19.2 Bankruptcy Law: Liquidation (Ch. 7), Reorganization (Ch. 11) & Wage Earner (Ch. 13)

19.2 Bankruptcy Law: Liquidation (Ch. 7), Reorganization (Ch. 11) & Wage Earner (Ch. 13)

[!NOTE] NALS PP Exam Blueprint Focus: Bankruptcy law represents a vital component of substantive civil practice on the NALS Professional Paralegal (PP) Certification Exam. Paralegals in bankruptcy and creditor-debtor practices must master the constitutional foundation of Title 11, distinguish the jurisdictional boundaries of Article I Bankruptcy Courts (core vs. non-core proceedings), calculate Means Test eligibility under BAPCPA, navigate the operational differences between Chapter 7, Chapter 11, and Chapter 13, enforce the Automatic Stay (§ 362) and handle motions for relief from stay, track bankruptcy estate property (§ 541) and statutory exemptions (§ 522), calculate claim distributions under the § 507 priority waterfall, prosecute or defend avoidance actions (preferences under § 547 and fraudulent transfers under § 548), and evaluate debt dischargeability under § 523 vs. general denial of discharge under § 727.

Bankruptcy law provides a structured federal mechanism to grant honest individual debtors a financial "fresh start" by discharging unmanageable liabilities, while ensuring an orderly, equitable distribution of the debtor's non-exempt assets among competing creditors.

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Constitutional Foundation & Federal Bankruptcy Courts

Under Article I, Section 8, Clause 4 of the United States Constitution, Congress is granted the explicit power "To establish ... uniform Laws on the subject of Bankruptcies throughout the United States." Federal bankruptcy legislation completely preempts state insolvency statutes that attempt to discharge debts.

1. Title 11 of the United States Code (The Bankruptcy Code)

The substantive and procedural rules governing bankruptcy are codified in Title 11 of the United States Code (11 U.S.C. §§ 101–1532). The Bankruptcy Code is organized into structural and operative chapters:

• Universal Chapters (Chapters 1, 3, 5): Apply generally across all substantive bankruptcy proceedings (unless specifically excepted):
  • Chapter 1: General provisions, statutory definitions (§ 101), and debtor eligibility rules (§ 109).
  • Chapter 3: Case administration, filing mechanisms, the Automatic Stay (§ 362), meeting of creditors (§ 341), and bankruptcy estate management.
  • Chapter 5: Creditors and claims (§§ 501–510), debtor duties and exemptions (§ 522), avoidance powers (§§ 544–550), and dischargeability (§ 523).
• Operative Relief Chapters (Chapters 7, 9, 11, 12, 13, 15):
  • Chapter 7: Liquidation of individual and business debtors.
  • Chapter 9: Adjustment of debts of municipalities.
  • Chapter 11: Reorganization for businesses and high-debt individuals (including Subchapter V for small businesses).
  • Chapter 12: Adjustment of debts of family farmers and fishermen.
  • Chapter 13: Adjustment of debts of individuals with regular income (wage earner repayment plans).
  • Chapter 15: Ancillary and cross-border insolvency cases.

2. Bankruptcy Court Structure: Core vs. Non-Core Proceedings

Federal bankruptcy courts are established as Article I units of the United States District Court under 28 U.S.C. § 151. Bankruptcy judges are appointed by the regional U.S. Court of Appeals for renewable 14-year terms. Under 28 U.S.C. § 157, bankruptcy court jurisdiction is strictly bifurcated into core and non-core matters:

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|                         Bankruptcy Court Jurisdiction (28 U.S.C. § 157)                           |
+---------------------------------------------------------------------------------------------------+
| Core Proceedings (28 U.S.C. § 157(b))              | Non-Core Proceedings (28 U.S.C. § 157(c))    |
+----------------------------------------------------+----------------------------------------------+
| - Arise under Title 11 or arise in a Title 11 case | - Related-to proceedings (matters that could |
| - Claim allowance/disallowance                     |   conceivably impact the bankruptcy estate)  |
| - Automatic stay relief motions                    | - State law contract breach or tort actions  |
| - Avoidance of preferences and fraudulent transfers|   against third parties                      |
| - Plan confirmations (Ch. 11 / Ch. 13)             | - Final orders entered ONLY with express     |
| - Determinations of debt dischargeability          |   consent of all parties; otherwise, judge   |
| - Bankruptcy judge enters FINAL ORDERS & JUDGMENTS |   submits PROPOSED FINDINGS to District Court|
+---------------------------------------------------------------------------------------------------+

Under Northern Pipeline Construction Co. v. Marathon Pipe Line Co. (1982) and Stern v. Marshall, 564 U.S. 462 (2011), the Supreme Court held that Article I bankruptcy judges lack constitutional authority under Article III to enter final judgments on state law counterclaims or non-core claims that do not stem from the bankruptcy itself or would not be resolved in the process of ruling on a creditor's proof of claim, absent voluntary party consent.

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The Core Bankruptcy Chapters Compared

The vast majority of bankruptcy filings occur under Chapter 7, Chapter 11, or Chapter 13. Paralegals must understand the distinct operational characteristics, eligibility mandates, and procedural lifecycles of each.

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|                             Comparison of Core Bankruptcy Chapters                                |
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| Feature             | Chapter 7 (Liquidation)    | Chapter 11 (Reorganization)| Chapter 13 (Wage Earner)  |
+---------------------+----------------------------+----------------------------+-------------------+
| Eligible Debtors    | Individuals, partnerships, | Corporations, LLCs,        | Individuals only with     |
|                     | corporations (§ 109(b)).   | partnerships, individuals. | regular income & debt cap.|
+---------------------+----------------------------+----------------------------+-------------------+
| Fiduciary in Charge | Private Panel Trustee      | Debtor-in-Possession (DIP) | Debtor retains assets;    |
|                     | gathers & liquidates assets| operates business.         | Standing Trustee collects.|
+---------------------+----------------------------+----------------------------+-------------------+
| Asset Disposition   | Non-exempt assets sold     | Assets retained; business  | All assets retained; plan |
|                     | for cash distribution.     | restructured under plan.   | funded by future income.  |
+---------------------+----------------------------+----------------------------+-------------------+
| Repayment Timeline  | None; immediate liquidation| Multi-year plan approved   | 3 to 5 years funded by    |
|                     | and case closure.          | by voting classes.         | disposable income.        |
+---------------------+----------------------------+----------------------------+-------------------+
| Discharge Scope     | Individual debts discharged| Discharge upon plan        | Broader discharge upon    |
|                     | NO corporate discharge.    | confirmation/completion.   | completing plan payments. |
+---------------------------------------------------------------------------------------------------+

1. Chapter 7: Liquidation (Straight Bankruptcy)

In a Chapter 7 proceeding, the debtor surrenders all non-exempt property to a court-appointed private Chapter 7 Panel Trustee, who liquidates the property and distributes the cash proceeds to creditors in accordance with statutory priorities.

• The BAPCPA Means Test (11 U.S.C. § 707(b)): Enacted under the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) to prevent consumer debtors with sufficient income from discharging debts in Chapter 7:
  • Step 1 (Median Income Comparison): The debtor calculates Current Monthly Income (CMI)—the average gross monthly income received from all sources during the 6 full calendar months preceding filing (multiplied by 12). If the debtor's annualized CMI is at or below the state median family income for their household size, the debtor automatically passes the Means Test and is eligible for Chapter 7.
  • Step 2 (Deduction of Allowable Expenses): If annualized CMI exceeds the state median, the debtor must calculate allowable monthly living expenses utilizing IRS National and Local Expense Standards, actual secured debt payments, and priority claims. Subtracting these allowable expenses from CMI yields the debtor's monthly disposable income.
  • Presumption of Abuse: If the debtor's projected 60-month disposable income exceeds statutory dollar thresholds, a rebuttable presumption of abuse arises. The case will be dismissed or, with the debtor's consent, converted to a Chapter 13 repayment plan unless the debtor proves "special circumstances" (e.g., serious medical illness or active military service).
• Entity Discharge Rule (11 U.S.C. § 727(a)(1)): Under Section 727(a)(1), only individuals receive a Chapter 7 discharge. Corporations, partnerships, and LLCs do not receive a discharge; their assets are simply liquidated, and the entity becomes an empty, defunct shell. This prevents businesses from liquidating under Chapter 7 to evade environmental or successor liabilities and reopening under a clean corporate shell.

2. Chapter 11: Reorganization

Chapter 11 allows distressed businesses (and high-debt individuals who exceed Chapter 13 debt limits) to reorganize their financial affairs, restructure debt, reject burdensome contracts, and emerge as a viable ongoing enterprise.

• Debtor-in-Possession (DIP): Under 11 U.S.C. §§ 1107 and 1108, the debtor's management generally remains in control of the business as a Debtor-in-Possession (DIP). The DIP exercises the statutory rights and powers of a bankruptcy trustee, owing fiduciary duties to the bankruptcy estate and creditors. A Chapter 11 trustee is appointed only for cause (fraud, dishonesty, gross incompetence).
• Official Committee of Unsecured Creditors (11 U.S.C. § 1102): The United States Trustee appoints an official committee, ordinarily comprised of the 7 largest unsecured creditors willing to serve. The committee retains professionals (attorneys and financial advisors paid by the estate) to investigate DIP operations and participate in formulating the reorganization plan.
• Disclosure Statement & Plan Formulation:
  • Disclosure Statement (§ 1125): The plan proponent must draft and submit a Disclosure Statement containing "adequate information" enabling a reasonable investor to make an informed judgment on the plan. The court must approve the disclosure statement after notice and a hearing before the proponent can solicit creditor votes.
  • Classification of Claims (§ 1122): The Plan of Reorganization must place substantially similar claims into designated classes (e.g., secured lenders, priority tax claims, general unsecured trade vendors, equity holders).
• Voting & Confirmation Standards (§ 1129):
  • Class Voting (§ 1126(c)): An impaired class of claims accepts the plan if approved by creditors holding at least two-thirds (2/3) in dollar amount and more than one-half (1/2) in total number of allowed claims voting.
  • Best Interests of Creditors Test (§ 1129(a)(7)): Every dissenting creditor in every class must receive at least as much value under the Chapter 11 plan as they would receive if the debtor were liquidated under Chapter 7.
  • The "Cramdown" Power & Absolute Priority Rule (§ 1129(b)): If at least one impaired class of non-insider claims votes to accept the plan, the court can confirm the plan over the objection of dissenting classes (a cramdown), provided the plan does not discriminate unfairly and is "fair and equitable." Under the Absolute Priority Rule, a plan is fair and equitable to a dissenting unsecured class only if senior classes are paid in full before junior classes receive or retain any property under the plan. Crucially, existing equity holders (stockholders, LLC members) cannot retain any ownership interest unless all senior dissenting classes are paid 100% of their claims.
• Subchapter V (Small Business Reorganization): Enacted under the Small Business Reorganization Act (SBRA) for small businesses with aggregate debts under statutory limits. Subchapter V eliminates the creditors' committee, removes the absolute priority rule for cramdown, appoints a standing facilitating trustee, and reduces administrative overhead.

3. Chapter 13: Wage Earner Individual Debt Adjustment

Chapter 13 is designed exclusively for individual wage earners with regular, stable income whose debts fall within statutory debt limits under 11 U.S.C. § 109(e).

• Asset Retention: The debtor retains all real and personal property; there is no asset liquidation.
• The Repayment Plan: The debtor files a repayment plan committing all projected disposable income to fund monthly payments to a court-appointed Standing Chapter 13 Trustee for distribution to creditors:
  • Plan Duration: 3 years (36 months) if the debtor's CMI is below the state median; 5 years (60 months) if CMI is above the state median (the plan cannot exceed 60 months under § 1322(d)).
• Curing Mortgage Arrearages: A unique feature of Chapter 13 is the power under § 1322(b)(5) to de-accelerate and cure pre-petition residential mortgage defaults (arrearages) over the 3- to 5-year life of the plan while maintaining regular ongoing monthly mortgage payments, thereby stopping residential foreclosure.
• Chapter 13 Discharge (§ 1328(a)): Granted upon completion of all plan payments. The Chapter 13 discharge is historically termed a "super discharge" because it extinguishes certain debts that cannot be discharged in Chapter 7 (e.g., non-support divorce property settlements under § 523(a)(15), debts for willful and malicious injury to property, and government fines).

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The Automatic Stay (11 U.S.C. § 362)

The filing of a voluntary or involuntary bankruptcy petition immediately triggers the Automatic Stay under 11 U.S.C. § 362. The stay operates as a self-executing, nationwide statutory injunction that automatically freezes all creditor collection efforts without the necessity of any judicial hearing or court order.

1. Scope of the Stay

Under § 362(a), the stay halts:

• The commencement or continuation of judicial, administrative, or other proceedings against the debtor to recover a pre-petition claim;
• The enforcement of pre-petition judgments against the debtor or estate property;
• Any act to obtain possession of, or exercise control over, property of the estate;
• Any act to create, perfect, or enforce any lien against property of the estate;
• Collection efforts, including phone calls, collection letters, wage garnishments, bank levies, repossessions, and foreclosure sales; and
• Setoff of any pre-petition debt owing to the debtor.

2. Statutory Exceptions to the Automatic Stay

Under § 362(b), the stay does not halt:

• Commencement or continuation of criminal proceedings against the debtor;
• Proceedings to establish paternity, establish or modify child support/alimony, or collect domestic support obligations (DSOs) from non-estate property;
• The enforcement of police and regulatory powers by governmental units (e.g., environmental enforcement actions, public health injunctions);
• Audits, notices of tax deficiency, and demands for tax returns by taxing authorities.

3. Relief from the Automatic Stay

Creditors may file a formal Motion for Relief from the Automatic Stay under 11 U.S.C. § 362(d). The court must grant relief:

1. For Cause (§ 362(d)(1)): Including the lack of adequate protection of a secured creditor's interest in collateral (e.g., declining property value, failure to maintain insurance, unpaid property taxes);
2. Act Against Property (§ 362(d)(2)): If the court finds: (A) the debtor has no equity in the collateral (the debt exceeds the property's market value); and (B) the property is not necessary to an effective reorganization (readily shown in Chapter 7 liquidations or commercial single-asset cases without business operations).

4. Sanctions for Willful Violations (11 U.S.C. § 362(k))

Actions taken in violation of the automatic stay are generally void ab initio. Under Section 362(k), an individual injured by any willful violation of the stay shall recover actual damages, including court costs and reasonable attorneys' fees, and, in appropriate circumstances involving malicious or reckless conduct, may recover punitive damages.

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The Bankruptcy Estate & Debtor Exemptions

1. Creation & Composition of the Estate (11 U.S.C. § 541)

The filing of a petition creates a separate legal entity: the Bankruptcy Estate. Under Section 541, the estate encompasses all legal or equitable interests of the debtor in property, wherever located and by whomever held, as of the commencement of the case.

[!IMPORTANT] The 180-Day Clawback Rule (11 U.S.C. § 541(a)(5)): Property acquired by the debtor after filing is generally excluded from the Chapter 7 estate. However, under Section 541(a)(5), any property the debtor becomes entitled to acquire within 180 days after the petition date through:

1. Bequest, devise, or inheritance;
2. Property settlement agreement with a spouse or interlocutory/final divorce decree; or
3. Life insurance policy proceeds or death benefit plan; automatically becomes property of the bankruptcy estate and must be reported immediately to the trustee.

Exclusion of ERISA Retirement Accounts: Under Patterson v. Shumate, 504 U.S. 753 (1992) and 11 U.S.C. § 541(c)(2), ERISA-qualified retirement plans (such as 401(k) plans, defined benefit pensions, and 403(b) accounts) containing anti-alienation provisions are completely excluded from property of the bankruptcy estate.

2. Debtor Exemptions (11 U.S.C. § 522)

Exemptions allow individual debtors to protect specific items of property from trustee liquidation and creditor claims, preserving the physical foundation for a fresh start.

• Federal Exemptions vs. State Opt-Out (§ 522(b)): Section 522(d) sets forth federal statutory exemptions (homestead, motor vehicle, household furnishings, jewelry, tools of the trade, and a "wildcard" exemption). However, under § 522(b), states possess the statutory power to opt out of the federal exemption scheme. In opt-out states, debtors are legally prohibited from using federal exemptions and must utilize their state's statutory exemption laws.
• Domicile Rules for Exemptions: Under BAPCPA, to prevent "forum shopping" (moving to a state with an unlimited homestead exemption, like Florida or Texas, right before filing), a debtor must have been domiciled in the filing state for at least 730 days (2 years) prior to filing to claim that state's exemptions. If not domiciled for 730 days, the debtor must use the exemptions of the state where they lived for the majority of the 180-day period preceding the 730 days.

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Claims Hierarchy & Distribution Waterfall

To participate in bankruptcy distributions, creditors must file a formal Proof of Claim (Official Form 410) prior to the bar date. The trustee evaluates claims and distributes estate funds in strict statutory accordance with the Claims Priority Waterfall:

+---------------------------------------------------------------------------------------------------+
|                         Bankruptcy Claims Priority Distribution Waterfall                         |
+---------------------------------------------------------------------------------------------------+
| 1. SECURED CLAIMS (11 U.S.C. § 506)                                                               |
|    Paid up to the value of collateral; bifurcated into secured and general unsecured deficiency.  |
|                                                 │                                                 |
|                                                 ▼                                                 |
| 2. PRIORITY UNSECURED CLAIMS (11 U.S.C. § 507)                                                    |
|    Paid in strict statutory numerical order; each rank must be satisfied in full before next:     |
|    • First (§ 507(a)(1)): Domestic Support Obligations (child support and alimony)                |
|    • Second (§ 507(a)(2)): Administrative Expenses (§ 503(b): trustee fees, attorney fees)        |
|    • Third (§ 507(a)(3)): Involuntary gap claims (incurred between petition and order for relief)  |
|    • Fourth (§ 507(a)(4)): Unpaid employee wages/salaries earned within 180 days (statutory cap)  |
|    • Fifth (§ 507(a)(5)): Unpaid employee benefit plan contributions                              |
|    • Sixth (§ 507(a)(6)): Claims of grain producers and fishermen                                 |
|    • Seventh (§ 507(a)(7)): Consumer deposits for undelivered retail goods/services               |
|    • Eighth (§ 507(a)(8)): Taxes and governmental customs duties                                  |
|                                                 │                                                 |
|                                                 ▼                                                 |
| 3. GENERAL UNSECURED CLAIMS                                                                       |
|    Credit cards, medical bills, trade debt, deficiency claims. Paid pro-rata from remaining cash. |
|                                                 │                                                 |
|                                                 ▼                                                 |
| 4. SUBORDINATED CLAIMS & EQUITY HOLDERS                                                           |
|    Fines, penalties, and equity security holders (shareholders, partners).                        |
+---------------------------------------------------------------------------------------------------+

Bifurcation of Undersecured Claims (11 U.S.C. § 506(a))

Under Section 506(a), an allowed claim of a creditor secured by a lien on property is an allowed secured claim to the extent of the fair market value of the collateral, and is an allowed unsecured claim for any remaining deficiency balance.

• Example: A lender holds a mortgage securing a $400,000 promissory note on real property valued at $300,000. Under § 506(a), the lender holds a secured claim of $300,000 and a general unsecured deficiency claim of $100,000.

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Trustee Avoidance Powers & Dischargeability

The bankruptcy trustee serves as the fiduciary of the estate and is armed with extraordinary statutory avoidance powers to recover assets transferred prior to filing, preventing debtor favoritism and clawing back fraudulent conveyances.

1. Preferential Transfers (11 U.S.C. § 547)

A preference is a pre-petition transfer of the debtor's property to a favored creditor that unfairly elevates that creditor over others. Under Section 547(b), the trustee can avoid and claw back any transfer of an interest of the debtor in property that satisfies all six statutory elements:

1. To or for the benefit of a creditor;
2. For or on account of an antecedent (pre-existing) debt owed before the transfer was made;
3. Made while the debtor was insolvent (debtor is statutorily presumed insolvent during the 90 days before filing);
4. Made on or within 90 days before the petition date (extended to one (1) year before filing if the creditor was an "insider"—such as a relative, general partner, director, or controlling officer);
5. That enables the creditor to receive more than it would receive in a hypothetical Chapter 7 liquidation if the transfer had not been made.

Statutory Defenses to Preference Actions (11 U.S.C. § 547(c))

A creditor can defeat a preference action by proving one of the statutory safe harbors:

• Contemporaneous Exchange for New Value (§ 547(c)(1)): The transfer was intended by both parties to be a contemporaneous exchange for new value given to the debtor, and in fact was substantially contemporaneous (e.g., paying cash upon delivery of goods).
• Ordinary Course of Business (§ 547(c)(2)): The debt was incurred in the ordinary course of business, and payment was made either: (A) in the ordinary course of business between the debtor and creditor (matching historical payment timing); or (B) according to ordinary business terms in the relevant industry.
• Subsequent New Value (§ 547(c)(4)): After receiving the payment, the creditor provided new, unsecured value (goods or services) to the debtor that remained unpaid.

2. Fraudulent Transfers (11 U.S.C. § 548 & § 544(b))

The trustee may avoid two types of fraudulent transfers made within 2 years before the petition date under federal law:

1. Actual Fraud (11 U.S.C. § 548(a)(1)(A)): Transfers made with actual intent to hinder, delay, or defraud any past or future creditor. Proven by circumstantial "badges of fraud" (transfer to an insider, retention of possession/control, concealment, transfer of substantially all assets, or debtor absconding).
2. Constructive Fraud (11 U.S.C. § 548(a)(1)(B)): The debtor received less than a reasonably equivalent value in exchange for the transfer, and the debtor was either: (a) insolvent on the date of transfer or rendered insolvent thereby; (b) engaged in business with unreasonably small capital; or (c) intended to incur debts beyond their ability to pay as they matured.

• State Law Reach-Back (§ 544(b)): Under the "strong-arm clause," the trustee can step into the shoes of an actual unsecured creditor and utilize state fraudulent transfer statutes (the Uniform Voidable Transactions Act [UVTA]), which typically provide a 4- to 6-year lookback period.

3. Non-Dischargeable Debts (11 U.S.C. § 523) vs. Denial of Discharge (§ 727)

Paralegals must distinguish between an objection to the discharge of a specific individual debt under Section 523 and a total denial of general discharge under Section 727:

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|                         Dischargeability under 11 U.S.C. § 523 vs. § 727                          |
+---------------------------------------------------------------------------------------------------+
| Specific Debt Non-Dischargeable (11 U.S.C. § 523)  | General Denial of Discharge (11 U.S.C. § 727)|
+----------------------------------------------------+----------------------------------------------+
| - Debtor receives general discharge, BUT specific  | - Debtor is DENIED a discharge entirely.     |
|   identified debts survive intact.                 | - Debtor remains personally liable for 100%  |
| - § 523(a)(1): Recent income/employment taxes.     |   of all pre-petition debts.                 |
| - § 523(a)(2): Money/property obtained by fraud.   | - Grounds:                                   |
| - § 523(a)(4): Embezzlement, larceny, fiduciary    |   • Fraudulent concealment/transfer of estate|
|   defalcation.                                     |     assets within 1 year before filing.      |
| - § 523(a)(5): Domestic Support Obligations (DSOs).|   • Concealing, destroying, or falsifying    |
| - § 523(a)(6): Willful and malicious injury.       |     business/financial records.              |
| - § 523(a)(8): Student loans (absent Brunner undue |   • Making a false oath or account.          |
|   hardship).                                       |   • Failure to satisfactorily explain loss   |
| - § 523(a)(9): Death/personal injury from DUI.     |     of assets.                               |
+---------------------------------------------------------------------------------------------------+