FindLaw gives the following composition legal definition: "A composition is a contract between you and two or more creditors where the creditors agree to take a partial payment of the debt. Their claim is satisfied by this, and the debt is gone." Composition settlements are voluntary, unlike bankruptcy court rulings. Typically, you must demonstrate financial hardship or insolvency to creditors before they will consider a composition settlement.
Composition Settlement 101
Debtors have a few alternatives when their debts overwhelm their ability to repay. Composition settlement is one response to debtor hardship, although bankruptcy is a more popular option. Negotiating a composition settlement can be a prolonged undertaking because it requires an agreement between a debtor and two or more creditors.
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In a typical scenario, a debtor contacts creditors directly or works through a debt relief company to initiate a composition settlement. These companies work on the debtor's behalf to convince creditors to reduce some debt in return for a lump sum or a series of payments.
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In either case, the usual first step is to withhold further debt repayment – an excellent way to get your creditors' attention. If you work with a credit counselor from a debt relief company, you can expect the following steps after you cease payments:
- The counselor will create an insured savings account into which you make payments. This account will eventually pay out the settlement to your creditors.
- You build up the balance in the savings account, ignoring collection attempts from your creditors.
- Once you accumulate a set amount, the counselor will contact your creditors and offer a composition settlement.
- One or more rounds of negotiation follow. If the parties reach an agreement, they sign a contract spelling out the repayment terms in exchange for debt forgiveness.
You could try to do this independently, but it usually requires specialized legal and negotiating skills. Debt relief companies collect fees after the parties agree to settle.
Characteristics of a Composition Settlement
A composition settlement is a form of "workout," which also covers extensions. An extension is an agreement to grant extra time for repayment, with or without loan forgiveness.
Only certain types of unsecured debts are eligible for workout, including those from credit cards, medical expenses, business activities and debts in collection. Because the process is voluntary, any party can pull out before contract signing. An agreement with some creditors does not bind others to the deal, and a workout does not impact your ability to file for bankruptcy later. Debtors who breach a composition settlement unleash creditors to pursue further actions.
Advantages of Composition Settlements
From the debtor's viewpoint, composition settlements offer the following potential advantages:
- Settlements reduce the amount debtors must repay. The agreements usually prevent creditors from further collection attempts if the debtor satisfies the contract terms.
- Settlements do not preclude future bankruptcies filings, whereas filing for a second bankruptcy requires up to an eight-year wait following the first one.
- Debtors can avoid the (real or imagined) stigma of bankruptcy.
Disadvantages of Composition Settlements
Composition with creditor settlements can be problematic for several reasons:
There is no guarantee that the negotiations will bear fruit. Contrast this with bankruptcy proceedings that offer a clear-cut finality.
You may have to pay taxes on any forgiven loan amounts.
Debt relief companies may charge high fees that reduce the settlement's benefits.
The debt relief industry has had its share of bad actors preying on desperate consumers.
Composition settlements damage debtors' credit scores and remain on their credit reports for seven years.
Prudence suggests that debtors consult an attorney or other qualified professional before starting a workout or filing for bankruptcy, as other alternatives may be worth consideration.
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