What is Bankruptcy?

Bankruptcy is something many people have heard of but they don't exactly know what it is. In fact, many people use the term "bankrupt" very imprecisely. Politicians for example, often exclaim "the United States is bankrupt!" or "that guy is morally bankrupt!"

Essentially, bankruptcy means that you have filed a petition with a bankruptcy court, asking the court to initiate some ancient rules--rules that are referred to in the Old Testament. There are two main rules in play.

• First, is the "stay" or "automatic stay." The stay is an order from the court to the world that no debt collectors are to attempt to collect a debt from the petitioner (called a "debtor") unless the court approves of it. This stops all wage garnishments, court proceedings, phone calls, etc.. You name it. 
• The second rule is the "discharge." If the court believes you qualify, it will grant a discharge of all the debtor's debt, except for that which Congress has decided is not dischargeable. That is mainly (but not solely) child support, alimony, and (ironically) certain taxes. Since ancient times, bankruptcies are available every 7 years. In the U.S. it is available every 8 years, with some exceptions. 

The purpose of asking for the initiation of these bankruptcy rules, is because they provide a process for getting a financial "fresh start." In fact, bankruptcy courts often refer to bankruptcy's purpose as "getting a fresh start." The discharge gets rid of oppressive debt; while the automatic stay gives you a breathing space to undergo the process of getting a discharge. The theory is that the government would rather have you working productively, than solely working to pay your bills. If you are only working to pay bills, then you may not have an incentive to work at all. Especially if the end is never in sight. Many people in that situation would simply stop working.

When considering the debtor's rights, the bankruptcy courts will look to make sure that the debtor doesn't have enough money available to pay debts and expenses on a periodic (generally month-to-month) basis. Those debtor's rights will depend generally on the money the debtor has available and the debtor's income--although several other factors may come into play as well.

Congress has set up a system of bankruptcy "chapters" that provide a framework for debtors to exercise their bankruptcy rights. Generally, individual and business debtors use chapter 7 and individuals sometimes use chapter 13 (on rare occasions, both might file under chapter 11). Generally, you consult with an attorney to decide which chapter to file for. We'll only address individual bankruptcies here and not chapter 11's which are rarely used.

Filing bankruptcy immediately creates a bankruptcy estate. The bankruptcy estate consists of all the assets of the debtor that are not "exempted" from the estate. Generally, a debtor's bankruptcy petition will exempt most or all of their personal belongings from the estate--at least that is what we attempt to do. Congress has created broad rules defining what is exempt. Those rules attempt to exempt items that debtors need to survive, plus a little extra.

The Courts will appoint a Trustee to manage the affairs of the estate. The Trustee's job is to sell the assets of the estate in order to pay the debtor's creditors. The Trustee gets to keep a percentage for himself. If any asset of the estate is not exempt, the estate Trustee will take it and sell it off to creditors if the Trustee thinks there is enough value in the item to make it worth his efforts. The theory behind this, is that the courts should not discharge a debtor's debt unless the debtor's assets are used to pay off creditors first.

After the Trustee has administered the assets of the estate (or determined that there are no assets) then the U.S. Department of Justice has an office that will take a look at the petition. Their office is called the U.S. Trustee's Office (not to be confused with the estate Trustee--there is no connection between the two). This office plays an oversight role and basically tries to root out petitioners who are not playing by the rules.

So in summary, bankruptcy is a two-handed process where--on one hand--a person petitions a court to grant the petitioner a stay on collection of debt until the court can grant a Discharge Order. On the other hand, the court will put the petitioner's non-essential (i.e., non-exempt) belongings into a bankruptcy estate and sells off the assets of the estate to pay off creditors.