What's With All the Chapters?
Have you had members declare bankruptcy recently? Is your first thought when you see Chapter 7 or Chapter 13: “why are my members doing book reports instead of paying back the credit union?” Well, this blog is for you. Many have heard of Chapter 7 or Chapter 11 bankruptcy but don’t know why they are called a “Chapter.” This has to do with the U.S. Bankruptcy Code. The U.S. Bankruptcy Code contains almost the entirety of federal bankruptcy law in the United States and is composed of 9 different chapters. Of these chapters, six deal with different types of bankruptcy and three deal with general, administrative, and procedural issues. The most common types of bankruptcies are Chapter 7, Chapter 11, and Chapter 13, which make up 99.8% of all bankruptcies filed in 2020 and are described below. The other types of bankruptcies, Chapter 9, Chapter 12, and Chapter 15, make up less than .2% of bankruptcies filed in 2020 and will not be discussed.
Chapter 7 Bankruptcy
Chapter 7 bankruptcy is the most common type of bankruptcy and can be declared by both individuals and organizations, such as corporations or nonprofits. Chapter 7 is a liquidation proceeding whereby the property of the debtor is sold or used to pay off their debts. This process is overseen by a local bankruptcy trustee who reviews the debtor’s bankruptcy and determines what actions are required, if any. While this is a liquidation, some of the debtor’s property may be protected, depending on the circumstances. A Chapter 7 bankruptcy generally discharges all of a debtor’s debts while leaving intact a secured creditor’s liens in the debtor’s property.
Chapter 13 Bankruptcy
Chapter 13 bankruptcy allows individuals, who have current income, to reorganize their debts. Based on the debtor’s income, the debtor will create a plan that pays all secured and priority claims while using any other available funds to pay unsecured creditors. A Chapter 13 plan lasts three to five years, after which a debtor’s unsecured debts are discharged. Often a debtor’s secured debts will not be discharged at the end of a Chapter 13 plan but will continue after the plan has ended. Like in a Chapter 7 proceeding, a bankruptcy trustee reviews the plan and the case to ensure compliance with the bankruptcy code.
Chapter 11 Bankruptcy
Chapter 11 bankruptcy allows for a reorganization of an individual’s or organization’s debts. Chapter 11, unlike Chapter 7, is not a liquidation and allows the individual to use current income or an organization to continue operating. In a Chapter 11 proceeding, the debtor submits a bankruptcy plan to the court and the creditors have an opportunity to review and vote on the plan. Unlike in a Chapter 13, creditors have the ability to vote on and reject a debtor’s bankruptcy plan. Furthermore, under the absolute priority rule, all creditors must be paid in full or current equity owners may lose their ownership interest if the debtor is an organization.
Generally, a Chapter 11 is more favorable to an organization’s creditors than the shareholders or owners of the organization. However, in 2019 Congress created a new type of bankruptcy by adding Subchapter V to Chapter 11 of the bankruptcy code. Subchapter V bankruptcy is geared toward small businesses with less than $2.7 million in debt. A Subchapter V bankruptcy is similar to a Chapter 13 bankruptcy for individuals. Like a Chapter 13 plan, a Subchapter V plan lasts between three to five years, approval of the plan does not require creditor acceptance, and the organization is only required to pay all of its projected disposable income. Unlike in a regular Chapter 11, the owners of an organization may keep their equity even if creditors are not paid in full.
Credit unions should note that the above provides only a shallow understanding of the different types of bankruptcy. If a credit union receives a notice of bankruptcy, it may want to contact counsel to see what actions the credit union may or may not need to do. For more information on bankruptcy, NAFCU member’s can review this Compliance Monitor article that provides a broad overview of bankruptcy for credit unions.
About the Author
Keith Schostag joined NAFCU as regulatory compliance counsel in February 2021. In this role, Keith assists credit unions with a variety of compliance issues.