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Banking & Finance Law Report

Part Seven

Posted in Bankruptcy

This article is Part Seven in a seven-part series on how to structure sales and what to do when your customer fails to pay. You can find previous articles in this series here: Structuring Sales to Ensure Payment; Signs of Trouble Before Payment Default; Default by a Customer: Knowledge is Power; What to Consider When Non-Payment Leads to Litigation and Post-Judgement Remedies. Please subscribe to this blog by entering your email in the box on the left, or check back weekly for additional articles in the series.

This posting will provide a general overview of bankruptcy law for the non-lawyer, including what it means to be "bankrupt," the types of bankruptcy, and bankruptcy issues for creditors, particularly for sellers of goods or services.

Bankruptcy Structure
Bankruptcy Code is federal law- it was created by, and is amended by the U.S. Congress. In theory, the same laws and rules apply wherever you file bankruptcy in this country, however it does happen that different Bankruptcy Courts around the country interpret the same statute differently. When this happens, the cases are appealed. If the U. S. Courts of Appeals reach different conclusions about the same statute, it is possible that the U.S. Supreme Court will resolve the controversy. 

Bankruptcy judges are appointed to 14-year terms. This differs from other federal judges, like District Court, Court of Appeals, and U.S. Supreme Court judges, who are appointed for life.   

Because Bankruptcy Courts are federal, Bankruptcy Courts generally only sit in the large cites in a state- they are not in every county seat or town, like county courts and municipal courts.

The Bankruptcy Courts require electronic filing and have their case filings imaged online, so anyone with an account can go into a specific court’s website and find out what pleadings have been filed in a case and read the pleadings on line or print what has been filed. 

What Does It Mean to be “Bankrupt?”
A person or business is bankrupt if it has either a balance sheet insolvency, meaning that the debtor’s debts exceed its assets, or cash flow insolvency, meaning that the debtor cannot pay its debts as they become due, although both types of insolvency are often present in a case. The notion of whether one is "bankrupt" for purposes of eligibility to file for bankruptcy protection comes up when it appears that a debtor has filed bankruptcy in order to escape one debt. This can occur when commercial real estate is in foreclosure and it is the only asset of the business. 

Initiation of a Bankruptcy
Bankruptcy begins with filing a petition in the Bankruptcy Court. A bankruptcy filing may be voluntary, where the debtor initiates the petition, or involuntary, where one or more of the debtor’s creditors petition the court to put the debtor into bankruptcy.

Universal Bankruptcy Concepts
There are some concepts that apply to all types of bankruptcies, whether they are reorganizations or liquidations:

  • Automatic Stay: upon the filing of any type of bankruptcy, something called the "automatic stay" is imposed. This means that creditors cannot continue litigation or collection action against someone who has filed bankruptcy. The automatic stay does not operate to halt criminal action or paternity or support obligations. What sometimes happens is that litigation that is pending when a bankruptcy is filed will be moved to the Bankruptcy Court.
  • Proof of Claim: A creditor makes its claim in bankruptcy by filing what is called a "proof of claim" that sets forth the amounts the creditor is owed, the basis for the claim (goods sold, etc.) and provides supporting documentation. A creditor knows if the debtor does not agree with the claim if the debtor files what is called an objection or lists the claim as "disputed" in its schedule of debts. If the debtor and creditor cannot resolve a dispute about the creditor’s claim, the Bankruptcy Court will determine the validity and/ or amount of the claim.
  • Priorities: The Bankruptcy Code sets what are called priorities- that is, who gets paid first. Under the Bankruptcy Code, the priorities are generally as follows: the administrative expenses, meaning the expenses of the case itself (including professional fees, costs of running a business, taxes, environmental remediation); wage claims, unpaid contributions to employee benefit claims and unsecured claims. Shareholders are generally paid last in corporate bankruptcies. Secured creditors will be repaid the value of the collateral securing their lien, so if a bank has a $500,000 mortgage loan on property that the Bankruptcy Court finds is worth only $200,000, the creditor will only be repaid $200,000 and the remaining $300,000 will be paid as an unsecured claim, and receives a percentage distribution. 
  • Nondischargeable Obligations: Certain types of debts cannot be eliminated in bankruptcy: money or property obtained by false representations about one’s financial condition; debts that are not listed in the bankruptcy schedules; court-ordered alimony or child support; debts arising from willful or malicious injury or from driving while under the influence; and, except under very rare circumstances, government guaranteed student loans.

Types Of Bankruptcies
There are several names given to the various types of bankruptcies: they are generally called by both the numbers used in the law, and by the actual subject matter dealt with. The chapters that are used the most frequently are Chapter 7 (liquidation), Chapter 11 (reorganization) and Chapter 13 (personal reorganization). First, however, a brief description of the other chapters.

  • Chapter 9- Municipalities. Bankruptcy filing by municipalities, particularly in California, are on the rise; most cities cite union and legacy costs as the cause. It makes sense that there are provisions for dealing with a city’s financial crisis, because of the impact on the provision of city services, including police and fire. 
  • Chapter 12- this is for family farmers, not corporate farmers, and in order to be eligible to file a Chapter 12 bankruptcy, a family farmer must derive at least 50% of their income from farming.
  • Chapter 13- this is personal, or opposed to corporate, reorganization. Many of the same concepts apply as in the corporate reorganization, and a Chapter 13 reorganization can be used to shed unsecured (generally credit card) debt.

Turning to the more frequently used chapters:

  • Chapter 11: this is a reorganization, and is used by businesses to restructure debt and continue in business. A business can shed leased locations, cancel contracts, restructure debt to more favorable interest rates or amortization periods, and pay pennies on the dollar on trade or unsecured debt.   A company can file bankruptcy in the state where it is incorporated or where is conducts most of its business. This has resulted in a great number of filings in the Bankruptcy Courts in Delaware and New York, because many businesses incorporate in those states. Legislation has been discussed to require businesses to file for bankruptcy where they conduct business, instead of where they are incorporated or happen to have a single office, which this will make participation by creditors, including former employees, easier. 
  • Plan of Reorganization - Chapter 11 (and Chapter 13) cases are supposed to conclude with what is called a "plan of reorganization" that sets forth how the debtor intends to restructure and pay its debts. Creditors get to vote on and object to the plan, and the Bankruptcy judge has the ultimate authority to approve or deny the plan. Of those plans that fail to obtain approval, most fail because they are deemed not “feasible” which means that the income projections are too optimistic and the expense projections are too low. In addition, the debtor must propose in its plan to treat creditors with the same types of claims equally. The best example of this is trade creditors, who are generally unsecured. It would not be permissible for one trade creditor to be paid 80 cents on the dollar and another to be paid 10 cents on the dollar.  
  • Reorganization to Liquidation- Chapter 11 cases and Chapter 13 reorganizations can turn into Chapter 7 liquidations. This can happed either voluntarily upon the debtor’s request or involuntarily, either by the request of a creditor or by the Bankruptcy Court’s order. This can happen if it doesn’t appear that reorganization, which requires a certain level of income and expense, is feasible.
  • Chapter 7, so named because it’s the 700 series of the Bankruptcy Code, is liquidation. Individuals and companies can file for Chapter 7 bankruptcy. For an individual, most assets will be sold or returned to the creditor. An asset might be returned to the creditor that has the first lien on it if there is no equity in the asset, for example if real estate is worth $500,000 but the mortgage on it is $750,000. In contrast, a debtor may chose to affirm certain debts if they want to retain the corresponding asset. For a business, Chapter 7 liquidation means the business is closed or will be closed, and will be sold off in whole or in parts. A trustee is appointed by the court to oversee the sale of the debtor’s assets (note that the debtor is not in charge, as in an 11); it’s also possible that the effect of a Chapter 7 for an individual (not a business) is a discharge from their debts. If an unsecured creditor receives a 10% distribution through a Chapter 7, the remaining 90% is discharged, meaning that the creditor cannot come back after bankruptcy and try to collect the 90% balance from the debtor. That creditor may face a contempt of court charge. There are specific sections in Chapter 7 for stockbroker, commodity broker and clearing bank liquidations.

Bankruptcy Issues For Vendors
The Bankruptcy Code creates certain obstacles for creditors. The filing of a bankruptcy petition creates a bankruptcy estate that is comprised of all the debtor’s property. A trustee will be appointed in a Chapter 7 case; a Chapter 11 case may be run by a court-appointed trustee or by the debtor, which will be called a "debtor in possession" or "DIP". The Bankruptcy Code gives broad powers to the DIP, or the trustee as the case may be, to carry out his or her duties.   Among the powers of the trustee or a DIP that may affect a lender or creditor are the following:

  • Preferences are transfers and payments made by or on behalf of the debtors within ninety days before the debtor filed its bankruptcy petition. Transactions made in the ordinary course of business generally cannot be avoided as preferential. There are defenses, including that the debt was incurred in the ordinary course of business and the payment was made in the ordinary course of business; the sale was a substantially contemporaneous exchange (ie- COD) or the transaction represented new value- money or money’s worth in goods, services or new credit
  • Superior Lien Creditor. The trustee or DIP has the power of a superior lien creditor and may set aside unperfected interests in real estate and personal property of the debtor. 11 U.S.C. §544. This arises, for example, if a creditor fails to record its mortgage or file its financing statement.
  • Post-petition transfers. The trustee may avoid certain transfers made after bankrutcpy, subject to certain exceptions including most purchases by a good faith purchaser without knowledge of the bankruptcy. 11 U.S.C.§549(a).
  • Fraudulent Transfers. The trustee can avoid fraudulent transfers of real and personal property, subject to Title 11 U.S.C.§548 and applicable state law. A creditor may urge the trustee to pursue transfers it believes are fraudulent.
  • Executory Contracts- a contract is executory if some performance, other than the payment of money, is due from both sides. 
  • First, a debtor (or a bankruptcy trustee) gets to decide whether to perform its obligations under an executory contract.  In bankruptcy parlance, a debtor who “assumes” a contract agrees to perform it; a debtor who “rejects” the contract has decides not to perform, and to breach it. 
  • Second, while the debtor is deciding what to do, the non-debtor party to an executory contract has to continue performing as if no bankruptcy had been filed. Your option is to ask the court to make the debtor decide what it’s going to do, aka, “compel”.
  • Third, if the debtor assumes the executory contract – here’s the good news — the debtor has to pay (“cure”) in full any payment or other defaults and show that it can actually perform in the future.  If the debtor wants to assume and assign the executory contract to someone else, commonly a buyer of its assets, at a minimum the debtor has to cure any defaults and the buyer has to show that it can actually perform under the contract in the future.
  • Personal services contract are not generally assignable, but they are assumable.

A bankruptcy filing by a business partner, whether a customer, tenants or supplier, can have a significant impact on your business. In the event you receive notice of a bankruptcy filing, notify your counsel, or obtain counsel in order to receive complete and accurate information and to be fully advised of your rights and your risks.