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In a chapter 13 bankruptcy, a debtor uses their future income to pay off debts over several years instead of liquidating assets. For creditors, this is usually good news because in many bankruptcy cases, the debtor’s income is worth more than their assets. 

However, chapter 13 cases are also more complex because the proceedings take much longer than a standard chapter 7 liquidation to complete. Creditors must decide whether to object to a debtor’s proposed repayment plan and then be ready to act if the debtor fails to meet the terms of the plan over the next few years. An experienced bankruptcy attorney can guide a creditor through this complicated process and make sure the creditor receives as much of what they are owed as possible.

How Does Chapter 13 Work?

In chapter 13, the debtor files a bankruptcy petition, schedules, and a proposed repayment plan. The petition initiates an automatic stay that forbids creditors from attempting to collect debts during the bankruptcy, even if a creditor has a court-ordered judgment. The automatic stay is especially important in chapter 13, because a chapter 13 proceeding will last for three to five years. The stay effectively forces creditors to pursue their claims within the bankruptcy case. Anyone subject to an automatic stay should contact a lawyer as soon as possible to review their options.

The bankruptcy schedules list all of a debtor’s assets and income, as well as the debts they owe. The bankruptcy court will notify all creditors on the schedule of the bankruptcy proceeding. To collect anything from the debtor, the creditor will have to file a proof of claim form establishing the exact amount of the debt along with proof that the debt is owed. Bankruptcy law has special rules for calculating interest, so it’s a good idea to consult with a lawyer before filling out a proof of claim.

The repayment plan details how much the debtor intends to pay each creditor. The bankruptcy code imposes requirements on how much each creditor is entitled to receive, but the debtor is allowed to modify the rights of creditors, including paying them less than originally owed, as long as the repayment plan is approved by the court.

It’s crucial to have a lawyer examine the debtor’s repayment plan. The plan will generally involve paying all of a debtor’s disposable income, defined as the income left over after covering reasonable personal expenses, to creditors over three to five years. 

Which expenses are reasonable is open to debate, and debtors will often try to inflate their expenses, which reduces how much creditors receive. If a debtor’s plan doesn’t meet the requirements of the bankruptcy code, a creditor can object to it. A skilled bankruptcy lawyer will know what expenses courts tend to accept, whether it’s possible to challenge the plan to receive more payment, if the plan violates the code, and draft an objection if it does.

Once a debtor’s repayment plan is confirmed, a court-appointed trustee will automatically deduct funds from the debtor’s paycheck and distribute them to creditors over the course of the plan (usually three to five years). If payments stop, a creditor can file to have the case dismissed so that the creditor can pursue other methods of collecting the debt.

Secured Creditors in Chapter 13

As in other chapters of bankruptcy, secured creditors have certain rights that unsecured creditors do not. In general, a secured creditor is entitled to receive either the value of the collateral or the value of the debt (whichever is lower) over the course of the plan, plus interest for any delays caused by payment being split over three to five years.

A common problem for secured creditors is the risk of leaving the collateral in the hands of the debtor. The automatic stay prohibits any attempt to repossess collateral, which means it may suffer damage or depreciation in the hands of the debtor. If the debtor ultimately proves unable to repay the debt, repossessing the damaged collateral won’t cover the secured creditor’s losses.

Fortunately, the bankruptcy code entitles secured creditors to adequate protection of their interests. Adequate protection can take many forms, from requiring a debtor to buy insurance for the collateral to allowing the creditor to repossess the collateral and get out of the bankruptcy proceeding entirely.

The form adequate protection takes ultimately depends on what the court thinks is necessary to protect the creditor. Thus, the arguments a creditor makes in court can make a major difference between being able to secure one’s interest or being dependent on the debtor’s continued payments. A bankruptcy attorney can determine the best strategy to get the protection a creditor needs.

Although a secured creditor is guaranteed payment of the full debt or collateral value plus interest, the debtor is allowed to set the terms of repayment, including by changing monthly payments or stretching out payment over a longer period of time. The interest required by the bankruptcy code is calculated at a market rate, not the rate of interest set in the loan. These rules mean that a creditor still might receive less and later payment than desired.

A few secured creditors are entitled to special rights. If the debt is for a motor vehicle the debtor bought in the last two and a half years before filing for bankruptcy, the creditor is entitled to full repayment of the debt even if it’s worth more than the collateral. The same rule applies to any other collateral purchased in the year before the filing.

Home mortgage lenders also get preferential treatment. Chapter 13 entitles debtors to cure a default but not otherwise modify the terms of the mortgage. The debtor may spread the payments for missed months before the filing over the course of the repayment plan, but may not reduce monthly payments or the repayment schedule. A bankruptcy lawyer can analyze a creditor’s situation and determine whether there is a valid objection to a debtor’s repayment plan under chapter 13. 

Unsecured Creditors in Chapter 13

Unsecured creditors have more limited protections in chapter 13. However, not all unsecured creditors have the same rights: those with priority claims are entitled to full repayment, while those with non-priority claims are entitled only to a portion of the debtor’s income, whether or not it fully repays the debt.

Creditors with a priority unsecured claim, such as ex-spouses entitled to alimony or victims of a drunk driving accident, are entitled to full payment of the value of the claim on the day the debtor filed for bankruptcy. This means they do not receive interest, but they will at least receive the original value over five years.

Unsecured creditors without priority have much less protection than those with priority. Non-priority creditors have only two legal guarantees: that they will receive more than they would if the debtor’s assets were liquidated in chapter 7 (known as the “best interests” requirement), and that they will receive a pro-rata share of the debtor’s disposable income over the life of the plan (known as the “disposable income” requirement).

The first guarantee, the best interests requirement, often does little to protect creditors. Many debtors do not have any assets that can be liquidated in chapter 7. If this is the case, any payment at all would satisfy the best interests requirement. A lawyer can evaluate a debtor’s filings to determine whether any of their assets would have value in a chapter 7 proceeding, and challenge the chapter 13 filing if the payments are less than this value.

The second guarantee, the disposable income requirement, determines how much a non-priority creditor receives in chapter 13. Payments are divided on a pro-rata basis, meaning they are paid to each non-priority creditor in proportion to how much the debtor owes them.

For example, if there are two unsecured creditors, one with a $10,000 claim and the other with a $20,000 claim, and the debtor has $300 in disposable income per month, the first creditor gets $100 per month and the other gets $200. Notice how neither creditor is fully repaid in this scenario: even if the plan lasts five years, the first creditor gets only $6,000 and the second gets only $12,000.

How much repayment a non-priority creditor receives depends entirely on the amount of the debtor’s disposable income. Disposable income is the amount of money a debtor earns each month minus the debtor’s reasonable expenses. One of the best ways to increase the share an unsecured creditor receives is to argue that an expense is unreasonable and the income the debtor spends on it should be paid to the creditors instead.

Which expenses are reasonable depends on the debtor’s income, the size of the expense, and the nature of the expense. There are separate rules for debtors with income below and above the median income amount set by the court. A bankruptcy lawyer can analyze a creditor’s situation and find the best strategy for making sure the creditor gets as much of what they are owed as possible.

Dealing with Nonpayment

Whether a creditor is secured or unsecured, payments under chapter 13 come in monthly installments. However, as one might imagine, it’s possible that over the 60-month course of a plan, a debtor may stop paying. Indeed, over 25% of chapter 13 cases closed in 2017 were dismissed because of the debtor’s failure to pay.

A debtor may stop paying under chapter 13 for a variety of reasons. If this occurs, a lawyer can help a creditor determine the best strategy to remedy the situation. Sometimes, the failure to pay is due to a temporary crisis in the debtor’s life and payment will resume. When this is the case, it may be best to wait a month or two for payments to resume.

However, other times, a debtor’s failure to pay indicates that the debtor either no longer has income or has consciously decided to abandon the plan. In either of these situations, the creditor should either move to dismiss or convert the bankruptcy to a chapter 7.

Section 1307 of the bankruptcy code allows a creditor to move for dismissal or conversion of a chapter 13 bankruptcy if a debtor fails to pay, underpays, or unreasonably delays in paying. The bankruptcy judge has discretion to decide whether to dismiss a chapter 13 bankruptcy. Judges usually consider the amount the debtor failed to pay and the reason for the failure. 

Whether the case is dismissed and the creditors’ normal right to payment is restored often comes down to the arguments lawyers make in court on the creditor’s behalf. An experienced bankruptcy attorney can evaluate a situation and determine the best strategy for either dismissing a case, or converting it to chapter 7 to pursue the debtor’s assets.