Module 30: Bankruptcy

Overview

The overall objective of bankruptcy law is to allow honest insolvent debtors to surrender most of their assets and obtain release from their debts.

A secondary purpose is to give creditors fair opportunity to share in the debtor’s limited assets in proportion to their claims.

Bankruptcy questions normally emphasize when involuntary and voluntary proceedings can be conducted, the federal exemptions, the role of the trustee in bankruptcy, preferential transfers, priorities of the creditors, and conditions under which debts may be discharged in bankruptcy. Although bankruptcy under Chapter 7 is emphasized on the CPA examination, you should also be familiar with the other portions of this module. Recently, for example, Chapter 11 on Business Reorganizations has received some increased treatment. Before beginning the reading you should review the key terms at the end of the module.

A. Alternatives to Bankruptcy Proceedings

B. Bankruptcy in General

C. Types of Bankruptcy

D. Filing the Bankruptcy Petition

E. Chapter 7 Voluntary Bankruptcy Petitions

F. Chapter 7 Involuntary Bankruptcy Petitions

G. Chapter 7 Bankruptcy Proceedings

H. Claims

I. Priority of Claims

J. Discharge of the Debtor

K. Debts Not Discharged by Bankruptcy

L. Revocation of Discharge

M. Reaffirmation

N. Business Reorganization—Chapter 11

O. Debts Adjustment Plans—Chapter 13

P. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005

Q. Bankruptcy Fees

Key Terms

Multiple-Choice Questions

Multiple-Choice Answers and Explanations

Simulations

Simulation Solutions

NOTE: Various dollar amounts in this module have been increased, so the dollar amounts in various textbooks may be too low under current bankruptcy law.

A. Alternatives to Bankruptcy Proceedings

1. Creditors may choose to do nothing
a. Expense of collection may exceed what creditors could recover
b. Creditors may expect debtor to pull through
2. Creditors may rush to satisfy their claims individually through legal proceedings (i.e., legal judgments, garnishing of wages, etc.; these are discussed in more detail in Module 31.)
a. Bankruptcy proceedings may result anyway, especially if some creditors are dissatisfied
3. Receiverships
a. This provides for general administration of debtor’s assets by a court appointee (a receiver) for benefit of all parties; these are discussed in more detail in Module 31.
4. Agreements can be used to avoid bankruptcy such as composition agreements with creditors whereby creditors agree to accept less; these are discussed in more detail in Module 31.
a. Creditors who do not agree may force debtor into bankruptcy

B. Bankruptcy in General

1. Bankruptcy is based mostly on federal law
2. Bankruptcy provides a method of protecting creditors’ rights and granting the debtor relief from his/her indebtedness
a. Debtor is permitted to have a fresh start free of previous debt.
b. Creditors are treated more fairly according to the priorities stated in bankruptcy laws to effect an equitable distribution of debtor’s property

C. Types of Bankruptcy

1. Chapter 7
a. Liquidation: Turning the majority of the debtor’s assets into cash to pay debts
b. Subject to the conditions discussed below; any debtor may file for Chapter 7 except:
(1) Railroads
(2) Banking institutions
(3) Insurance companies
2. Chapter 11
a. Reorganization of debts
b. Usually businesses who do not want to liquidate choose Chapter 11, but most debtors who qualify for Chapter 7 bankruptcy qualify for Chapter 11
(1) Railroads may file under Chapter 11
(2) Stockbrokers and commodity brokers are not eligible for Chapter 11
3. Chapter 13
a. Reorganization of debts primarily for individuals
b. Similar to Chapter 11, but more streamlined

D. Filing the Bankruptcy Petition

1. Filing the petition stays most other legal proceedings
a. This effectively stops creditors, current and future, from pursuing claims against the debtor, except in bankruptcy court.
b. A stay does not apply to actions concerning paternity, alimony, or child support (i.e., those matters may be pursued outside the bankruptcy court).
2. Educational requirements
a. Consumer filers must receive credit counseling from an approved agency within 180 days prior to filing the petition.
(1) Failure to obtain a certificate of completion from counseling agency will result in a dismissal of the bankruptcy petition
(2) Does not apply to debtors who are incapacitated, disabled, or on active duty in a military zone
b. Consumers seeking a discharge of their debts, under either Chapter 7 or 13, must also attend an approved financial management course or their discharge will be denied.

E. Chapter 7 Voluntary Bankruptcy Petitions

1. Voluntary bankruptcy petition is a formal request by debtor for an order of relief
a. Petition is filed with court along with list of debtor’s assets and liabilities
b. Debtor is automatically given an order of relief upon filing of petition
c. The Bankruptcy Abuse and Protection Act of 2005 imposes criteria that a consumer debtor must meet to prove that the debtor is not abusing the Bankruptcy Code. In other words, the law is trying to assure that debtors with the ability to repay their debts are not declaring bankruptcy.
(1) If the consumer debtor’s income falls below the state’s median income, then the presumption of abuse is removed and the debtor may continue under Chapter 7.
(2) If the debtor’s income exceeds the state’s median income, then the law presumes abuse unless the debtor’s monthly income falls below certain dollar limits. The law does permit the deduction of monthly living expenses when calculating monthly income.
(3) Other special circumstances such as a medical conditions or service in the armed forces will be considered.
(4) If the debtor’s income exceeds the statutory amount and the debtor is unable to remove the presumption of abuse, the debtor may proceed under Chapter 13 instead of Chapter 7.
d. Petition may be filed by husband and wife jointly
2. There is no minimum number of creditors required to file for bankruptcy
NOW REVIEW MULTIPLE-CHOICE QUESTIONS 1 THROUGH 4

F. Chapter 7 Involuntary Bankruptcy Petitions

1. Involuntary bankruptcy petition may be filed with bankruptcy court by creditors requesting an order for relief
2. Requirements to file petition
a. If there are fewer than twelve creditors, a single creditor may file the petition as long as his/her claim aggregates $15,325 in excess of any security s/he may hold
(1) Claims must be undisputed
(2) If necessary, more than one creditor may join together to have combined debts of more than $15,325 of unsecured claims
EXAMPLE
Poor-R-Us Company is not paying its debts as they become due. Its creditors are A (owed $17,000), B (owed $8,000), and C (owed $10,000). A alone may file the involuntary petition to force the company into bankruptcy; however, if A does not wish to do so, neither B nor C separately may force the company into bankruptcy because of failure to meet the $15,325 test. B and C may join together to file the petition.
EXAMPLE
XYZ Corporation is unable to pay current obligations. XYZ has three creditors: L (owed $17,000 which is secured by personal property), M (owed $35,000 of which one-half is secured), and N (owed $18,000 of which none is secured). L may not file an involuntary bankruptcy petition but can use the personal property to pay off the debt. Either M or N can file the petition.
EXAMPLE
Trump Inc. is not paying its debts as they become due. Trump has two creditors: Hart and Diamond. Hart claims Trump owes him $18,000, while Diamond claims she is owed $6,000. Trump admits to owing Diamond $6,000, but in good faith claims to owe Hart $12,000. Hart cannot force Trump into bankruptcy by himself. The bankruptcy court will only count the $12,000 toward the $15,325 because that amount is not in dispute. If Hart wants to force Trump into bankruptcy Hart must get Diamond to join the petition.
b. If there are twelve or more creditors, then at least three must sign the petition and they must have claims that aggregate $15,325 in excess of any security held by them
(1) Claims must be undisputed
(2) Claims subject to bona fide dispute are not counted in above $15,325 tests
EXAMPLE
Poor, Inc. is unable to meet its current obligations as they are becoming due because of severe business difficulties. It owes over $25,000 to a dozen different creditors. One of the unsecured creditors, Green, is owed $18,000. Green may not force Poor, Inc. into Chapter 7 bankruptcy because even though Green is owed more than $15,325, Green must be joined by two other creditors, even if their claims are very small.
EXAMPLE
Same facts as above except that Poor, Inc. has only eleven creditors. Now Green alone may force Poor, Inc. into bankruptcy under Chapter 7.
c. Creditors who file petition in bankruptcy may need to post a bond that indemnifies debtor for losses caused by contesting petition to avoid frivolous petitions
(1) Bankruptcy court may award damages including attorneys’ fees to debtor who successfully challenges involuntary bankruptcy petition against creditors filing petition
(2) If petition was made in bad faith, punitive damages may also be awarded
3. Exempt from involuntary bankruptcy are
a. Persons (individuals, partnerships, or corporations) owing less than $15,325
b. Farmers
c. Charitable organizations
4. Bankruptcy not available for deceased person’s estate, but once bankruptcy has begun, it is not stopped if bankrupt (debtor) dies
5. An order for relief will be granted if the requirements for filing are met, and
a. The petition is uncontested; or
b. The petition is contested; and
(1) The debtor is generally not paying his/her debts as they become due; or
(2) During the 120 days preceding the filing of the petition, a custodian was appointed or took possession of substantially all of the property of the debtor
EXAMPLE
Debtor assigns his property for the benefit of his creditor.
c. Note that the above rules involve a modified insolvency in the “equity sense” (i.e., debtor not paying debts as they become due). The rest of the Bankruptcy Act uses insolvency in the “bankruptcy sense” (i.e., liabilities exceed fair market value of all nonexempt assets). The use of insolvency in the equity sense for involuntary proceedings is important.
NOW REVIEW MULTIPLE-CHOICE QUESTIONS 5 THROUGH 10
G. Chapter 7 Bankruptcy Proceedings (also called a liquidation or straight bankruptcy)
1. Take place under federal law
a. An order of relief is sought
b. Court appoints interim trustee
c. Filing petition automatically stays other legal proceedings against debtor’s estate until bankruptcy case is over or until court orders otherwise
d. Debtor may regain property in possession of interim trustee by filing court approved bond
EXAMPLE
Mortgage foreclosure by savings and loan will be suspended against debtor.
2. First creditors’ meeting
a. Debtor furnishes a schedule of assets, their locations, and a list of creditors
b. Claims of debtors are deemed allowed unless objected to, in which case the court will determine their validity
(1) Claims must be filed within six months of first creditors’ meeting
(2) Contingent and unliquidated claims are estimated
(3) Any attorneys’ fees above those ruled reasonable by court are disallowed when objected to by creditors
c. Trustee may be elected by creditors in Chapter 7 proceeding
(1) If no election requested by creditors, interim trustee appointed by court continues in office
3. Trustee—the representative of the estate
a. Trustee has right to receive compensation for services rendered based on value of those services (rather than only on size of estate)
b. Duties—to collect, liquidate, and distribute the estate, keeping accurate records of all transactions
c. Trustee represents estate of bankrupt (debtor)
4. Property of the estate
a. Property presently owned by debtor as of the filing date
b. Property owed to debtor by third parties that can be recovered by trustee
c. Property acquired by the estate after the filing date of the petition is generally not part of the estate. The following are exceptions to this rule; thus the following are included in the estate:
EXAMPLE
Mitch filed Chapter 7 bankruptcy on April 1. Mitch received a paycheck on April 15; the paycheck is not part of the estate.
(1) Property received by debtor within 180 days after filing of petition by following methods: inheritance, life insurance, property settlement with spouse
EXAMPLE
Mitch filed Chapter 7 bankruptcy on April 1. Mitch received an inheritance of $5,000 on June 1, when his aunt dies unexpectedly. The $5,000 is part of the estate.
(2) Income from property owned by estate after petition is filed
EXAMPLE
Mitch filed Chapter 7 bankruptcy on April 1. Mitch received a royalty check of $400 from a book he had published the previous January. The $400 is part of the estate.
5. Exempt property: Property that does not go to the estate
a. Keeps any interests in joint tenancy property if those interests are exempt under other nonbankruptcy law, and
b. Debtor usually has option of choosing either exemptions under state law or exemptions under the Bankruptcy Code
c. The Examiners expect you to be familiar with the Bankruptcy Code exemptions; the dollar amounts for the exemptions are generally not tested.
(1) $22,975 equity in principal residence including co-op or mobile home
(2) $3,675 equity in one motor vehicle
(3) $2,300 in books and tools of one’s trade
(4) $575 per item qualifying for personal, family, or home use (has an aggregate ceiling of $12,250)
(5) $1,550 in jewelry
(6) Life insurance with accrued dividends and interest to $12,250
(7) Unmatured life insurance contracts
(8) Social security benefits
(9) Unemployment compensation
(10) Disability, illness, or unemployment benefits
(11) Alimony and child support
(12) Veteran’s benefits
(13) Prescribed health aids
(14) Public assistance
(15) Pensions and retirement benefits needed for support and ERISA qualified
(16) Lost earnings payments
(17) Wrongful death payments that bankrupted party depended on
(18) Wages up to maximum of specified formula (75% of person’s disposable income or 30 times federal minimum wage
(19) Crime victim’s compensation
(20) Interest in any property not to exceed $1,225 plus $11,500 of any unused portion of the homestead exemption (item [1] above); can be used to protect any type of property including cash
(21) Specified personal injury awards up to $22,975 (not to include pain and suffering or monetary loss)
d. Above exemptions doubled for married couples
6. Duties of trustee under Chapter 7 bankruptcy (i.e., a liquidation)
a. In general, to liquidate and sell assets owned to pay creditors based on priorities discussed later and to examine propriety of claims brought by creditors
(1) Considers how best to sell, use, or lease property of estate to act in best interest of estate
(2) Acquires all legal assets owed to estate for equitable distribution to creditors
(3) Trustee makes interim reports and presents final accounting of the administration of the estate to the court
7. Powers of trustee
a. Trustee may take any legal action necessary to carry out duties
(1) Trustee may utilize any defense available to the debtor against third parties
(2) Trustee may continue or cease any legal action started by the debtor for the benefit of the estate
b. Trustee, with court approval, may employ professionals (e.g., accountants and lawyers) to assist trustee in carrying out duties that require professional expertise
(1) Employed professional must not hold any interest adverse to that of debtor (i.e., to avoid conflicts of interest)
(2) Employed professional has right to receive compensation for reasonable value of services performed
(a) Reasonable fee is based on amount and complexity of services rendered, not on size of estate
(3) Trustee, with court approval, may act in professional capacity if capable and be compensated separately for professional services rendered
c. Trustee must within sixty days of the order for relief assume or reject any executory contract, including leases, made by the debtor
(1) Any not assumed are deemed rejected
(2) Trustee must perform all obligations on lease of nonresidential property until lease is either assumed or rejected
(3) Rejection of a contract is a breach of contract and injured party may become an unsecured creditor
(4) Trustee may assign or retain leases if good for bankrupt’s estate and if allowed under lease and state law
(5) Rejection or assumption of lease is subject to court approval
d. Trustee may set aside liens (those which arise automatically under law) if lien
(1) Becomes effective when bankruptcy petition is filed or when debtor becomes insolvent
(2) Is not enforceable against a bona fide purchaser when the petition is filed
(3) In the case of a security interest, is not perfected before filing of bankruptcy petition
e. Trustee may set aside transfers made within one year prior to the filing of the bankruptcy petition if
(1) The transfer was made with intent to hinder, delay, or defraud any creditor. The debtor need not be insolvent at time of transfer.
(2) Debtor received less than a reasonably equivalent value in exchange for such transfer or obligation and the debtor was insolvent at the time, or became insolvent as a result of the transfer
f. Trustee may also set aside preferential transfers of nonexempt property to a creditor made within the previous ninety days prior to the filing of the petition
(1) Preferential transfers are those made for preexisting debts that enable the creditor to receive more than s/he would have otherwise under a Chapter 7 liquidation proceeding
(a) Includes a security interest given by debtor to secure antecedent debt
EXAMPLE
Debtor paid off a loan, before the loan was due, to BB Bank sixty days before Debtor filed a bankruptcy petition. This is a preferential transfer.
EXAMPLE
Debtor gave CC Bank a security interest in some office furniture he owns to secure a previous loan CC Bank had granted him. This is a preferential transfer if Debtor gave the security interest within ninety days of the filing of bankruptcy. The reason for this is that it gives the creditor (bank) greater rights than it had before.
EXAMPLE
Debtor prepaid some installments on an installment loan on equipment. This is also a preferential transfer.
(2) Preferential transfers made to insiders within the previous twelve months may be set aside
(a) Insiders are close blood relatives, officers, directors, controlling stockholders of corporations, or general partners of partnerships
EXAMPLE
S is a secured creditor of XYZ Co. that is in Chapter 7 bankruptcy. S is not an insider.
EXAMPLE
One year ago Herb purchased a car on credit from Ike. Thirty days before filing for bankruptcy, Herb, while insolvent, makes a payment to Ike concerning the auto. This is a preferential transfer. If Ike were Herb’s brother, this preference could have been set aside if it had occurred, for example, 120 days before the filing of the petition while Herb was insolvent (insider preference).
(3) Exceptions to trustee’s power to avoid preferential transfers
(a) A contemporaneous exchange between creditor and debtor whereby debtor receives new value
EXAMPLE
Herb, while insolvent, purchases a car for cash from Ike within ninety days of filing a petition in bankruptcy. The trustee could not avoid this transaction because Herb, the debtor, received present (i.e., contemporaneous) value (the car) for the cash transferred to Ike, the creditor. This is not a voidable preference.
(b) Transfer made in the ordinary course of business is not a voidable preference, nor is the perfected security interest that arises from it (if filed within forty-five days of creation of that debt)
EXAMPLE
Debtor pays the utility bill for the business.
(c) A security interest given by debtor to acquire property that is perfected within ten days after such security interest attaches
(d) Consumer debts less than $650
(e) Business debts less than $6,225
g. When the bankruptcy trustee sets aside a transaction, the trustee places the parties back in their original positions.
EXAMPLE
Rhonda “sells” her car to her sister for $200. The car had a fair market value of $10,000. Two weeks later Rhonda declares bankruptcy. The trustee will set the aforementioned transaction aside. As a result, the estate will get the car and Rhonda’s sister will get back her $200.
8. Trustee may be sued or sue on behalf of estate
NOW REVIEW MULTIPLE-CHOICE QUESTIONS 11 THROUGH 17

H. Claims

1. Property rights—where claimant has a property right, property is turned over to claimant, because not consid ered part of debtor’s estate
a. Reclamation is a claim against specific property by a person claiming it to be his/hers
EXAMPLE
A person rented a truck for a week and in the meantime he becomes bankrupt. The lessor will make a reclamation.
b. Trust claim is made by beneficiary for trust property when the trustee is bankrupt
EXAMPLE
Trustee maintains a trust account for beneficiary under a trust set up in a will. Trustee becomes bankrupt. The trust account is not part of trustee’s estate. The beneficiary may claim the trust account as his property.
c. Secured claim when creditor has a security interest (e.g., mortgage in property or security interest under UCC)
(1) As long as trustee does not successfully attack the security—basically, security interest must be without defects to prevail against trustee (i.e., perfected security interests)
(2) Secured status may be achieved by subrogation (e.g., surety is subrogated to creditor’s collateral)
d. Setoffs are allowed to the extent the bankrupt and creditor have mutual debts whether unsecured or not
2. Filing of claims
a. All claims must be filed within six months after the first creditors’ meeting
3. Proof of claims
a. Timely claims are deemed allowed unless creditor objects
(1) Contingent and unliquidated claims may be estimated
b. Claims below are not allowed if an objection is made
(1) Unenforceable claims (by law or agreement)
(2) Unmatured interest as of date of filing bankruptcy petition
(3) Claims that may be offset
(4) Property tax claim in excess of the property value
(5) Insider or attorney claims in excess of reasonable value of services as determined by court
(6) Alimony, maintenance, and support claims for amounts due after bankruptcy petition is filed (they are not dischargeable)
(7) Landlord’s damages for lease termination in excess of specified amounts
(8) Damages for termination of an employment contract in excess of one year’s wages
(9) Certain employment tax claims
I. Priority of Claims (be sure to know)
1. Secured creditors
a. Technically, they are not a part of the priorities because they never become part of the bankrupt estate. Valid security interests though, perfected prior to the filing of the bankruptcy petition, supersede the bankruptcy trustee’s interest. Therefore, these secured creditors’ claims must be satisfied first to see if there are any assets left over for the bankruptcy estate.
(1) If the value of the collateral is sufficient to pay off the secured party, then any excess will go to junior secured parties. If there is any money left after all secured parties are paid, then the trustee may use that money as part of the estate to pay the general creditors (discussed below).
(2) If the value of the collateral is insufficient to satisfy the claim of the secured party, the secured party will receive the money from the collateral and the remaining debt that the secured party is owed will be treated as a general obligation.
(3) The secured party must have a security interest in the specific collateral or the secured party has no priority to the collateral.
EXAMPLE
Sandy Clause Corp., a toy wholesaler, was petitioned involuntarily into bankruptcy under Chapter 7 of the Federal Bankruptcy Code on July 21. Keebler Inc., has a perfected PMSI in some toys that it has sold to Clause. Clause owes Keebler $30,000 and has not been paying Keebler’s or its others creditors’ debts as they have become due. When Clause’s assets were liquidated the toys were sold for $40,000. Keebler will be paid in full; the extra $10,000 will go to the bankruptcy trustee and be used to pay the general creditors.
EXAMPLE
Same facts as above except the toys are only sold for $25,000. Keebler will receive the $25,000. Keebler will be treated as a nonpriority general creditor for the remaining $5,000 it is owed.
2. Unsecured creditors’ (general creditors) claims are paid in full at each level of priority before any lower level is paid. If there are insufficient assets to pay any given level, then assets are prorated at that level and the next levels receive nothing.
a. Priority general creditors
(1) Domestic support obligations (e.g., child support, alimony)
(2) Administration costs
(a) Includes fees to accountants, attorneys, trustees, and appraisers as well as expenses incurred only in recovering, preserving, selling, or discovering property that should be included in debtor’s estate
EXAMPLE
Bee, Ware, and Watch, a partnership of CPAs, performed professional services for Dee-Funct Company before it was forced into bankruptcy by its creditors. These fees are not put in the first priority but the last because they do not qualify as administration costs.
(b) Also includes reasonable fees, salary, or wages needed for services such as operating the business after the bankruptcy action begins
(3) Claims arising in ordinary course of debtor’s business after involuntary bankruptcy petition is filed but before the order for relief is entered (gap creditors)
(4) Wages, salaries, and commissions, including vacation, severance, and sick leave owing to bankrupt’s employees up to $12,475 per employee earned within 180 days before the petition in bankruptcy was filed (or cessation of business, whichever occurred first)
(a) Any amount earned in excess of $12,475 is treated as a general claim as explained in (11) below
(b) This priority does not include officers’ salaries
(5) Contributions to employee benefit plans within the prior 180 days, limited to $12,475 per employee, reduced by amount received as wage preference
(6) Claims on storage of grain or fish up to $6,150 for each individual
(7) Consumer deposits for undelivered goods or services limited to $2,775 per individual
EXAMPLE
Mary placed a $3,000 deposit for a $10,000 wedding dress at Barb’s Bridal Boutique. Before the dress was delivered Barb declared bankruptcy. Mary’s claim for $2,775 would fall at this level; the remaining $225 will fall to the nonpriority general creditor group below.
(8) Taxes (federal, state, and local)
(9) Obligations to an insured bank
(10) Debts arising from motor vehicle accidents while under the influence of drugs or alcohol
(11) General (unsecured) creditors that filed timely proofs of claims
(a) Includes amounts owed to secured creditors in excess of amount for which security sells
(b) Includes amounts owed to priority general creditors that exceed the priority amount
(c) Unsecured claims filed late (unless excused) are paid after timely claims
NOW REVIEW MULTIPLE-CHOICE QUESTIONS 18 THROUGH 19

J. Discharge of the Debtor

1. A discharge is the release of a debtor from all his/her debts not paid in bankruptcy; the debtor has no further obligation even for the debts that were not paid at all or partially paid
2. Creditors not paid are prohibited from any further debt collection on the discharged debts.
3. There are, however, some nondischargeable debts, which are discussed in detail below
4. Debtor must be an individual to be discharged
a. Business organizations do not receive a discharge because they no longer exist; all of their assets have been liquidated.
b. Conversely, individual debtors need to be discharged to get a fresh start.
5. Debtor must be adjudged an “honest debtor” to be discharged
6. Discharge will only be granted once every 8 years
7. Acts that bar discharge of all debts
a. Improper actions during bankruptcy proceeding
(1) Making false claims against the estate
(2) Concealing property
(3) Transfer of property after filing with intent to defeat the law (i.e., fraudulent transfer)
(4) Making any false entry in or on any document of account relating to bankrupt’s affairs
(5) These acts are also punishable by fines and imprisonment
b. Failing to satisfactorily explain any loss of assets
c. Refusing to obey court orders
d. Removing or destroying property within twelve months prior to filing of petition with intent to hinder, delay, or defraud any creditor
e. Destroying, falsifying, concealing, or failing to keep books of account or records unless such act is justified under the circumstances
f. “Substantial abuse” of bankruptcy by individual debtor with primarily consumer debts
g. A preferential transfer does not bar discharge (but can be set aside)
K. Debts Not Discharged by Bankruptcy (even though general discharge allowed)
1. Taxes within three years of filing bankruptcy petition
2. Loans for payment of federal taxes
3. Unscheduled debts unless creditor had actual notice of proceedings (i.e., where bankrupt failed to list creditor and debt)
EXAMPLE
In a petition in bankruptcy, a mistake was made so that a debt owed to ABC Company was listed as owed to XYZ Company. The debt to ABC is not discharged unless ABC somehow was aware of the mistake.
4. Alimony, separate maintenance, or child support
5. Liability due to theft or embezzlement
6. Debts arising from debtor’s fraud about his/her financial condition or fraud in connection with purchase or sale of securities
EXAMPLE
Obtaining credit using false information such as materially fraudulent financial statements that the creditor relied on.
7. Willful and/or malicious injuries to a person or property of another (intentional torts)
a. Unintentional torts (i.e., negligence) and breaches of contract are dischargeable
8. Congress amended Bankruptcy Code making it more difficult for student loans to be discharged in bankruptcy
a. This was prompted because many students have had large student loans to pay for tuition and living expenses
(1) Upon graduation some students have few assets and may be inclined to file for bankruptcy trying to get student loans discharged
b. Student loans are defined by bankruptcy code to include those loans made or guaranteed by units of government
(1) Recent additions include loans for students made also by nongovernmental commercial institutions such as banks
(a) Also includes stipends, scholarships or benefits given by educational institutions
c. Bankruptcy Code now provides that student loans can be discharged in cases of “undue hardship” to debtor and any dependants
(1) “Undue hardship” is defined very strictly so s/he needs to basically show payment would negate payment of basic necessities of food or shelter
(2) Cosigners such as parents who guarantee family member’s student loan must meet same “undue hardship” test to discharge obligation
9. Governmental fines or penalties imposed within prior three years
10. Those from a prior bankruptcy proceeding in which the debtor waived discharge or was denied discharge
11. Liability incurred by operating any vehicle, vessel or aircraft while legally intoxicated
12. To avoid the practice of “loading up on luxury goods” before bankruptcy, there is a presumption of nondischargeability for
a. Consumer debts to a single debtor under specified conditions for luxury goods or services made within 60 days of filing
b. Certain cash advances based on consumer credit taken within 60 days of filing
13. Any debt from violation of securities laws including those under Sarbanes-Oxley Act
14. Sarbanes-Oxley Act makes it criminal for any person to intentionally falsify, destroy, or cover up records intending to influence proper investigation or administration of matters involving bankruptcy cases
15. Debts owed to pension plans, profit sharing plans or similar employee plans
16. Homeowner association, condo, or cooperative fees

L. Revocation of Discharge

1. Discharge may be revoked if
a. Bankrupt committed fraud during bankruptcy proceedings unknown to creditors seeking revocation
EXAMPLE
A bankrupt conceals assets in order to defraud creditors.
(1) Must be applied for within one year of discharge
b. Bankrupt acquired rights or title to property of estate and fraudulently failed to report this
c. Bankrupt refused to obey lawful court order or refused to testify when not in violation of his/her constitutional right against self-incrimination

M. Reaffirmation

1. Debtor promises to pay a debt that will be discharged. The Code makes it difficult to reaffirm dischargeable debt.
a. To be enforceable, reaffirmation of dischargeable debt must satisfy the following conditions:
(1) Reaffirmation must take place before discharge granted
(2) Must be approved by bankruptcy court
(3) Debtor is allowed sixty days to rescind reaffirmation once agreed to
(a) Debtor must have received appropriate warnings from the court or attorney on effects of reaffirmation, and
(b) If also involves consumer debt not secured by real property, court must approve new agreement as being in best interests of debtor and not imposing undue hardship on debtor
NOW REVIEW MULTIPLE-CHOICE QUESTIONS 20 THROUGH 26

N. Business Reorganization—Chapter 11

1. Goal is to keep financially troubled firm in business
a. It is an alternative to liquidation under Chapter 7 (straight bankruptcy)
b. In general, allows debtor to keep assets of business
2. Can be initiated by debtor (voluntary) or creditors (involuntary)
a. Available to individuals, partnerships, or corporations including railroads. Other entities ineligible to be debtors under Chapter 7 are ineligible under Chapter 11.
b. If involuntary, same requirements must be met as needed to initiate a Chapter 7 involuntary proceeding
3. Creditor’s committee is appointed after the order for relief is entered. This committee essentially functions as the bankruptcy trustee.
a. Investigation of debtor’s financial affairs is conducted
b. Committee is made up of unsecured creditors only
c. If debtor’s management capable of continuing business, no trustee is appointed
d. If debtor’s management is not considered capable of running business, then trustee is appointed to conduct business
e. Trustee may also be appointed if it is in the best interest of the creditors
f. Committee will create a reorganization plan; however, the debtor has an exclusive right to file its own plan within 120 days after the order for relief is entered.
4. A reorganization plan
a. Allows for continued operation of business unless court orders otherwise
b. Provides for payment of part or all of debts over extended period
(1) Payment to creditors comes primarily from future income
c. Must divide claims into classes of similar claims, and claims within a class must be treated equally.
EXAMPLE
A reorganization plan might put employees who are owed back wages in one class, shareholders in another class, and unpaid suppliers in a third class. Assume that the plan calls for the suppliers to be paid 70 cents for each dollar owed. All suppliers must get 70 cents, some cannot get 80 cents, and others only 60 cents on the dollar.
d. Plan may provide for some creditors to receive stock in place of debt
(1) Preferred shareholders may be converted to common shareholders
(2) Common shareholders may forfeit shares of stock
(3) Typically, claimants receive reduced amounts
e. Approval of reorganization plan needs
(1) Over 1/2 of creditors in each committee owed at least 2/3 of the total debt in that class, and
(2) Acceptance of stockholders holding at least 2/3 in amount of the stock
(3) Complete reorganization plan can still be approved by court if court determines plan is fair even if some committees fail to approve it; called “cram down” power
f. Priority general creditors must be paid in full (e.g., bankruptcy administrative fees, employee wages up to $12,475 per employee; see Section I.2.a. of this outline for further examples).
5. Fast tracking provides for small businesses (having debt less than $2,490,925) which cuts out much of red tape of bankruptcy proceedings
6. After court confirms plan and issues final decree
a. Debtor is discharged from debts that arose before confirmation of plan, except
(1) Those agreed to continue under the recognized plan
(2) Those exempted by law (e.g., taxes; see part K. of this outline for further examples)
7. Court may convert Chapter 11 reorganization into Chapter 7 straight bankruptcy if fairer
8. SEC has limited power to participate in bankruptcy reorganizations
9. When debtor keeps and operates business, debtor has right to retain employees and professionals it used before reorganization
EXAMPLE
Debtor, after a Chapter 11 reorganization, wishes to keep its CPA firm. This is permitted.

O. Debts Adjustment Plans—Chapter 13

1. Most individuals are eligible if
a. Have regular income, and
b. Owe unsecured debts of less than $383,175, and
c. Owe secured debts of less than $1,149,525
2. Initiated when debtor files voluntary petition in bankruptcy court
a. Creditors may not file involuntary petition under Chapter 13
b. Filing of petition stays all collection and straight bankruptcy proceedings against debtor
c. Debtor has exclusive right to propose plan
(1) If debtor does not file plan, creditors may force debtor into involuntary proceeding under Chapter 7
d. Plan will be confirmed or denied by court without approval of unsecured creditors
(1) However, unsecured creditors must receive as much as they would get under Chapter 7, and
(a) Either be paid in full, or
(b) Have all debtor’s disposable income committed to plan
(c) Plan may put claims in different classifications but may not discriminate unfairly against any of designated classes and each claimant within same classification must receive same treatment
(2) If debts to unsecured creditors are not paid in full, plan must commit to payments for three years. If debtor’s monthly income exceeds the state’s average median annual income, plan must make payment for five years.
e. Court must appoint trustee in Chapter 13 cases
f. Debtor engaged in business may continue to operate that business subject to limitations imposed by court
g. Completion of plan discharges debtor from debts dischargeable by law. Nondischargeable debts are similar to those under Chapter 7 of the Bankruptcy Code (see section K. of this outline)
NOW REVIEW MULTIPLE-CHOICE QUESTIONS 27 THROUGH 30

P. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005

1. Amends various parts of US Bankruptcy Code including consumer bankruptcies and business bankruptcies
2. Provisions under new Act allow trade creditors to treat large portions, sometimes most or even all of vendors’ claims as being administrative expenses, significantly increasing their priority status.
3. This Act creates a new Bankruptcy Code section that imposes limits on the payment of severance pay or retention bonuses to key employees in a Chapter 11 case
a. Retention bonuses are permitted only if key employees have good-faith offers from other businesses at the same or greater compensation
4. For consumer cases, the time between discharges has been increased so that Bankruptcy Code will deny discharge to a Chapter 7 debtor if that debtor received either a Chapter 7 or Chapter 11 discharge in a case filed within 8 years of filing of pending case
a. Prior law said 6 years between such discharges under Chapter 7 or Chapter 11
b. Under the new act, Chapter 13 debtors have a few different time limitations when combined with the various chapters.
5. This Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 creates a new Chapter 15 of the US Bankruptcy Code on cross-border insolvency cases
a. Meant to make bankruptcy proceedings across international borders more functional
(1) Favors and promotes cooperation and communication with both foreign courts and foreign representatives
NOW REVIEW MULTIPLE-CHOICE QUESTION 31

Q. Bankruptcy Fees

1. In recent years, bankruptcy specialists have made much larger fees. Rising fees have elicited major objections coming from
a. Federal watchdogs
b. Organized labor
c. Major creditors of bankrupt companies
2. Major complaint is that lawyers and other advisors have been taking too many fees and leaving less money for others in the bankruptcy
3. Thus bankruptcy is more likely testable on CPA Exam because it is now on minds of many

KEY TERMS

Chapter 7 bankruptcy. Debtor liquidates assets, except exempt assets, to pay creditors.

Chapter 11 bankruptcy. Debtor reorganizes debts to pay creditors; primarily used by businesses.

Chapter 13 bankruptcy. Debtor reorganizes debts to pay creditors; primarily used by individuals.

Creditor’s committee. A group of unsecured creditors who essentially function as the bankruptcy trustee in Chapter 11 cases.

Discharge. After debtor completes bankruptcy, debtor is relieved of all previous debt except debts that are nondischargeable. This allows debtor to get a financial fresh start.

Estate. The debtor’s assets that are used to pay the creditors.

Insider. A party who has a close relationship with the debtor. Relevant in the area of preferential transfers: Transactions with insiders are examined by the trustee for 1 year prior to the filing of the bankruptcy petition.

Involuntary petition. Debtor is sued by creditors and forced into bankruptcy.

Liquidation. The process of turning assets into cash to pay creditors.

Order for relief. Granted, in most cases, to the debtor upon the filing of the bankruptcy petition. Allows debtor to stop paying creditors until the bankruptcy can be finalized.

Preferential transfer. When the debtor provides payment or security to a creditor, which would allow creditor to collect more than the creditor would have under Chapter 7 bankruptcy. If such a transfer took place 90 days prior to the filing of the bankruptcy petition, the trustee may set the transaction aside. This is done to assure all creditors are treated fairly.

Reaffirmation. When a debtor voluntarily chooses to repay a debt that otherwise would be fully discharged under the Bankruptcy Code.

Reorganization (rehabilitation). A debtor retains assets, as opposed to liquidating the assets, and agrees to pay creditors out of future earnings under Chapters 11 or 13 of the Bankruptcy Code.

Set aside. If a bankruptcy trustee discovers a preferential transfer then the trustee will reclaim the asset improperly taken from the estate and return whatever consideration, if any, was given to the creditor. Effectively this action returns the parties back to their original position before the wrongful transfer took place.

Stay. A court order that prevents further collection actions by creditors. The stay is issued upon the filing of the bankruptcy petition, but does not apply to family law issues.

Trustee. The bankruptcy trustee presides over the bankruptcy estate and organizes the estate for the court. The trustee determines what the assets and liabilities of the estate are.

Voluntary petition. A debtor chooses to file bankruptcy, as opposed to being forced into bankruptcy by creditors.

Multiple-Choice Questions (1–31)

E. Chapter 7 Voluntary Bankruptcy Petitions

1. Which of the following statements is correct concerning the voluntary filing of a petition in bankruptcy?

a. If the debtor has twelve or more creditors, the unsecured claims must total at least $15,325.

b. The debtor must be insolvent.

c. If the debtor has less than twelve creditors, the unsecured claims must total at least $15,325.

d. The petition may be filed jointly by spouses.

2. A voluntary petition filed under the liquidation provisions of Chapter 7 of the Federal Bankruptcy Code

a. Is not available to a corporation unless it has previously filed a petition under the reorganization provisions of Chapter 11 of the Federal Bankruptcy Code.

b. Automatically stays collection actions against the debtor except by secured creditors.

c. Will be dismissed unless the debtor has twelve or more unsecured creditors whose claims total at least $15,325.

d. Does not require the debtor to show that the debtor’s liabilities exceed the fair market value of assets.

3. On February 28, Master, Inc. had total assets with a fair market value of $1,200,000 and total liabilities of $990,000. On January 15, Master made a monthly installment note payment to Acme Distributors Corp., a creditor holding a properly perfected security interest in equipment having a fair market value greater than the balance due on the note. On March 15, Master voluntarily filed a petition in bankruptcy under the liquidation provisions of Chapter 7 of the Federal Bankruptcy Code. One year later, the equipment was sold for less than the balance due on the note to Acme.

If a creditor challenged Master’s right to file, the petition would be dismissed

a. If Master had less than twelve creditors at the time of filing.

b. Unless Master can show that a reorganization under Chapter 11 of the Federal Bankruptcy Code would have been unsuccessful.

c. Unless Master can show that it is unable to pay its debts in the ordinary course of business or as they come due.

d. If Master is an insurance company.

4. Which of the following conditions, if any, must a debtor meet to file a voluntary bankruptcy petition under Chapter 7 of the Federal Bankruptcy Code?

  Insolvency Three or more creditors
a. Yes Yes
b. Yes No
c. No Yes
d. No No

F. Chapter 7 Involuntary Bankruptcy Petitions

5. Brenner Corporation is trying to avoid bankruptcy but its four creditors are trying to force Brenner into bankruptcy. The four creditors are owed the following amounts:

Anteed Corporation – $7,000 of unsecured debt
Bounty Corporation – $5,000 of unsecured debt and $8,500 of secured debt
Courtney Corporation – $3,000 of unsecured debt
Dauntless Corporation – $2,000 of unsecured debt

Which of the creditors must sign the petition to force Brenner into bankruptcy?

a. Bounty is sufficient.

b. At least Anteed and Bounty are needed.

c. At least Bounty, Courtney, and Dauntless are needed.

d. All of these four creditors are needed.

Items 6 through 10 are based on the following:

Dart Inc., a closely held corporation, was petitioned involuntarily into bankruptcy under the liquidation provisions of Chapter 7 of the Federal Bankruptcy Code. Dart contested the petition.

Dart has not been paying its business debts as they became due, has defaulted on its mortgage loan payments, and owes back taxes to the IRS. The total cash value of Dart’s bankruptcy estate after the sale of all assets and payment of administration expenses is $100,000.

Dart has the following creditors:

  • Fracon Bank is owed $75,000 principal and accrued interest on a mortgage loan secured by Dart’s real property. The property was valued at and sold, in bankruptcy, for $70,000.
  • The IRS has a $12,000 recorded judgment for unpaid corporate income tax.
  • JOG Office Supplies has an unsecured claim of $3,000 that was timely filed.
  • Nanstar Electric Co. has an unsecured claim of $1,200 that was not timely filed.
  • Decoy Publications has a claim of $14,000, of which $2,000 is secured by Dart’s inventory that was valued and sold, in bankruptcy, for $2,000. The claim was timely filed.

6. Which of the following statements would correctly describe the result of Dart’s opposing the petition?

a. Dart will win because the petition should have been filed under Chapter 11.

b. Dart will win because there are not more than 12 creditors.

c. Dart will lose because it is not paying its debts as they become due.

d. Dart will lose because of its debt to the IRS.

7. Which of the following events will follow the filing of the Chapter 7 involuntary petition?

A trustee will be appointed A stay against creditor collection proceedings will go into effect
a. Yes Yes
b. Yes No
c. No Yes
d. No No

For items 8 through 10 assume that the bankruptcy estate was distributed.

8. What dollar amount would Nanstar Electric Co. receive?

a. $0

b. $ 800

c. $1,000

d. $1,200

9. What total dollar amount would Fracon Bank receive on its secured and unsecured claims?

a. $70,000

b. $72,000

c. $74,000

d. $75,000

10. What dollar amount would the IRS receive?

a. $0

b. $ 8,000

c. $10,000

d. $12,000

G. Chapter 7 Bankruptcy Proceedings

11. Which of the following is not allowed as a federal exemption under the Federal Bankruptcy Code?

a. Some specified amount of equity in one motor vehicle.

b. Unemployment compensation.

c. Some specified amount of value in books and tools of one’s trade.

d. All of the above are allowed.

12. Flax, a sole proprietor, has been petitioned involuntarily into bankruptcy under the Federal Bankruptcy Code’s liquidation provisions. Simon & Co., CPAs, has been appointed trustee of the bankruptcy estate. If Simon also wishes to act as the tax return preparer for the estate, which of the following statements is correct?

a. Simon is prohibited from serving as both trustee and preparer under any circumstances because serving in that dual capacity would be a conflict of interest.

b. Although Simon may serve as both trustee and preparer, it is entitled to receive a fee only for the services rendered as a preparer.

c. Simon may employ itself to prepare tax returns if authorized by the court and may receive a separate fee for services rendered in each capacity.

d. Although Simon may serve as both trustee and preparer, its fees for services rendered in each capacity will be determined solely by the size of the estate.

13. Which of the following transfers by a debtor, within 90 days of filing for bankruptcy, could be set aside as a preferential payment?

a. Making a gift to charity.

b. Paying a business utility bill.

c. Borrowing money from a bank secured by giving a mortgage on business property.

d. Prepaying an installment loan on inventory.

Items 14 and 15 are based on the following:

On August 1, Hall filed a voluntary petition under Chapter 7 of the Federal Bankruptcy Code. Hall’s assets are sufficient to pay general creditors 40% of their claims.

The following transactions occurred before the filing:

  • On May 15, Hall gave a mortgage on Hall’s home to National Bank to secure payment of a loan National had given Hall two years earlier. When the loan was made, Hall’s twin was a National employee.
  • On June 1, Hall purchased a boat from Olsen for $10,000 cash.
  • On July 1, Hall paid off an outstanding credit card balance of $500. The original debt had been $2,500.

14. The National mortgage was

a. Preferential, because National would be considered an insider.

b. Preferential, because the mortgage was given to secure an antecedent debt.

c. Not preferential, because Hall is presumed insolvent when the mortgage was given.

d. Not preferential, because the mortgage was a security interest.

15. The payment to Olsen was

a. Preferential, because the payment was made within ninety days of the filing of the petition.

b. Preferential, because the payment enabled Olsen to receive more than the other general creditors.

c. Not preferential, because Hall is presumed insolvent when the payment was made.

d. Not preferential, because the payment was a contemporaneous exchange for new value.

16. Under the liquidation provisions of Chapter 7 of the Federal Bankruptcy Code, a debtor will be denied a discharge in bankruptcy if the debtor

a. Fails to list a creditor.

b. Owes alimony and support payments.

c. Cannot pay administration expenses.

d. Refuses to satisfactorily explain a loss of assets.

17. On May 1, 2013, two months after becoming insolvent, Quick Corp., an appliance wholesaler, filed a voluntary petition for bankruptcy under the provisions of Chapter 7 of the Federal Bankruptcy Code. On October 15, 2012, Quick’s board of directors had authorized and paid Erly $50,000 to repay Erly’s April 1, 2012, loan to the corporation. Erly is a sibling of Quick’s president. On March 15, 2013, Quick paid Kray $100,000 for inventory delivered that day.

Which of the following is not relevant in determining whether the repayment of Erly’s loan is a voidable preferential transfer?

a. Erly is an insider.

b. Quick’s payment to Erly was made on account of an antecedent debt.

c. Quick’s solvency when the loan was made by Erly.

d. Quick’s payment to Erly was made within one year of the filing of the bankruptcy petition.

H. Claims

18. Brook Corporation has filed for bankruptcy. Of the following debts Brook owes, indicate their priorities from the highest to the lowest.

I. Federal taxes unpaid for the previous year.

II. Wages of $3,000 owed to employees.

III. Balance of $5,000 owed to a creditor that had a security interest. This creditor got paid fully by selling off the collateral except for this $5,000 deficiency.

a. I, II, III.

b. I, III, II.

c. II, I, III.

d. III, I, II.

19. Kessler Company has filed a voluntary bankruptcy petition. Kessler’s debts include administration costs owed to accountants, attorneys, and appraisers. It also owes federal and state taxes. Kessler still owes various employees for the previous month’s wages accrued before the petition was filed. None of these wages are owed to the officers and at most total $4,000 per employee. The company also owes several creditors for claims arising in the ordinary course of business. All of these latter claims arose before Kessler filed the bankruptcy petition. What are the priorities from highest to lowest of these listed debts and claims?

a. The claims arising in the ordinary course of business; the administration costs; the employees’ wages; the federal and state taxes.

b. The administration costs; the employees’ wages; the federal and state taxes; the claims arising in the ordinary course of business.

c. The federal and state taxes; the administration costs; the claims arising in the ordinary course of business; the employees’ wages.

d. The claims arising in the ordinary course of business; the federal and state taxes; the administration costs; the employees’ wages.

J. Discharge of a Bankrupt

20. Which of the following acts will not bar a general discharge in bankruptcy?

a. The debtor tried to hide some property to prevent the estate from getting it.

b. The debtor intentionally injured a creditor during an argument about the bankruptcy proceedings.

c. The debtor is unwilling to explain satisfactorily why some assets are missing.

d. The debtor intentionally destroyed records of his assets.

21. Chapter 7 of the Federal Bankruptcy Code will deny a debtor a discharge when the debtor

a. Made a preferential transfer to a creditor.

b. Accidentally destroyed information relevant to the bankruptcy proceeding.

c. Obtained a Chapter 7 discharge ten years previously.

d. Is a corporation or a partnership.

22. Eckson was granted an order for relief after having filed a petition in bankruptcy. Which of the following actions would bar a general discharge in bankruptcy?

I. Ten months before the bankruptcy proceedings, Eckson had obtained credit from Cardinal Corporation by using false information on the credit application.

II. Six months before he filed the petition, Eckson removed assets from his land with the intent to defraud creditors.

III. During the bankruptcy proceedings, Eckson made a false entry on some records pertaining to his assets.

a. I only.

b. I and II only.

c. II and III only.

d. I, II, and III.

23. Which of the following acts by a debtor could result in a bankruptcy court revoking the debtor’s discharge?

I. Failure to list one creditor.

II. Failure to answer correctly material questions on the bankruptcy petition.

a. I only.

b. II only.

c. Both I and II.

d. Neither I nor II.

24. Which of the following debts will not be discharged by bankruptcy even though a general discharge is allowed?

I. Debt owed to a corporation because the debtor was caught embezzling from it.

II. Money owed to a bank because the debtor was found to have committed fraud about her financial condition to get a loan.

III. Damages owed to a major customer because the debtor intentionally breached an important contract.

a. I only.

b. II only.

c. I and II only.

d. I, II, and III.

25. Which of the following claims will not be discharged in bankruptcy?

a. A claim that arises from alimony or maintenance.

b. A claim that arises out of the debtor’s breach of contract.

c. A claim brought by a secured creditor that remains unsatisfied after the sale of the collateral.

d. A claim brought by a judgment creditor whose judgment resulted from the debtor’s negligent operation of a motor vehicle.

26. By signing a reaffirmation agreement on April 15, a debtor agreed to pay certain debts that would be discharged in bankruptcy. On June 20, the debtor’s attorney filed the reaffirmation agreement and an affidavit with the court indicating that the debtor understood the consequences of the reaffirmation agreement. The debtor obtained a discharge on August 25. The reaffirmation agreement would be enforceable only if it was

a. Made after discharge.

b. For debts aggregating less than $5,000.

c. Not for a household purpose debt.

d. Not rescinded before discharge.

N. Business Reorganization—Chapter 11

27. Strong Corp. filed a voluntary petition in bankruptcy under the reorganization provisions of Chapter 11 of the Federal Bankruptcy Code. A reorganization plan was filed and agreed to by all necessary parties. The court confirmed the plan and a final decree was entered.

Which of the following statements best describes the effect of the entry of the court’s final decree?

a. Strong Corp. will be discharged from all its debts and liabilities.

b. Strong Corp. will be discharged only from the debts owed creditors who agreed to the reorganization plan.

c. Strong Corp. will be discharged from all its debts and liabilities that arose before the date of confirmation of the plan.

d. Strong Corp. will be discharged from all its debts and liabilities that arose before the confirmation of the plan, except as otherwise provided in the plan, the order of confirmation, or the Bankruptcy Code.

28. Which of the following statements is correct with respect to the reorganization provisions of Chapter 11 of the Federal Bankruptcy Code?

a. A trustee must always be appointed.

b. The debtor must be insolvent if the bankruptcy petition was filed voluntarily.

c. A reorganization plan may be filed by a creditor anytime after the petition date.

d. The commencement of a bankruptcy case may be voluntary or involuntary.

29. Under Chapter 11 of the Federal Bankruptcy Code, which of the following would not be eligible for reorganization?

a. Retail sole proprietorship.

b. Advertising partnership.

c. CPA professional corporation.

d. Savings and loan corporation.

O. Debts Adjustment Plans—Chapter 13

30. Which of the following is false regarding a Chapter 13 bankruptcy?

a. Individuals in general need not have regular income.

b. Creditors may not file involuntary petitions under this chapter.

c. It is initiated when the debtor files a voluntary petition in a bankruptcy court.

d. All of the above are true.

P. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005

31. Under the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, which of the following type(s) of debts is (are) nondischargeable in bankruptcy?

I. Death caused while intoxicated when operating an aircraft.

II. Injury caused while intoxicated when driving any motor vehicle.

III. Debts for Homeowner Association fees.

a. Only I.

b. I and II but not III.

c. I and III but not II.

d. I, II, and III.

Multiple-Choice Answers and Explanations

Answers

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Explanations

1. (d) Voluntary bankruptcy petition is a formal request by the debtor for an order of relief. This voluntary bankruptcy petition may be filed jointly by a husband and a wife. Answer (b) is incorrect because the debtor in a voluntary bankruptcy petition need not be insolvent but needs to state that s/he has debts and generally, has income below the state’s median income. Answers (a) and (c) are incorrect because there is no requirement as to the minimum amount of the debtor’s liabilities in a voluntary proceeding.

2. (d) Under Chapter 7 of the Federal Bankruptcy Code, a debtor may file a voluntary petition without showing that s/he is insolvent. S/he merely has to state the existence of debts and generally, has income below the state’s median income. Therefore, the debtor is not required to show that liabilities exceed the fair market value of assets. Answer (a) is incorrect because a corporation may generally file a voluntary bankruptcy petition and there is not a requirement that it has previously filed under Chapter 11. Answer (b) is incorrect because when the debtor is automatically given an order for relief upon filing the petition, the actions to collect money by creditors are stayed. Secured creditors will resort to the collateral, however. Answer (c) is incorrect because the debtor is voluntarily going into bankruptcy and there is no requirement that twelve or more unsecured creditors be owed at least $15,325. Note that this requirement, as written, does not exist for an involuntary bankruptcy petition either.

3. (d) Most debtors may file a voluntary bankruptcy petition. Among those that may not are insurance companies, banks, and saving and loan associations. Answer (a) is incorrect because the number of creditors is not relevant for a voluntary bankruptcy petition. Answer (b) is incorrect because there is no need to show that a Chapter 11 bankruptcy would have been unsuccessful. Answer (c) is incorrect because the inability of the debtor to pay its debts as they become due is not relevant to a voluntary bankruptcy, only for involuntary bankruptcy.

4. (d) A debtor may file a voluntary bankruptcy petition without showing that s/he is insolvent. As long as the debtor’s income does not exceed the state’s median income, then the debtor may merely state that s/he has debts. There is also no requirement as to the number of creditors needed.

5. (d) Since there are fewer than twelve creditors, it is true that only one creditor is needed to file the petition. However, no one creditor is owed at least $15,325 of unsecured debt. Therefore, the claims can be aggregated to total at least $15,325 of unsecured debt. The only way this can be accomplished is by aggregating the claims of all four creditors. Note that Bounty Corporation is not enough because the secured debt is not counted in the total.

6. (c) When the debtor contests the petition s/he can still be forced into bankruptcy if the debtor is generally not paying his/her debts as they become due. Answer (a) is incorrect because the petition may be filed under either Chapter 7 (straight bankruptcy) or Chapter 11 (business reorganization). When the bankruptcy is involuntary, Chapter 7 and Chapter 11 are alternatives and have the same requirements for filing against business debtors. Answer (b) is incorrect because although the rules are different when there are fewer than twelve creditors versus when there are twelve or more creditors, Dart can be forced into bankruptcy when Decoy Publications files the petition because Decoy is owed over $15,325 of unsecured debt. Answer (d) is incorrect because there is no exception for the IRS.

7. (a) Once a valid petition in bankruptcy is filed, this automatically stays other legal proceedings against the debtor’s estate. Also, the court appoints an interim trustee.

8. (a) The bankruptcy estate contains $100,000 after the sale of all assets and payment of administration expenses. The secured debt of $70,000 to Fracon Bank and the secured debt of $2,000 to Decoy Publications are satisfied first. (This actually takes place as a higher priority over the administrative expenses.) Therefore, after paying this $72,000 there is $28,000 left. The $12,000 of unpaid income tax has the next highest priority of those listed. This leaves $16,000 for the general creditors who filed on time. There are three of these, that is, Fracon who is owed $5,000 in excess of what the sale of the property brought, JOG who is owed $3,000, and Decoy who is still owed $12,000 in excess of the security interest. These three creditors together are owed $20,000 ($5,000 + $3,000 + $12,000). Since this is more than the $16,000 left, these 3 general creditors’ debts are prorated. The last priority of unsecured claimants who filed late get nothing. Therefore, Nanstar Electric gets $0.

9. (c) The bankruptcy estate contains $100,000 after the sale of all assets and payment of administration expenses. The secured debt of $70,000 to Fracon Bank and the secured debt of $2,000 to Decoy Publications are satisfied first. (This actually takes place as a higher priority over the administrative expenses.) Therefore, after paying this $72,000 there is $28,000 left. The $12,000 of unpaid income tax has the next highest priority of those listed. This leaves $16,000 for the general creditors who filed on time. There are three of these, that is, Fracon who is owed $5,000 in excess of what the sale of the property brought, JOG who is owed $3,000, and Decoy who is still owed $12,000 in excess of the security interest. These three creditors together are owed $20,000 ($5,000 + $3,000 + $12,000). Since this is more than the $16,000 left, these three general creditors’ debts are prorated. Fracon Bank gets money from both the unsecured and secured claims. From the unsecured claim, Fracon receives a prorated share or

image

Add this prorated share of $4,000 to the $70,000 Fracon received from the sold property to arrive at $74,000.

10. (d) The bankruptcy estate contains $100,000 after the sale of all assets and payment of administration expenses. The secured debt of $70,000 to Fracon Bank and the secured debt of $2,000 to Decoy Publications are satisfied first. (This actually takes place as a higher priority over the administrative expenses.) Therefore, after paying this $72,000 there is $28,000 left. The $12,000 of unpaid income tax has the next highest priority of those listed.

11. (d) Federal exemptions allowed under the Federal Bankruptcy Code include some equity in one motor vehicle and some equity in books and tools of one’s trade. They also include various sources of income, among others, unemployment compensation.

12. (c) A trustee in bankruptcy has the power to employ court approved professionals, such as accountants and attorneys, to handle estate matters which require professional expertise. These professionals have the right to reimbursement for services rendered. A trustee is not deemed to have the appropriate expertise required to prepare tax returns; thus, a trustee may employ a CPA to perform this function. Simon, as trustee, has the power to employ himself to prepare tax returns if authorized by the court and may receive a separate fee for services rendered. Answer (a) is incorrect because Simon may serve as both trustee and preparer if authorized to do so by the court. Answer (b) is incorrect because Simon has the right to receive fees for services rendered as both a trustee and a preparer. Answer (d) is incorrect because the fee for services rendered in each capacity is determined on the basis of the value of the services rendered, not solely the size of the estate.

13. (d) Preferential transfers are payments made for antecedent debts which enable the creditor to receive more than s/he would under a Chapter 7 liquidation proceeding. Answer (a) is incorrect because a gift is not payment for an antecedent debt. Answer (b) is incorrect because transfers made in the ordinary course of business are exceptions to the trustee’s power to avoid a preferential transfer. Answer (c) is incorrect because a contemporaneous exchange between a creditor and the debtor whereby the debtor receives new value is not a preferential transfer. Prepaying an existing installment loan on inventory is making a payment on an antecedent debt which enables the creditor to receive more than s/he would in a liquidation proceeding.

14. (b) Under Chapter 7 of the Federal Bankruptcy Code, the trustee may set aside preferential transfers made to a creditor within ninety days prior to the filing of the petition for bankruptcy. Preferential transfers are those made for antecedent debts that allow the creditor to receive more than s/he would have under the bankruptcy law. All of these conditions were met for the National mortgage. Answer (a) is incorrect because National would not be considered an insider. Even though Hall’s twin was a National employee, he was not an officer, director, or controlling stockholder of National. Furthermore, the preferential transfer was not made to him personally but to National Bank. Answer (c) is incorrect because to set aside a preferential transfer, the debtor must have made the transfer while he was insolvent in the bankruptcy sense. Therefore, if Hall was presumed insolvent when the mortgage was given, the trustee is able to set aside the preferential transfer. Note that insolvency is irrelevant to whether a transfer is preferential or nonpreferential. Answer (d) is incorrect because when Hall gave National Bank the mortgage to secure payment of the two-year-old loan, this was a preferential transfer because it attempted to give National Bank more priority than it would have had as a general unsecured creditor.

15. (d) An exception to the trustee’s powers to avoid preferential transfers is a contemporaneous exchange between the debtor and creditor for new values. When Hall paid the $10,000 cash, he received the boat he had purchased from Olsen. Therefore, this $10,000 payment was a contemporaneous exchange for new value. Answer (a) is incorrect because this fact pattern fits the contemporaneous exchange exception. It does not matter that the exchange occurred within ninety days of the filing. Answer (b) is incorrect because Olsen received the $10,000 cash in exchange for the boat. Olsen therefore has not been put in a better position than other general creditors, as Hall received new value for the cash. Answer (c) is incorrect because the issue of presumption of insolvency is not relevant when determining whether a transfer is preferential or nonpreferential.

16. (d) Improper actions during a bankruptcy that bar a discharge of all of the debts include concealing property and refusing to explain a loss of assets. Answer (a) is incorrect because this action means that this particular creditor’s claim will not be discharged but does not bar a general discharge of the other debts. Answer (b) is incorrect because although alimony and support payments are not discharged themselves, their existence does not bar a general discharge. Answer (c) is incorrect because the inability to pay does not bar a general discharge.

17. (c) The trustee in bankruptcy may set aside preferential transfers made within ninety days before the filing of the bankruptcy petition while the debtor is insolvent. The time is extended to the previous twelve months if the preferential transfer was made to an insider. In this question, Quick’s solvency when the loan was made by Erly is not relevant because this loan was made thirteen months before the filing of the petition for bankruptcy. Answer (a) is incorrect because since payment to Erly was made more than three months but less than twelve months before the filing, it is important that Erly is an insider. Answer (b) is incorrect because the definition of a preferential transfer incorporates transfers made for an antecedent debt. Answer (d) is incorrect because since Erly is an insider, it is relevant that the payment to Erly was made within one year of the filing of the bankruptcy petition.

18. (c) Of those listed, wages of the bankrupt’s employees receive the highest priority for up to a specified formula. Federal taxes have a low priority but are ahead of general creditors. Any deficiency for secured creditors after the collateral is sold is paid along with the general creditors.

19. (b) The highest priority includes the administration costs. Of those listed, the wages to employees up to a specified formula each accrued within 180 days before the petition was filed have the next priority. Federal and state taxes have the second lowest priority but are next because the claims in the ordinary course of business arose before the petition was filed and therefore get the lowest priority as general creditors.

20. (b) This is an intentional tort and the liability for these injuries would not be discharged in bankruptcy; however, this does not bar a general discharge of the debts. Answer (a) is incorrect because this is one of the prime acts that the law attempts to prevent. Answer (c) is incorrect because failing to satisfactorily explain a loss of assets can bar a general discharge. Answer (d) is incorrect because this is an act that can bar a general discharge.

21. (d) Corporations and partnerships cannot receive a discharge under Chapter 7 of the Federal Bankruptcy Code. Answer (a) is incorrect because although preferential transfers can be set aside, this would not prevent the discharge in bankruptcy. Answer (b) is incorrect because the rule is that destroying information relevant to the bankruptcy proceeding can bar a general discharge unless the act was justified under the circumstances. The accidental nature of the act in answer (b) is not a good case to bar the discharge. Answer (c) is incorrect because the rule states that the discharge is not allowed if the debtor has been discharged in bankruptcy within the past six years rather than ten years.

22. (c) Actions that bar a general discharge in bankruptcy include removing or destroying property within twelve months prior to filing the petition with intent to hinder, delay, or defraud creditors. Also included is making a false entry in a document related to the bankrupt’s affairs. Obtaining credit by fraud involving the debtor’s financial condition causes that debt to be nondischargeable. It, however, does not prevent a general discharge of all debts.

23. (b) The bankruptcy court can revoke the debtor’s discharge if the debtor committed fraud during the bankruptcy proceedings, refused to obey lawful court orders, or failed to answer correctly material questions on the bankruptcy petition. Failure to list a creditor causes that creditor’s debt not to be discharged but does not cause a revocation of the discharge.

24. (c) There is a list of various types of debts that will not be discharged in bankruptcy, even though a general discharge is allowed. Among these are liabilities from theft, embezzlement, and committing fraud about one’s financial condition. Note that liabilities from ordinary negligence or from breaches of contract, whether intentional or not, are dischargeable in bankruptcy.

25. (a) Debts that are not discharged in bankruptcy include alimony, separate maintenance, and child support. Answer (b) is incorrect because a claim from a breach of contract is a typical type of claim discharged. Answer (c) is incorrect because any amount unsatisfied after sale of the collateral is paid along with the rest of the general creditors if sufficient funds remain after all of the other creditors are paid. These are discharged in bankruptcy. Answer (d) is incorrect because although intentional torts are not dischargable in bankruptcy, claims based on mere negligence are.

26. (d) To get debtors to reaffirm debts that have been discharged in bankruptcy, creditors must comply with certain procedures. In general, the reaffirmation must take place before the discharge is granted and it must be approved by the bankruptcy court. The debtor is given sixty days to rescind the reaffirmation after s/he agrees to it. Answer (a) is incorrect because it must be agreed to before discharge. Answer (b) is incorrect because there is no such limitation on the dollar amounts. Answer (c) is incorrect because the reaffirmation agreement is valid for almost all debt including household purpose debt.

27. (d) Under the reorganization provisions of Chapter 11 of the Federal Bankruptcy Code, a court supervised rehabilitation plan is adopted. It typically allows for the continued operation of the business and provides for the payment of all or part of the debts over an extended period of time. The payments to the creditors often come largely from future earnings. Answer (a) is incorrect because the court typically does not discharge the debtor from all of its debts under a Chapter 11 bankruptcy but provides for payments of debts out of future earnings. Answer (b) is incorrect because the plans can apply to any creditors whether they were in the portion that agreed to the plan or not. Answer (c) is incorrect because the debtor under Chapter 11 is often required to pay all or part of the debts out of future earnings.

28. (d) The Chapter 11 bankruptcy petition may either be filed voluntarily by the debtor or filed by the creditors to force the debtor into bankruptcy. Answer (a) is incorrect because a trustee need not be appointed. Answer (b) is incorrect because the debtor need not be insolvent to file a voluntary bankruptcy petition. Answer (c) is incorrect because only the debtor has the right to file the reorganization plan during the first 120 days the order for relief occurs.

29. (d) Under Chapter 11 of the Federal Bankruptcy Code, individuals, partnerships, and corporations are eligible for reorganization. Savings and loan companies, banks, and insurance companies are not eligible.

30. (a) It is a false statement and therefore the correct answer to be chosen because under a Chapter 13 bankruptcy—Debts Adjustment Plan—in general individuals need to have regular income along with other specified requirements. Answers (b) and (c) are not correct because they are both accurate statements for a Chapter 13 bankruptcy. Answer (d) is incorrect because response (a) is an accurate statement.

31. (d) Under the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, all three of the listed types of debts are nondischargeable in bankruptcy. Note that this act causes bankruptcy law to be much less friendly to debtors over previous law. Also note that Statement I is still true even if the situation caused injury rather than death.

Simulations

Task-Based Simulation 1

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Situation

On May 1, 2013, Able Corp. was petitioned involuntarily into bankruptcy under the provisions of Chapter 7 of the Federal Bankruptcy Code.

When the petition was filed, Able had the following unsecured creditors:

Creditor Amount owed
Cole $18,000
Lake 2,000
Young 1,500
Thorn 1,000

The following transactions occurred before the bankruptcy petition was filed:

  • On February 15, 2013, Able paid Vista Bank the $1,000 balance due on an unsecured business loan.
  • On February 28, 2013, Able paid $1,000 to Owen, an officer of Able, who had lent Able money.
  • On March 1, 2013, Able bought a computer for use in its business from Core Computer Co. for $2,000 cash.

Items 1 through 3 refer to the bankruptcy filing. For each item, determine whether the statement is True or False.

True False
1. Able can file a voluntary petition for bankruptcy if it is solvent. image image
2. Lake, Young, and Thorn can file a valid involuntary petition. image image
3. Cole alone can file a valid involuntary petition. image image

Items 4 through 6 refer to the transactions that occurred before the filing of the involuntary bankruptcy petition. Assuming the bankruptcy petition was validly filed, for each item determine whether the statement is True or False.

True False
4. The payment to Vista Bank would be set aside as a preferential transfer. image image
5. The payment to Owen would be set aside as a preferential transfer. image image
6. The purchase from Core Computer Co. would be set aside as a preferential transfer. image image

Task-Based Simulation 2

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On April 25, 2013, Rusk Corporation was petitioned involuntarily into bankruptcy. At the time of the filing, Rusk had the following creditors:

  • Safe Bank, for the balance due on the secured note and mortgage on Rusk’s warehouse.
  • Employee salary claims.
  • 2012 federal income taxes due.
  • Accountant’s fees outstanding.
  • Utility bills outstanding.

Prior to the bankruptcy filing, but while insolvent, Rusk engaged in the following transactions:

  • On January 15, 2013, Rusk repaid all corporate directors’ loans made to the corporation.
  • On February 1, 2013, Rusk purchased raw materials for use in its manufacturing business and paid cash to the supplier.

Items 1 through 4 relate to Rusk’s creditors and the January 15 and February 1 transactions. For each item, select from List I whether only statement I is correct, whether only statement II is correct, whether both statements I and II are correct, or whether neither statement I nor II is correct.

  List I
A. I only.
B. II only.
C. Both I and II.
D. Neither I nor II.
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Simulation Solutions

Task-Based Simulation 1

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  True False
1. Able can file a voluntary petition for bankruptcy if it is solvent. image image
2. Lake, Young, and Thorn can file a valid involuntary petition. image image
3. Cole alone can file a valid involuntary petition. image image

Explanations

1. (T) A debtor need not be insolvent to file a voluntary petition for bankruptcy. S/he merely needs to state that s/he has debts. Thus, Able could file even if solvent.

2. (F) In order to file a valid involuntary petition when there are fewer than twelve creditors, a single creditor may file the petition as long as s/he is owed at least $15,325 of unsecured debt. More than one creditor may be used to reach the $15,325 requirement. However, Lake, Young, and Thorn may not file a valid involuntary petition because they are collectively owed only $4,500.

3. (T) In order to file a valid involuntary petition when there are fewer than twelve creditors, a single creditor can file the petition as long as s/he is owed at least $15,325 of unsecured debt. Cole may file alone as s/he is owed $18,000.

  True False
4. The payment to Vista Bank would be set aside as a preferential transfer. image image
5. The payment to Owen would be set aside as a preferential transfer. image image
6. The purchase from Core Computer Co. would be set aside as a preferential transfer. image image

Explanations

4. (T) The trustee may set aside preferential transfers of nonexempt property to a creditor made within the previous ninety days while insolvent. The payment made to Vista Bank is a preferential transfer because it was made less than ninety days before May 1, 2013, the date the involuntary petition was filed.

5. (T) The trustee may set aside preferential transfers of nonexempt property to a creditor made within the previous ninety days while insolvent. If the creditor was an insider, the time period is extended to within one year prior to the filing of the bankruptcy petition. The payment to Owen is a preferential transfer because Owen, an officer of Able Corp., is an insider, and the payment was made within one year prior to the filing of the petition.

6. (F) The payment to Core is not a preferential transfer because contemporaneously, Able received new value; that is, the computer. A contemporaneous exchange between creditor and debtor whereby the debtor receives new value is an exception to the trustee’s power to set aside as a preferential transfer.

Task-Based Simulation 2

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Explanations

1. (A) Statement I is correct since secured creditors receive payments before unsecured creditors (up to the value of the collateral) or receive the collateral itself. Statement II is incorrect because a secured creditor gets paid first only up to the value of the security. Any debt above the value of the security is given the lowest priority along with the general creditors.

2. (B) Statement I is incorrect because there is no collateral backing the 2012 federal income tax claim. It will thus not be paid as a secured creditor. Statement II is correct because taxes (federal, state, or local) have a higher priority than the general creditors.

3. (C) Statement I is correct because preferential transfers to insiders may be set aside when made within the previous twelve months. Thus, the January 15 repayment of corporate directors’ loans are preferential transfers. Statement II is correct because the preferential transfer rule of ninety days is extended to twelve months in the case of insiders.

4. (D) Both transfers in the ordinary course of business and contemporaneous exchanges between creditors and debtors (whereby the debtors receive new value) are exceptions to the trustee’s power to avoid preferential transfers. In this case, Rusk had purchased raw materials for use in its manufacturing business and paid cash to the supplier. These facts constitute an exception to the trustee’s power to avoid a preferential transfer. Statement II is incorrect because the purchase and payment constitute an exception to the preferential transfer avoiding powers.

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