Bankruptcy Glossary: “Claims” Against the Estate

Posted by Roy McFarland on Oct 5, 2011 in Bankruptcy Code Roadmap, Blog, Glossary | 0 comments

A “claim” against a debtor’s bankruptcy estate is creditor’s allegation that it has a bona fide legal right to payment from the debtor or the debtor-in-possession if the case is filed under chapter 11.

Because claims are used by creditors to legitimize the debts they are owed in the bankruptcy proceedings, it is commonly said that claims are made “against” a debtor’s bankruptcy estate. Chapter 5 of the US Bankruptcy Code (the “Code”) plays a critical role in identifying and processing creditors’ claims.

Processing claims is important because it determines which parties will be able to participate in the bankruptcy proceedings. To dig into the details, it’s best to begin with the basics. Section 101(5) of the Code defines a “claim” broadly to include any secured or unsecured right to payment. A particular claim need not be fixed, settled or even due at the time the bankruptcy case is filed. As a general rule, however, only debts that were incurred before the debtor filed for bankruptcy are included in the case. Debts that arise after filing for bankruptcy are unaltered by the proceedings.

Section 506 of the Code defines the rights of a creditor who has a properly-perfected security interest in the debtor’s collateral. (“Perfection” of a security interest is a technical legal term, governed by Colorado state law.) Congress created section 506 of the Code to handle two common situations that occur in bankruptcy. First, if the collateral securing a debt is worth more than the outstanding debt (i.e., the creditor is “oversecured”), the creditor is entitled to receive the amount that has yet to be paid. An oversecured creditor may also receive interest payments and reasonably-related expenses if it originally contracted for them. On the other hand, if the collateral is worth less than the amount of the debt (i.e., the creditor is “undersecured”), the claim can be bifurcated by the US Bankruptcy Court, which leaves the creditor with a secured claim that equals the collateral’s value and an unsecured claim for the difference. This process is commonly known as lien “stripping” or a “strip off.”

The remaining unsecured claims against the debtor’s bankruptcy estate are paid from the estate’s general funds. To do so, section 507 of the Code creates a categorical hierarchy of claims that are paid in descending order. Domestic support obligations, like maintenance payments owed to an ex-spouse, receive the highest priority, and unsecured creditors like credit cards and stockholders, if the debtor is a corporation, are given lowest priority. Many of the categories outlined in section 507 of the Code are capped, so any excess value is transferred to the next pool of creditors in order of priority.