause of the Fourteenth Amendment to the U.S. Constitution requires that the debtor be given notice and an opportunity to be heard. To attach before judgment, a creditor must comply with the specific state's statutory requirements. The creditor must have an enforceable right to payment of the debt under law and must follow certain procedures or risk liability for wrongful attachment. Typically, the creditor must file an affidavit—that is, a written statement, made under oath—with the court and post a bond. The affidavit states that the debtor is in default and indicates the statutory grounds under which attachment is sought. The bond covers at least the court costs, the value of the debtor's loss of use of the goods, and the value of the property attached. When the court is satisfied that all of the requirements have been met, it issues a writ of attachment, which directs the sheriff or other public officer to seize nonexempt property. If the creditor prevails at trial, the seized property can be sold to satisfy the judgment.

Substantial Abuse and the Means Test

In the past, a bankruptcy court could dismiss a Chapter 7 petition for relief (discharge of debts) if the use of Chapter 7 would constitute a "substantial abuse" of bankruptcy law. Today, the law provides a means test to determine a debtor's eligibility for Chapter 7. The purpose of the test is to keep upper-income people from abusing the bankruptcy process by filing for Chapter 7, as was thought to have happened in the past. The test forces more people to file for Chapter 13 bankruptcy rather than have their debts discharged under Chapter 7.

Writ of Execution

Similarly, if a creditor wins a judgment against a debtor, but the debtor cannot or will not pay the judgment, the creditor is entitled to go back to the court and request a writ of execution. This writ is a court order directing the sheriff to seize (levy) and sell any of the debtor's nonexempt real or personal property that is within the court's geographic jurisdiction (usually the county in which the courthouse is located). The proceeds of the sale are used to pay off the judgment, accrued interest, and the costs of the sale. Any excess is paid to the debtor. The debtor can pay the judgment and redeem the nonexempt property any time before the sale takes place. (Because of exemption laws and bankruptcy laws, many judgments are uncollectible.)

Liquidation

Liquidation under Chapter 7 is the most familiar type of bankruptcy proceeding and is often referred to as an ordinary, or straight, bankruptcy. Put simply, a debtor in a liquidation bankruptcy turns all assets over to a trustee. The trustee sells the nonexempt assets and distributes the proceeds to creditors. With certain exceptions, the remaining debts are then discharged, and the debtor is relieved of the obligation to pay the debts. Any "person"—defined as including individuals, partnerships, and corporations—may be a debtor under Chapter 7. Railroads, insurance companies, banks, savings and loan associations, investment companies licensed by the U.S. Small Business Administration, and credit unions cannot be Chapter 7 debtors, however. Other chapters of the Code or other federal or state statutes apply to them. A husband and wife may file jointly for bankruptcy under a single petition. A straight bankruptcy may be commenced by the filing of either a voluntary or an involuntary petition in bankruptcy—the document that is filed with a bankruptcy court to initiate bankruptcy proceedings. If a debtor files the petition, then it is a voluntary bankruptcy. If one or more creditors file a petition to force the debtor into bankruptcy, then it is called an involuntary bankruptcy.

Transfers That Do Not Constitute Preferences

Not all transfers are preferences. To be a preference, the transfer must be made in exchange for something other than current consideration. Most courts do not consider a debtor's payment for services rendered within fifteen days prior to the payment to be a preference. If a creditor receives payment in the ordinary course of business, such as payment of last month's cell phone bill, the trustee in bankruptcy cannot recover the payment. To be recoverable, a preference must be a transfer for an antecedent (preexisting) debt, such as a year-old landscaping bill. In addition, the Code permits a consumer-debtor to transfer any property to a creditor up to a total value of $5,850 without the transfer constituting a preference. Payments of domestic-support debts do not constitute a preference. Neither do payments required under a plan created by an approved credit-counseling agency.

Debtor in Possession

On entry of the order for relief, the debtor in Chapter 11 generally continues to operate the business as a debtor in possession (DIP). The court, however, may appoint a trustee (often referred to as a receiver) to operate the debtor's business if gross mismanagement of the business is shown or if appointing a trustee is in the best interests of the estate. The DIP's role is similar to that of a trustee in a liquidation. The DIP is entitled to avoid preferential payments made to creditors and fraudulent transfers of assets. The DIP has the power to decide whether to cancel or assume prepetition executory contracts (those that are not yet performed) or unexpired leases. Cancellation of executory contracts or unexpired leases can be a substantial benefit to a Chapter 11 debtor.

Estate in Property

On the commencement of a liquidation proceeding under Chapter 7, an estate in property is created. The estate consists of all the debtor's interests in property currently held, wherever located, together with community property (property jointly owned by a husband and wife in certain states), property transferred in a transaction voidable by the trustee, proceeds and profits from the property of the estate, and certain after-acquired property. Interests in certain property—such as gifts, inheritances, property settlements (from divorce), and life insurance death proceeds—to which the debtor becomes entitled within 180 days after filing may also become part of the estate. Withholdings for employee benefit plan contributions are excluded from the estate. Generally, though, the filing of a bankruptcy petition fixes a dividing line: property acquired before the filing of the petition becomes property of the estate, and property acquired after the filing of the petition, except as just noted, remains the debtor's.

Creditors' Best Interests

Once a petition for Chapter 11 has been filed, a bankruptcy court, after notice and a hearing, can dismiss or suspend all proceedings in a case at any time if dismissal or suspension would better serve the interests of the creditors. The Bankruptcy Code also allows a court, after notice and a hearing, to dismiss a case under reorganization "for cause." Cause includes the absence of a reasonable likelihood of rehabilitation, the inability to effect a plan, and an unreasonable delay by the debtor that is prejudicial to (may harm the interests of) creditors.

Can the Debtor Afford to Pay Unsecured Debts?

Once future disposable income has been estimated, that amount is used to determine whether the debtor will have income that could be applied to unsecured debts. The court may also consider the debtor's bad faith or other circumstances indicating abuse.

Acceptance and Confirmation of the Plan

Once the plan has been developed, it is submitted to each class of creditors for acceptance. Each class must accept the plan unless the class is adversely affected by it. The plan need not provide for full repayment to unsecured creditors. Instead, creditors receive a percentage of each dollar owed to them by the debtor. Even when all classes of creditors accept the plan, the court may refuse to confirm it if it is not "in the best interests of the creditors." The plan can also be modified upon the request of the debtor, DIP, trustee, U.S. trustee, or holder of an unsecured claim. If an unsecured creditor objects to the plan, specific rules apply to the value of property to be distributed under the plan. Tax claims must be paid over a five-year period. Even if only one class of creditors has accepted the plan, the court may still confirm the plan under the Code's so-called cram-down provision. In other words, the court may confirm the plan over the objections of a class of creditors. Before the court can exercise this right of cram-down confirmation, it must be demonstrated that the plan is fair and equitable, and does not discriminate unfairly against any creditors.

Require Mortgage Insurance

One precaution is to require debtors to obtain private mortgage insurance if they do not make a down payment of at least 20 percent of the purchase price. For instance, if a borrower makes a down payment of only 5 percent of the purchase price, the creditor might require insurance covering 15 percent of the cost. Then, if the debtor defaults, the creditor repossesses the house and receives reimbursement from the insurer for the covered portion of the loan.

Filing the Plan

Only the debtor may file a plan within the first 120 days after the date of the order for relief. This period may be extended up to eighteen months from the date of the order for relief. If the debtor does not meet the 120-day deadline or obtain an extension, or if the debtor fails to obtain the required creditor consent (discussed below) within 180 days, any party may propose a plan. If a small-business debtor chooses to avoid a creditors' committee, the time for the debtor's filing is 180 days.

Exempted Personal Property

Personal property that is most often exempt under state law includes the following: 1.Household furniture up to a specified dollar amount. 2. Clothing and certain personal possessions, such as family pictures or a religious text. 3. A vehicle (or vehicles) for transportation (at least up to a specified dollar amount). 4. Certain classified animals, usually livestock but including pets. 5. Equipment that the debtor uses in a business or trade, such as tools or professional instruments, up to a specified dollar amount.

Exempted Real Property

Probably the most familiar real property exemption is the homestead exemption. Each state permits the debtor to retain the family home, either in its entirety or up to a specified dollar amount, free from the claims of unsecured creditors or trustees in bankruptcy.

The Bankruptcy Trustee

Promptly after the order for relief has been entered, a bankruptcy trustee is appointed. The basic duty of the trustee is to collect the debtor's available estate and reduce it to cash for distribution, preserving the interests of both the debtor and the unsecured creditors. This requires that the trustee be accountable for administering the debtor's estate. To enable the trustee to accomplish this duty, the Code gives the trustee certain powers, stated in both general and specific terms. These powers must be exercised within two years of the order for relief.

Preferences to Insiders

Sometimes, the creditor receiving the preference is an insider. An insider is any individual, partner, partnership, or officer or director of a corporation (or a relative of one of these) who has a close relationship with the debtor. In this situation, the avoidance power of the trustee is extended to transfers made within one year before filing. (If the transfer was fraudulent, as will be discussed shortly, the trustee can avoid transfers made within two years before filing.) Note, however, that if the transfer occurred before the ninety-day period, the trustee is required to prove that the debtor was insolvent at the time it occurred or that the transfer was made to or for the benefit of an insider.

Good Faith Requirement

The Bankruptcy Code imposes the requirement of good faith on a debtor in both the filing of the petition and the filing of the plan. The Code does not define good faith, but if the circumstances as a whole indicate bad faith, a court can dismiss a debtor's Chapter 13 petition. Should a determination of good faith take into account whether a debtor includes Social Security income in the amount of disposable income to be dedicated to the payment of unsecured creditors under a Chapter 13 plan? That was the contention of the bankruptcy trustee in the following case.

Types of Bankruptcy Relief

The Bankruptcy Code is contained in Title 11 of the United States Code (U.S.C.) Note that a debtor (except for a municipality) need not be insolvent to file for bankruptcy relief under the Bankruptcy Code. Anyone obligated to a creditor can declare bankruptcy. 1.Chapter 7 provides for liquidation proceedings—that is, the selling of all nonexempt assets and the distribution of the proceeds to the debtor's creditors. 2. Chapter 11 governs reorganizations. 3.Chapter 12 (for family farmers and family fishermen) and Chapter 13 (for individuals) provide for adjustment of the debts of parties with regular income.

The Homestead Exemption

The Bankruptcy Code limits the amount that can be claimed under the homestead exemption in bankruptcy. In general, if the debtor acquired the home within three and one-half years preceding the date of filing, the maximum equity exempted is $155,675 even if state law would permit a higher amount. In addition, the state homestead exemption is available only if the debtor has lived in the state for two years before filing the petition. Furthermore, a debtor who has violated securities law, been convicted of a felony, or engaged in certain other intentional misconduct may not be permitted to claim the homestead exemption at all.

Exceptions to the Automatic Stay

The Code provides several exceptions to the automatic stay. Collection efforts can continue for domestic-support obligations, which include any debt owed to or recoverable by a spouse, a former spouse, a child of the debtor, that child's parent or guardian, or a governmental unit. In addition, proceedings against the debtor related to divorce, child custody or visitation, domestic violence, and support enforcement are not stayed. Also excepted are investigations by a securities regulatory agency and certain statutory liens for property taxes.

Distribution of Property

The Code provides specific rules for the distribution of the debtor's property to secured and unsecured creditors. If any amount remains after the priority classes of creditors have been satisfied, it is turned over to the debtor.

Content and Confirmation of the Plan

The content of a plan under Chapter 12 is basically the same as that of a Chapter 13 repayment plan (described below). The plan can be modified by the debtor but generally must be confirmed or denied within forty-five days of the filing of the plan. The plan must provide for payment of secured debts at the value of the collateral. If the secured debt exceeds the value of the collateral, the remaining debt is unsecured. For unsecured debtors, the plan must be confirmed if either the value of the property to be distributed under the plan equals the amount of the claim or the plan provides that all of the debtor's disposable income to be received in a three-year period (or longer, by court approval) will be applied to making payments. Completion of payments under the plan discharges all debts provided for by the plan.

Record the Mortgage

The creditor will record the mortgage with the appropriate office in the county where the property is located. Recording ensures that the creditor is officially on record as holding an interest in the property. In essence, recording a mortgage perfects the lender's security interest in the property (see Chapter 19). A lender that fails to record a mortgage could find itself in the position of an unsecured creditor.

The Length of the Plan

The length of the payment plan can be three or five years, depending on the debtor's family income. If the debtor's family income is less than the median family income in the relevant geographic area under the means test, the term of the proposed plan must be three years. The term may not exceed five years.

Automatic Stay

The moment a petition, either voluntary or involuntary, is filed, an automatic stay, or suspension, of almost all actions by creditors against the debtor or the debtor's property normally goes into effect. In other words, once a petition has been filed, creditors cannot contact the debtor by phone or mail or start any legal proceedings to recover debts or to repossess property. If a creditor knowingly violates the automatic stay (a willful violation), any injured party, including the debtor, is entitled to recover actual damages, costs, and attorneys' fees and may be entitled to punitive damages as well. Until the bankruptcy proceeding is closed or dismissed, the automatic stay prohibits a creditor from taking any act to collect, assess, or recover a claim against the debtor that arose before the filing of the petition.

Exceptions to Discharge

The most important claims that are not dischargeable under Chapter 7 include the following: 1. Claims for back taxes accruing within two years prior to bankruptcy. 2.Claims for amounts borrowed by the debtor to pay federal taxes or any nondischargeable taxes. 3.Claims against property or funds obtained by the debtor under false pretenses or by false misrepresentations. 4.Claims based on fraud or misuse of funds by the debtor or claims involving the debtor's embezzlement or larceny. 5.Domestic-support obligations and property settlements. 6.Claims for amounts due on a retirement loan account. 7.Claims based on willful or malicious conduct by the debtor toward another or the property of another. 8.Certain government fines and penalties. 9.Certain student loans, unless payment of the loans causes an undue hardship for the debtor and the debtor's dependents.

Discharge

The plan is binding on confirmation. The law provides, however, that confirmation of a plan does not discharge an individual debtor. For individual debtors, the plan must be completed before discharge will be granted, unless the court orders otherwise. For all other debtors, the court may order discharge at any time after the plan is confirmed. The debtor is given a reorganization discharge from all claims not protected under the plan. This discharge does not apply to any claims that would be denied discharge under liquidation.

Filing the Petition

The procedure for filing a family-farmer or family-fisherman bankruptcy plan is similar to the procedure for filing a repayment plan under Chapter 13, discussed in detail below. The debtor must file a plan not later than ninety days after the order for relief. The filing of the petition acts as an automatic stay against creditors' and co-obligors' actions against the estate. A farmer or fisherman who has already filed a reorganization or repayment plan may convert the plan to a Chapter 12 plan. The debtor may also convert a Chapter 12 plan to a liquidation plan

The General Rule

The purpose of the homestead exemption is to ensure that the debtor will retain some form of shelter.

Adjustable-Rate Mortgages

The rate of interest paid by the borrower changes periodically with an adjustable-rate mortgage (ARM). Typically, the initial interest rate for an ARM is set at a relatively low fixed rate for a specified period, such as a year or three years. After that time, the interest rate adjusts annually or by some other period, such as biannually or monthly. The interest rate adjustment is calculated by adding a certain number of percentage points (called the margin) to an index rate (one of various government interest rates). ARMs contractually shift the risk that the interest rate will change from the lender to the borrower. Borrowers will have lower initial payments if they are willing to assume the risk of interest rate changes.

Distribution to Secured Creditors

The rights of perfected secured creditors were discussed in Chapter 19. The Code requires that consumer-debtors file a statement of intention with respect to the secured collateral. They can choose to pay off the debt and redeem the collateral, claim it is exempt, reaffirm the debt and continue making payments, or surrender the property to the secured party. If the collateral is surrendered to the secured party, the secured creditor can enforce the security interest either by accepting the property in full satisfaction of the debt or by selling the collateral and using the proceeds to pay off the debt. Thus, the secured party has priority over unsecured parties as to the proceeds from the disposition of the collateral. Should the collateral be insufficient to cover the secured debt owed, the secured creditor becomes an unsecured creditor for the difference.

The Right of Reimbursement

The surety has a right of reimbursement from the debtor. Basically, the surety is entitled to receive from the debtor all outlays made on behalf of the suretyship arrangement. Such outlays can include expenses incurred as well as the actual amount of the debt paid to the creditor.

The Right of Subrogation

The surety has the legal right of subrogation, which means that any right the creditor had against the debtor now becomes the right of the surety. Included are creditor rights in bankruptcy, rights to collateral possessed by the creditor, and rights to judgments secured by the creditor. In short, the surety stands in the shoes of the creditor and may pursue any remedies that were available to the creditor against the debtor.

Trustee's Powers

The trustee has the power to require persons holding the debtor's property at the time the petition is filed to deliver the property to the trustee. To enable the trustee to implement this power, the Code provides that the trustee has rights equivalent to those of certain other parties, such as a creditor who has a judicial lien. The power of a trustee to assume the status of a lien creditor is known as the strong-arm power. In addition, the trustee has specific powers of avoidance—that is, the trustee can set aside (avoid) a sale or other transfer of the debtor's property, taking it back as a part of the debtor's estate. The trustee's powers of avoidance extend to any voidable rights available to the debtor, preferences, and fraudulent transfers by the debtor. Each of these is discussed in more detail shortly. A trustee can also avoid certain statutory liens (creditors' claims against the debtor's property). The debtor shares most of the trustee's avoidance powers. Thus, if the trustee does not take action to enforce one of these rights, the debtor in a liquidation bankruptcy can enforce it.

Duties for Means Testing

The trustee is required to review promptly all materials filed by the debtor to determine if there is substantial abuse. Within ten days after the first meeting of the creditors (discussed shortly), the trustee must file a statement as to whether the case is presumed to be an abuse under the means test. The trustee must provide all creditors with a copy of this statement. When there is a presumption of abuse, the trustee must either file a motion to dismiss the petition (or convert it to a Chapter 13 case) or file a statement setting forth the reasons why the motion would not be appropriate.

Exemptions

The trustee takes control over the debtor's property, but an individual debtor is entitled to exempt certain property from the bankruptcy. The Code exempts the following property: 1.Up to $22,975 in equity in the debtor's residence and burial plot (the homestead exemption). 2.Interest in a motor vehicle up to $3,675. 3.Interest, up to $550 for a particular item, in household goods and furnishings, wearing apparel, appliances, books, animals, crops, and musical instruments (the aggregate total of all items is limited to $12,250). 4.Interest in jewelry up to $1,550. 5.Interest in any other property up to $1,225, plus any unused part of the $22,975 homestead exemption up to $11,500. 6.Interest in any tools of the debtor's trade up to $2,300. 7.A life insurance contract owned by the debtor (other than a credit life insurance contract). 8.Certain interests in accrued dividends and interest under life insurance contracts owned by the debtor, not to exceed $12,250. 9.Professionally prescribed health aids. 10.The right to receive Social Security and certain welfare benefits, alimony and support, certain retirement funds and pensions, and education savings accounts held for specific periods of time. 11.The right to receive certain personal-injury and other awards up to $22,975. Individual states have the power to pass legislation precluding debtors from using the federal exemptions within the state. A majority of the states have done this. In those states, debtors may use only state, not federal, exemptions. In the rest of the states, an individual debtor (or a husband and wife filing jointly) may choose either the exemptions provided under state law or the federal exemptions.

Chapter 11—Reorganization

The type of bankruptcy proceeding used most commonly by corporate debtors is the Chapter 11 reorganization. In a reorganization, the creditors and the debtor formulate a plan under which the debtor pays a portion of its debts and the rest of the debts are discharged. The debtor is allowed to continue in business. Although this type of bankruptcy is generally a corporate reorganization, any debtors who are eligible for Chapter 7 relief (including individuals but excluding stockbrokers and commodities brokers) are eligible for relief under Chapter 11. In 1994, Congress established a "fast-track" Chapter 11 procedure for small-business debtors whose liabilities do not exceed $2.19 million and who do not own or manage real estate. The fast track enables a debtor to avoid the appointment of a creditors' committee and also shortens the filing periods and relaxes certain other requirements. Because the process is shorter and simpler, it is less costly. The same principles that govern the filing of a liquidation (Chapter 7) petition apply to reorganization (Chapter 11) proceedings. The case may be brought either voluntarily or involuntarily. The automatic-stay provision and its exceptions apply in reorganizations as well, as do the provisions regarding substantial abuse and additional grounds for dismissal (or conversion) of bankruptcy petitions.

Chapter 7 Schedules

The voluntary petition contains the following schedules: 1. A list of both secured and unsecured creditors, their addresses, and the amount of debt owed to each. 2.A statement of the financial affairs of the debtor. 3.A list of all property owned by the debtor, including property claimed by the debtor to be exempt 4.A list of current income and expenses. 5.A certificate of credit counseling (as discussed previously). 6.Proof of payments received from employers within sixty days prior to the filing of the petition. 7.A statement of the amount of monthly income, itemized to show how the amount is calculated. 8.A copy of the debtor's federal income tax return for the most recent year ending immediately before the filing of the petition. The official forms must be completed accurately, sworn to under oath, and signed by the debtor. To conceal assets or knowingly supply false information on these schedules is a crime under the bankruptcy laws With the exception of tax returns, failure to file the required schedules within forty-five days after the filing of the petition (unless an extension is granted) will result in an automatic dismissal of the petition. The debtor has up to seven days before the date of the first creditors' meeting to provide a copy of the most recent tax returns to the trustee.

Ways to Avoid Foreclosure

There are several possible methods of avoiding foreclosure. If the borrower might be able to make payments in the future, the lender may grant a forbearance, which is a postponement of part or all of the payments on a loan for a limited time. This option works well when the debtor can solve the problem by securing a new job, selling the property, or finding another acceptable solution. The borrower and the lender may also enter into a workout agreement—a contract that describes their respective rights and responsibilities as they try to resolve the default without proceeding to foreclosure. Usually, the lender agrees to delay seeking foreclosure in exchange for the borrower providing additional financial information that might be used to modify the mortgage. When a borrower is unable to make mortgage payments, a lender may agree to a short sale—that is, a sale of the property for less than the balance due on the mortgage loan. The borrower must obtain the lender's permission for the short sale and typically has to show some hardship, such as the loss of a job or a divorce. The lender receives the proceeds of the sale, and the borrower still owes the balance of the debt to the lender, unless the lender specifically agrees to forgive the remaining debt. A short sale avoids foreclosure proceedings and avoids the eviction of the homeowner, but it can take longer than a standard real estate transaction.

Procedures

To be enforceable, reaffirmation agreements must be made before the debtor is granted a discharge. The agreement must be signed and filed with the court. Court approval is required unless the debtor is represented by an attorney during the negotiation of the reaffirmation agreement and submits the proper documents and certifications. Even when the debtor is represented by an attorney, court approval may be required if it appears that the reaffirmation will result in undue hardship to the debtor. When court approval is required, a separate hearing will take place. The court will approve the reaffirmation only if it finds that the agreement will not result in undue hardship to the debtor and that the reaffirmation is consistent with the debtor's best interests.

Voluntary Bankruptcy

To bring a voluntary petition in bankruptcy, the debtor files official forms designated for that purpose in the bankruptcy court. The law requires that before debtors can file a petition, they must receive credit counseling from an approved nonprofit agency within the 180-day period preceding the date of filing. Debtors filing a Chapter 7 petition must include a certificate proving that they have received individual or group counseling from an approved agency within the last 180 days (roughly six months). A consumer-debtor who is filing a liquidation bankruptcy must confirm the accuracy of the petition's contents. The debtor must also state in the petition, at the time of filing, that he or she understands the relief available under other chapters of the Code and has chosen to proceed under Chapter 7. Attorneys representing consumer-debtors must file an affidavit stating that they have informed the debtors of the relief available under each chapter of the Code. In addition, the attorneys must reasonably attempt to verify the accuracy of the consumer-debtors' petitions and schedules (described below). Failure to do so is considered perjury.

Required Disclosures

To discourage creditors from engaging in abusive reaffirmation practices, the law provides specific language for disclosures that must be given to debtors entering reaffirmation agreements. Among other things, these disclosures explain that the debtor is not required to reaffirm any debt, but that liens on secured property, such as mortgages and cars, will remain in effect even if the debt is not reaffirmed. The reaffirmation agreement must disclose the amount of the debt reaffirmed, the rate of interest, the date payments begin, and the right to rescind. The disclosures also caution the debtor: "Only agree to reaffirm a debt if it is in your best interest. Be sure you can afford the payments you agree to make." The original disclosure documents must be signed by the debtor, certified by the debtor's attorney, and filed with the court at the same time as the reaffirmation agreement. A reaffirmation agreement that is not accompanied by the original signed disclosures will not be effective.

The Right of Contribution

Two or more sureties are called co-sureties. When one co-surety pays more than her or his proportionate share on a debtor's default, she or he is entitled to recover from the other co-sureties the amount paid above that surety's obligation. This is the right of contribution. Generally, a co-surety's liability either is determined by agreement between the co-sureties or, in the absence of an agreement, is specified in the suretyship contract itself.

Rights of the Surety and the Guarantor

Usually, when the surety pays the debt owed to the creditor, the surety is entitled to certain rights.

Artisan's Lien

When a debtor fails to pay for labor and materials furnished for the repair or improvement of personal property, a creditor can recover payment through an artisan's lien. In contrast to a mechanic's lien, an artisan's lien is possessory. The lienholder ordinarily must have retained possession of the property and have expressly or impliedly agreed to provide the services on a cash, not a credit, basis. The lien remains in existence as long as the lienholder maintains possession of the property, and the lien is terminated once possession is voluntarily surrendered—unless the surrender is only temporary. Selena leaves her diamond ring at the jeweler's to be repaired and to have her initials engraved on the band. In the absence of an agreement, the jeweler can keep the ring until Selena pays for the services. Should Selena fail to pay, the jeweler has a lien on Selena's ring for the amount of the bill and normally can sell the ring in satisfaction of the lien. Modern statutes permit the holder of an artisan's lien to foreclose and sell the property subject to the lien to satisfy payment of the debt. As with a mechanic's lien, the holder of an artisan's lien must give notice to the owner of the property prior to foreclosure and sale. The sale proceeds are used to pay the debt and the costs of the legal proceedings, and the surplus, if any, is paid to the former owner.

Mechanic's Lien

When a person contracts for labor, services, or materials to be furnished for the purpose of making improvements on real property but does not immediately pay for the improvements, the creditor can file a mechanic's lien on the property. This creates a special type of debtor-creditor relationship in which the real estate itself becomes security for the debt—that is, the property can be taken and held to guarantee payment of the debt, or it can be sold through foreclosure proceedings to effect actual payment. (Foreclosure is a process by which a creditor deprives a debtor of property.) State law governs the procedures that must be followed to create a mechanic's lien. Generally, the lienholder must file a written notice of lien against the property involved. The notice must be filed within a specific time period, normally 60 to 120 days from the last date on which materials or labor were provided. If the property owner fails to pay the debt, the lienholder is entitled to foreclose on the real estate for which the work or materials were provided and to sell it to satisfy the amount of the debt. Notice of the foreclosure and sale must be given to the debtor in advance.

Suretyship and Guaranty

When a third person promises to pay a debt owed by another in the event the debtor does not pay, either a suretyship or a guaranty relationship is created. The third person's income and assets become the security for the debt owed. Suretyship and guaranty provide creditors with the right to seek payment from the third party if the primary debtor defaults on her or his obligations. At common law, there were significant differences in the liability of a surety and a guarantor, as discussed in the following subsections. Today, however, the distinctions outlined here have been abolished in some states.

Creditor Protection

When creditors extend mortgages, they are advancing a significant amount of funds for a number of years. Consequently, creditors take a number of steps to protect their interest, including the following: Require Mortgage Insurance Record the Mortgage Include Contract Provisions Mortgage Foreclosure

Mortgages

When individuals purchase real property, they typically borrow from a financial institution part or all of the funds needed to pay the purchase price A mortgage is a written instrument that gives the creditor an interest in, or lien on, the debtor's real property as security for payment of a debt. The creditor is the mortgagee, and the debtor is the mortgagor. Typically, as part of the mortgage loan, borrowers make a down payment—that is, the part of the purchase price that is paid up front in cash. Lenders offer various types of mortgages to meet the needs of different borrowers, but a basic distinction is whether the interest rate is fixed or variable.

Guaranty

With a suretyship arrangement, the surety is primarily liable for the debtor's obligation. With a guaranty arrangement, the guarantor—the third person making the guaranty—is secondarily liable.

Creditors' Meeting and Claims

Within a reasonable time after the order of relief has been granted (not more than forty days), the trustee must call a meeting of the creditors listed in the schedules filed by the debtor. The bankruptcy judge does not attend this meeting, but the debtor must attend and submit to an examination under oath. At the meeting, the trustee ensures that the debtor is aware of the potential consequences of bankruptcy and the possibility of filing under a different chapter of the Code. To be entitled to receive a portion of the debtor's estate, each creditor normally files a proof of claim with the bankruptcy court clerk within ninety days of the creditors' meeting. The proof of claim lists the creditor's name and address, as well as the amount that the creditor asserts is owed to the creditor by the debtor. In a bankruptcy case in which the debtor has no assets (called a "no-asset case"), creditors are notified of the debtor's petition for bankruptcy but are instructed not to file a claim. In no-asset cases, the unsecured creditors will receive no payment, and most, if not all, of these debts will be discharged.