What are a Creditor’s Rights When a Debtor Files for Bankruptcy?

Filing for bankruptcy is a legal process. It’s not intended to be a magic wand to thwart creditors from collecting what they are owed. In fact, creditors have certain protections.

While some debts are discharged entirely, the bankruptcy system typically requires a debtor to pay off as much of their debt as possible.

Depending on the type of bankruptcy the debtor files, a creditor could be paid back over time or receive a lump-sum payment. If the latter is the case, the money to pay back creditors comes from selling off the debtor’s assets, with the proceeds distributed to the creditors.

Whether a creditor will recover funds and how much depends on the priority assigned to that creditor’s claim.

Bankruptcy law prioritizes claims. Secured debts get the highest priority because they have collateral attached, such as a mortgage against real property or auto loan. This makes sense because collateral can be used to pay off the debt to the extent of the collateral’s remaining value.

If your loan to the debtor is secured by collateral, and the value of the collateral exceeds the amount of the loan, then you might be able to seek repayment according to the terms of the loan contract, via foreclosure of a mortgage, or via the repossession of a vehicle under the auto loan.

A secured creditor is generally more likely  to get paid than an unsecured creditor. Often, a bankruptcy discharge does not eliminate a lien or security interest on a debtor’s property. It only cancels the debtor’s personal liability to pay the debt.

This means that if the person filing for bankruptcy wants to keep their house or car, they must continue making their payments to the creditor until the debt is paid off.

How much a creditor recovers also depends on the type of bankruptcy the trustee is overseeing.

In a chapter 7 bankruptcy where a trustee sells the collateral, the money must go toward fully repaying the secured debt before other creditors receive payment.

In a chapter 13 bankruptcy, a debtor who wants to keep secured property – like their home – can make arrangements to repay arrearages through a three- to five-year plan.

Unsecured debts get the lowest priority because they are not secured by collateral. Unsecured debt includes, but is not limited to, utility bills, credit cards, and medical bills. Creditors with unsecured debt may receive little or no payment once the debtor declares bankruptcy.

Child support payments have such a high priority that they can never be discharged with bankruptcy. A debtor must keep paying court-ordered child support even after finalizing a bankruptcy process. Student loan debt on rare occasions can be discharged, but it is very difficult to do.

The first thing a creditor should do after receiving a bankruptcy notice is to stop all collection efforts on the debtor who filed. No more phone calls, billing actions, or lawsuits.

The next thing a creditor should do is file a claim with the bankruptcy court. Filing deadlines tend to be short and are rigidly enforced, so it’s important to act quickly to preserve your rights in the bankruptcy proceeding.

Once the strict filing deadline has passed, the bankruptcy trustee will review all claims and determine how much each creditor should get paid, if anything.

As a creditor, you can challenge in court a debtor’s right to the discharge of their payments to you. For example, you can allege that the debtor is defrauding the court in some manner – but only with sufficient cause.

A discharge means the debtor’s liability to pay pre-bankruptcy debt is erased. Certain debts, however, can be reaffirmed and allowed to continue. These include secured debts such as a mortgage and most car loans, so long as the automobile has not been surrendered or repossessed. Any unsecured debt is canceled by the discharge, and any further attempt to subsequently collect on it can result in serious sanctions from the bankruptcy court.

A dismissal means the debtor did not complete the bankruptcy process and is not entitled to the court’s protection. After a dismissal, creditors may resume collection efforts. However, as a creditor, be aware that the debtor could refile fairly quickly. It is common for a debtor to refile after the initial filing is dismissed.

If the tenant/debtor breached their lease or rental agreement before filing for bankruptcy, you can seek relief from the automatic stay (injunction against creditors) to either begin or continue the eviction process.

If the debtor is leasing property, but not living on it, then the trustee or debtor in possession must take over the lease within a short period after the filing. Otherwise, the court will deem it rejected. If that happens, the bankruptcy trustee cannot attempt to assign the lease to a third party.

Even if the lease is rejected, the trustee could have a right to continue occupying the property until the estate’s assets can be sold or moved to a new location.

If you are the landlord of a bankruptcy debtor, you will likely need a lawyer to enforce your rights in a timely manner.

The bankruptcy discharge happens on one timeline. Distributions on claims happen on a separate timeline. However, the fact the debtor got a discharge does not necessarily mean you will receive any payment on your claim.

After the discharge, the bankruptcy trustee continues administering the assets until the job is complete. Assets must be sold. Claims must be reviewed. Fees must be assessed. Creditors will be paid to the extent there are assets and according to the priority of their claim.

Keep in mind: A great majority of individual chapter 7 discharges have no assets from which creditors can be paid.

Employee claims for wages earned in the 180 days (roughly six months) prior to the bankruptcy filing, or the debtor’s business failing, are considered a high priority for payment. That’s the good news.

The bad news is, the court won’t get around to distributing payment owed to employees until the bankruptcy case is over.

Here’s what you can do: File your claim with the bankruptcy court. Check the box on the form for “priority claim,” provide your social security number, and wait.

If you are not sure where to get a claim form, it is probably printed on the back of the notice of the first meeting of creditors. As an employee owed money by a debtor employer, you are now a creditor. You can also get forms from the court clerk or  online.

While many debtors use bankruptcy as a sincere attempt to rebuild their financial lives, some may exploit the legal process for personal gain. These individuals may resort to deceptive tactics to avoid paying their debts, such as misleading creditors or the courts to gain an unfair advantage.

Most bankruptcy fraud involves the concealment of assets, or fraudulent conveyance. You see, creditors can only liquidate assets that have been listed by the debtor. However, if the debtor fails to reveal certain assets, they can fraudulently keep them despite owing an outstanding debt. A debtor might even transfer undisclosed assets to friends, relatives, or business associates so the assets cannot be found. This sort of dishonesty makes loans more expensive, because it raises the risk and costs associated with lending, and creditors end up passing those costs on to other hopeful borrowers.

Fraudulent conveyance is one of the more common forms of debtor dishonesty. When a debtor transfers assets to a third party insider — a friend, relative, a brand new company — so they can claim in bankruptcy court that they no longer possess those assets, it is called fraudulent conveyance, and it is illegal under the Colorado Uniform Voidable Transactions Act (CUVTA) which was formerly known as the Colorado Uniform Fraudulent Transfers Act (Colorado Revised Statutes § 38-8-105).

It defines fraudulent conveyance this way: "A transfer by a debtor is fraudulent as to a creditor if the debtor made the transfer with actual intent to hinder, delay or defraud any creditor." This is a rather simple definition used to cover a broad and sophisticated spectrum of dishonest transfers to elude creditors and bankruptcy courts. Another type of fraudulent transfer is when a debtor engages in a high-risk entrepreneurial endeavor, and shovels all their valuable assets to a friendly place just in case the risk doesn't pay off and the debtor ends up filing bankruptcy.

So ... what can you do as a creditor?

Fortunately, creditors who suspect a fraudulent transfer can ask a court for various remedies made available under the CUVTA.

One popular remedy is an unwinding of the transfer. Here, the court ignores the fraudulent transfer or pretends it never happened. An example of this might be if an award-winning show bike is brought back into garage storage. The sheriff could seize and sell the motorcycle to pay off creditors.

Another remedy is the court can issue a judgment against the person who received the transferred asset. This kind of judgment allows the creditor to go after other assets of the recipient to get paid back what the debtor had owed. This is especially effective when the transferred asset is no longer available.

There are also potential criminal consequences for the debtor who committed the fraud. In fact, if the value of assets transferred amounts to more than $2000, then the debtor has committed a felony.

Still, a word of caution: Fraudulent transfer lawsuits can be complex and expensive, and the CUVTA does not provide for recovery of the creditor's attorneys fees. These lawsuits therefore present a risk of throwing good money after bad.

As a creditor, you can have oppornunties to sit in a room with the debtor and bankruptcy trustee and ask questions.

The first opportunity is at the 341 hearing. There, the trustee will ask the debtor various routine questions to verify their identity and initially confirm the accuracy of their bankruptcy petition. The trustee will also ask standard, fraud-related questions, like “Have you listed all your assets?” and “Have you accounted for all of your income (over a specific period)?” and “Do you expect to receive an inheritance or any other form of windfall soon?”

They are standard questions, sure, and it’s likely the debtor will have been prepared for them by their bankruptcy attorney. That’s no problem. If you still suspect fraud, you can file an “adversary proceeding” or bankruptcy lawsuit asking the court to not discharge or erase debt owed to you or your company.

As a lender or creditor, you can make your own inquiries into:

• the accuracy of reported income on a loan application
• the location of property securing the loan, and
• whether the debtor has sold or given away assets.

If the trustee begins to suspect fraud after the 341 hearing, and after hearing from creditors intending to file an “adversary proceeding”, they can move for a Rule 2004 Examination. This is one way to compel broad testimony and document production, under oath, from the debtor and anyone else who might know if the debtor has committed fraud.

For instance, Bankruptcy Rule 2004 authorizes the bankruptcy trustee to examine:

• the debtor’s acts, conduct, property, liabilities, or financial condition
• any matter which may affect the administration of the bankruptcy estate, or
• any issue which may affect the debtor’s right to a discharge.

The debtor must appear at the examination.