In bankruptcy proceedings, creditors often navigate the complexities of distinguishing between secured and unsecured claims. A key factor in determining whether a creditor’s claim falls under one category or another lies in the nature of the debt contract established between the creditor and the bankruptcy filer. Let’s understand more about this in this guide.
What is an Unsecured Claim?
An unsecured claim is a financial obligation, debt, or loan that is devoid of collateral. If the borrower is unable to meet the terms and conditions of the agreement, there is no way to settle the amount. The lender relies on the promise of the borrower to repay the debt in a contract and their general creditworthiness and debt history.
This increases the risk associated with lending for the lender. Unlike secured claims, where the creditor has the right to take specific property (collateral) if the debtor fails to pay, unsecured claims are not backed by any collateral. This means that if you file for bankruptcy, creditors with unsecured claims typically have no claim to your property unless the bankruptcy court allows it. Unsecured claims often arise from credit card debt, medical bills, utility bills, and other forms of unsecured loans.
In the hierarchy of bankruptcy proceedings, these claims are paid after secured and priority claims, making them more vulnerable to discharge or significant reduction. Creditors holding unsecured claims must file a proof of claim with the bankruptcy court to participate in any distribution from the bankruptcy estate.
What are Common Examples of Unsecured Claims?
Some common examples of unsecured claims that aren’t backed by any collateral include the following:
- Credit Card Debt
- Medical Bills
- Personal Loans
- Utility Bills
- Student Loans
- Unpaid Rent
- Income Taxes
- Payday Loans
- Utility Bills: These include electricity, water, gas, and internet bills.
- Legal Judgments
- Unpaid Consumer Debts, such as unpaid balances on purchases or services.
What are the Types of Unsecured Claims?
In bankruptcy, unsecured claims are categorized into two main types and they are:
- Priority Unsecured Claims
- Non-priority Unsecured Claims
Priority Unsecured Claims
As the name suggests, this category of debts hold a higher priority for repayment in bankruptcy or insolvency proceedings than other types of unsecured claims. The bankruptcy law gives special status to priority unsecured claims, which are paid first out of any available assets before other unsecured claims can be addressed.
These debts are often not dischargeable in bankruptcy, meaning the debtor is still responsible for their repayment even after the bankruptcy process concludes. In a Chapter 13 bankruptcy, these debts must be paid in full through the debtor’s repayment plan.
Examples of priority unsecured claims are certain taxes, employee wage claims, child support, and alimony.
Non-priority Unsecured Claims
Non-priority unsecured claims are generally lower in priority for repayment compared to priority unsecured claims and secured debts in bankruptcy proceedings. As a result, creditors holding these claims may receive partial or no repayment depending on the available assets and the outcome of the bankruptcy case. These are the most common types of unsecured debt in bankruptcy and are typically dischargeable, meaning the debtor can be released from the obligation to repay these debts once the bankruptcy process is completed. In a Chapter 7 bankruptcy, nonpriority unsecured claims are only paid after priority claims have been settled and only if there are any assets left. Often, there are no funds available, and these debts are discharged, releasing the debtor from further liability. In a Chapter 13 bankruptcy, these creditors may receive a portion of their claims through the debtor’s repayment plan, depending on the debtor’s income and assets.
Examples of non-priority unsecured claims are credit card balances, medical bills, and personal loans not secured by collateral.
Who are Unsecured Creditors?
Examples of unsecured creditors include:
- Credit Card Companies
- Personal Loan Providers
- Business Suppliers and Vendors
- Utility Companies
- Landlords
- Unpaid Employees who haven’t received wages or promised benefits
What happens if there are Insufficient Assets to Cover Unsecured Claims?
If the borrower fails to repay the unsecured debt, a common outcome is the lender not receiving the total repayment for the debts owed to them. In such cases, the distribution of assets among unsecured creditors is typically governed by the:
- Nature of the unsecured claims (whether they are priority or nonpriority).
- Bankruptcy laws,
- Type of bankruptcy filed
- Jurisdiction
Chapter 7 bankruptcy directs the liquidation of the debtor’s assets to pay off debts. Here, the bankruptcy trustee sells the debtor’s nonexempt assets, and proceeds from these sales are used to pay creditors in a specific order of priority established by bankruptcy law. Priority unsecured claims are paid first, such as certain taxes, child support, and alimony. If any amount remains, then nonpriority unsecured debts are discharged. When nonpriority unsecured debts are cleared, the debtor is no longer legally required to pay them.
In a Chapter 13 bankruptcy, the debtor is made to enter an repayment plan that lasts between three to five years and is designed based on the debtor’s income, living expenses, and debt types. The plan prioritizes the repayment of priority unsecured debts in full. Nonpriority unsecured creditors may receive a portion of their claims or, in some cases, no payment at all, depending on the disposable income of the borrower and the total amount of debt. The key difference in Chapter 13 is that the debtor must use their income over the plan period to repay as much debt as possible. At the end of the repayment plan, most remaining nonpriority unsecured debts are discharged.
If the assets or income are insufficient to cover all unsecured claims, the bankruptcy process provides a legal framework for determining how available resources are distributed among creditors. This process ensures that creditors receive as fair a treatment as possible under the circumstances while also providing debtors a path to financial recovery by discharging remaining unsecured debts that cannot be paid.
How do Unsecured & Secured Claims Differ?
The difference between secured and unsecured claims are:
Secured Claims
- Collateral: Secured claims are backed by collateral, meaning the creditor has a lien on the pledged assets of the debtor. This asset could be a house, car, or other property. If the debtor fails to make payments, the creditor has the right to take possession of the collateral through foreclosure or repossession.
- Priority in Bankruptcy: In bankruptcy proceedings, secured creditors are generally paid first from the proceeds of the sale of the collateral. If the sale does not cover the full amount of the debt, the remaining balance may become an unsecured claim, depending on the circumstances.
- Risk & Interest Rates: Because secured claims are backed by collateral, they typically carry lower risk for the creditor and, consequently, often come with lower interest rates compared to unsecured debts.
Unsecured Claims
- No Collateral: Unsecured claims do not have collateral backing them. Creditors of unsecured debts do not have rights to specific assets of the debtor if the debtor fails to pay.
- Priority in Bankruptcy: Unsecured claims are paid after secured claims in bankruptcy proceedings. There are two types of unsecured claims: priority and nonpriority. Priority unsecured claims (e.g., certain taxes, child support) are paid before nonpriority unsecured claims (e.g., credit card debt, medical bills). If there are insufficient assets to cover all unsecured claims, nonpriority creditors may receive little or no payment.
- Risk & Interest Rates: Unsecured claims carry a higher risk for creditors because there is no collateral to recover in case of default. As a result, unsecured debts often have higher interest rates to mitigate the increased risk.
What is General Unsecured Claim?
A general unsecured claim refers to a type of unsecured debt that does not have any specific priority status in bankruptcy proceedings. Unlike priority unsecured claims, which are afforded higher priority for repayment based on specific criteria such as domestic support obligations or certain tax debts, general unsecured claims are not given any special treatment in terms of repayment. However, because general unsecured claims are lower in priority, there may be insufficient assets available to fully repay these creditors, resulting in partial repayment or even no repayment at all.
What is Special Class Unsecured Claim?
Special class unsecured claims refer to a kinda of unsecured claims that are treated differently due to specific circumstances or legal provisions in a particular bankruptcy case. Usually, the lender serves a special petition that their claim reserve a special treatment, unlike general unsecured claims. An example could be creditors with similar claims that are petitioned together in a special class lawsuit to provide fair results.
How can Creditors Protect Themselves Against Unsecured Claims?
Creditors have a higher risk associated with unsecured debts; hence, it must be handled with utmost care to avoid losses. Here are some strategies lenders can adopt to protect themselves against unsecured claims.
- Conduct a thorough assessment of the borrower. Evaluate their credit history, past debts, repayment behaviors, and more. For instance, if an individual has been inconsistent with their repayments, it is a red flag. Verify all documents and background, including proof of income, employment history, and financial info like credit reports.
- Mandatory collateral is recommended if possible, especially in cases where the borrower is under scrutiny. The collateral can be any asset, including real estate, vehicles, and jewelry.
- In commercial lending, it is always advisable to have a personal guarantee from borrowers, adding an additional layer of security.
- Get stronger co-signers or joint applicants who have a strong credit history.
- Negotiate settlements to get the best deal while recovering a portion of the debt in exchange for forgiving the remaining balance.
