02 Nov 2022

Bankruptcy: What is it & how does it work?


10 min

The 101 of not letting bad debt pin you down.

Bankruptcy is a legal process that gives a financial fresh start. Thousands of Australians choose to go bankrupt each year by voluntarily filing a debtor’s petition.

As we start to see an increase in the corporate insolvency appointments, we also expect to see personal insolvency appointments to increase. The following 101 of bankruptcy is designed to assist you in answering your clients questions about bankruptcy.

We are always available to provide an obligation-free consult to your clients about the options available to take control of their financial situation.

What is bankruptcy?
Bankruptcy is a legal process where a bankruptcy trustee is appointed to administer an insolvent person’s affairs, in order to provide for a fair distribution of that person’s divisible assets to their creditors. Bankruptcy is a legitimate and just way for a debtor to resolve their debt problems, and it is one way for creditors to take action against someone for their unpaid debts.

Why choose bankruptcy?
The Bankruptcy Act 1966 exists to protect debtors (i.e. the bankrupt) and creditors. The debtor is protected from being pursued by creditors and, with limited exceptions, is released from their debts upon their discharge from bankruptcy. Bankruptcy aims to provides a debtor with a fresh start.

Bankruptcy protects creditors’ interests by having an independent, qualified professional control and investigate the bankrupt’s affairs and collect and distribute the bankrupt’s divisible assets.

How does a person become bankrupt?
A person may become bankrupt in one of two ways:

  1. Self-initiated: debtor’s petition.

  2. Creditor-initiated: creditor’s petition.

A person can bankrupt themselves by filing a ‘debtor’s petition’ and a Statement of Affairs with the Official Receiver. A person is made bankrupt when the Official Receiver processes the debtor’s petition and issues an estate number.

A creditor can apply to the court through a ‘creditor’s petition’. In most instances, a creditor must have a court judgment for their debt and served a ‘bankruptcy notice’ on the debtor. If the debt remains unsatisfied at the bankruptcy notice’s expiry, the creditor may file a creditor’s petition with the Court seeking a sequestration order—bankrupting the debtor.

What is a statement of affairs?
A Statement of Affairs must be completed by all bankrupts and sets out their personal and financial information. A Statement of Affairs is an important document for two reasons:

  1. It is the financial disclosure of a bankrupt’s assets and liabilities, and this information is used by the trustee in administering the estate.

  2. The date the Statement of Affairs is lodged will determine when the bankruptcy ends (i.e. the date of discharge).

Who looks after a bankrupt estate?
When a person is made bankrupt, a bankruptcy trustee is appointed to administer the person’s bankruptcy estate.

The bankruptcy trustee is an appropriately qualified and registered specialist who is either an officer of the court (i.e. a registered bankruptcy trustee) or a public servant (i.e. the Official Receiver). A person presenting a debtor’s petition or a creditor’s petition may choose to obtain consent from a registered trustee of their choice. If no consent is obtained, the Official Receiver will be the trustee.

What are the trustee’s powers?
A bankruptcy trustee has the power to:

  • sell any divisible property of the bankrupt

  • investigate the affairs of the bankrupt

  • examine the bankrupt and their associates under oath

  • conduct and sell any business of the bankrupt

  • admit debts

  • distribute dividends.

The bankruptcy trustee can exercise all the rights and powers that the bankrupt had before they became bankrupt. In addition, the bankruptcy trustee has recovery powers that the bankrupt does not have. In summary, the bankruptcy trustee will:

  • identify and protect the divisible assets of the bankrupt

  • realise those assets

  • conduct investigations into the financial affairs of the bankrupt and any suspicious transactions

  • make appropriate recoveries

  • report to creditors

  • report any offences to the Australian Financial Security Authority (AFSA)

  • distribute surplus funds to creditors.

How does bankruptcy affect someone?
A person is an ‘undischarged bankrupt’ from the date of bankruptcy until they are either discharged or their bankruptcy is annulled. During this period a bankrupt:

  • cannot act as a company officer

  • cannot trade under a registered business name without advising people that they are bankrupt; however, they can trade under their own name

  • must make all of their divisible assets available to the trustee

  • cannot incur credit over an indexed amount (currently indexed by AFSA at $6,501) without disclosing to the lender that they are bankrupt

  • must obtain permission to travel overseas

  • must make all books, records and financial statements available, including those of associated entities (e.g. companies and trusts).

Can a bankrupt continue to earn income?
Yes. If the income earned by a bankrupt exceeds the annualised indexed threshold limits (as prescribed by the AFSA), a contribution from this income must be paid by the bankrupt to the estate. Income under these provisions includes personal income, certain benefits provided by third parties, income from superannuation funds and distributions from trusts. The total income is then reduced by the income tax payable, appropriate business expenses, and any child support payments. Read more on this here.

The bankruptcy trustee has a range of powers to collect the amount due, including garnisheeing the bankrupt’s wages or the use of a supervised account. The obligation to pay an assessed income liability to the estate survives the bankrupt’s discharge from their bankruptcy and is enforceable by the bankruptcy trustee as a debt.

How does bankruptcy affect property?
A bankrupt’s assets includes property that is defined under the Bankruptcy Act as ‘divisible’, i.e. property that can be divided among creditors. A bankruptcy trustee controls all of a bankrupt’s divisible property. This includes all property owned at the time of bankruptcy and all property received after the date of bankruptcy, but before discharge. This latter property is called ‘after-acquired property’.

Some property is not ‘divisible’, such as:

  • necessary clothing and household items

  • tools of trade to an indexed amount ($3,950)

  • a motor vehicle to an indexed amount ($8,550)

  • life assurance or endowment policies (subject to some limitations)

  • certain damages and compensation payments

  • sentimental property (as defined in the Bankruptcy Act)

  • superannuation payments (subject to certain limitations).

Can a trustee recover property sold before bankruptcy?
Maybe. A bankruptcy trustee will consider any sales or transfers of property within the five years before bankruptcy. If these transactions appear improper, undervalued, or had the purpose of attempting to defeat creditors, that property or its value may be recovered from the recipient.

A bankruptcy trustee may also recover monies from creditors who received payment of their debts in the six months before bankruptcy. Such payments are commonly referred to as ‘preferential payments’.

What is the effect on creditors?
When a person is made bankrupt, their creditors exchange the right to enforce their claims against the person for a right to prove for a dividend in the bankrupt estate. All creditors with a provable debt at the date of bankruptcy can prove for a dividend.

Are the rights of secured creditors affected?
Bankruptcy does not affect secured creditors’ rights relating to their security. A secured creditor can enforce their charge or security and may then prove for any deficiency in the bankruptcy estate. Special provisions outline how secured creditors may prove for shortfalls before the secured assets are sold.

What are non-provable debts?
Certain debts, called non-provable debts, cannot be claimed in bankruptcy, and are not released at the end of the bankruptcy. These debts include:

  • some portion of a HECS and HELP debts (government student loans)

  • court-imposed fines

  • the remainder of maintenance agreements under the Family Law Act 1975

  • unliquidated debts (a debt where debtors and their creditors are yet to determine the amount).

Full details of provable debts are set out in section 82 of the Bankruptcy Act.

Can the trustee pay dividends?
Yes. Ultimately the bankruptcy trustee’s role is to distribute the bankrupt’s divisible assets to creditors. Section 109 of the Bankruptcy Act sets out the order of priorities under which dividends must be paid. Certain payments and debts must be paid before dividends are paid to unsecured creditors.

When does bankruptcy end?
The bankruptcy period automatically ends (i.e. the bankrupt is discharged) three years after the filing date of the Statement of Affairs. However, the administration of the estate may continue for some time afterwards.

A bankruptcy’s term can be extended for up to eight years. To extend a bankruptcy, a bankruptcy trustee lodges ‘an objection to discharge’ with the Official Trustee. Reasons to object a discharge include:

  • if the bankrupt fails to cooperate

  • leaves Australia without permission

  • manages a company (without the leave of the court)

  • engages in misleading conduct relating to an amount over an indexed sum.

What is an annulment of bankruptcy?
An annulment is a cancellation of bankruptcy and reinstates a debtor’s affairs as if the bankruptcy had not occurred. An annulment can be obtained by:

  • a court order on the basis that the bankruptcy should not have occurred,

  • the bankrupt’s debts and the administration’s costs being paid in full, or

  • a section 73 proposal being accepted by creditors.

Is a bankruptcy on public record?

Yes. A bankruptcy’s status and a debtor’s personal information is permanently recorded on the National Personal Insolvency Index (NPII). The NPII is a publicly available and permanent electronic record of all personal insolvency proceedings in Australia. The NPII is updated with the status of the bankruptcy: current, and discharged.

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