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Chapter 13 and the "Best interests of the Creditors" Test: A Primer

The bankruptcy process is meant to do two things: 1) rescue the debtor from overwhelming loads of debt and 2) make sure the creditors get something out of the rescue. By far, #1 is more important; that's why the bankruptcy asset exemptions are around. However, we should not discount #2. The importance of this goal is most evident in a Chapter 7 Liquidation, when the debtor's non-exempt assets are seized and liquidated by the trustee to pay off the creditors (after the pay off, the debt is discharged, of course). This goal is also evident in the other major individual bankruptcy chapter, the Chapter 13 Repayment Plan, though it is not as evident. As I mentioned in an earlier blog post, you can file a Chapter 13 petition instead of a Chapter 7 petition if you are seeking to protect a valuable asset from seizure and liquidation. There is a limit to this and it is called the "Best Interests of the Creditor" test. What this test asks is a simple question: if the Chapter 13 debtor were to instead file under Chapter 7, will the unsecured creditors be in a better position? Essentially, your Chapter 13 Repayment Plan must provide the unsecured creditors with the same amount or more money they would have have received in a Chapter 7 Liquidation. The best way to explain this test is through a simple example: a debtor's bankruptcy estate possesses a house with equity (after accounting for the value of your mortgage, California's homestead exemption and Chapter 7 trustee fees) of $50,000. His unsecured debts (credit cards, medical bills, personal and business loans and the like) are $100,000. He has no other non-exempt assets or debts of note. His Chapter 13 Plan must then pay his unsecured creditors at least $50,000 over the term of the repayment plan as that is the amount they would have received if a Chapter 7 trustee seized and liquidated the debtor's house. Otherwise, the plan will not be confirmed by the court. You can see an immediate problem with this test for certain debtors wishing to go through Chapter 13. If a debtor has high amounts of non-exempt equity in his assets and a large amount of debt, Chapter 13 could force him to file a plan which will mirror his current situation, one where he cannot service his debt with the income he has. Such a plan will also not be confirmed by the court. If he can only submit unaffordable repayment plans, then his only other option will be Chapter 7 (the Chapter 7 means test does take into account potential Chapter 13 expenses). A Chapter 7 liquidation, of course, is what the debtor is trying to avoid to protect his high-value assets. In such instances, the debtor must carefully consider his options -- including whether bankruptcy is a feasible option -- and restructure his financial affairs in such a way that he is comfortable with abandoning a high-value asset.

If you are considering Chapter 13, you must talk to a bankruptcy lawyer to see if you qualify.

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