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WHEN DEBTOR FILES BANKRUPTCY On April 20, 2005, President Bush signed into law the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (the "Act"). Almost all of the provisions of the Act became effective for cases filed on or after October 17, 2005. For cases filed before that date, the old provisions will still be in effect While the Act has received media attention mostly for its consumer provisions, it contains several sections that will affect business bankruptcies. A. ALTERNATIVES TO BANKRUPTCY Prior to foreclosing on property or taking other collection action that could force a debtor into bankruptcy, consider a debt workout that encompasses one or more of the following: Short pay or short refinance: sometimes a friend, relative or investor can buy or pay off the mortgage from the creditor at a discount. Modify the existing mortgage: the creditor, usually a bank, agrees to change the terms of the loan; most often the changes are temporary. Reducing the interest rate, principal portions of payments, or extending the amortization in an effort to reduce overall payment obligations, remain the changes most acceptable to creditors. Repayment plan: debtor pays a portion of the arrearage and agrees to pay the rest in addition to the regular payment over a period of months.. Possibly consider less down from debtor with payment over a longer period of time. Deed in lieu of foreclosure: debtor gives the property back to the creditor usually in exchange for their forgiveness of potential deficiencies. Short Sale: the property sells to a third party; the creditor accepts this price as full settlement of the debt. Friendly Foreclosure: the creditor or a friendly third party that has bought the mortgage sells the property at foreclosure to clean the title of other lienholders. Later the property sells back to the debtor or another predetermined entity. Forbearance: in exchange for money or the debtor taking some other action (perhaps listing the property with a realtor or making repairs) the creditor agrees to temporarily cease legal actions. Encourage debtor to contact Consumer Credit Counseling Service: this is a nationwide nonprofit organization that will work with the debtor and creditors to devise a more manageable repayment plan suited to debtor's finances. Out-of-Court Settlement: rather than file bankruptcy, debtor attempts to settle unsecured debt at a reduced amount! Debt Consolidation Loans: debtor borrows against the equity in his/her home to pay down credit card debt. B. RECURRING ISSUES IN BANKRUPTCY PROCEEDINGS If the debtor files bankruptcy, your first step will be to file a notice of appearance and request for copies with the bankruptcy court. This will assure that you will receive copies of pleadings and other notices filed with the bankruptcy court. Second, you should file a proof of claim for the entire amount of your claim. Blank proofs of claim forms are located on the homepages of each bankruptcy court. The proof of claim will bring your debt into the case even if the debtor fails to mention you in his filing. Once the petition is filed, the court sets a deadline for filing claims, so make sure to file your claim as soon as possible. The deadlines can be found online by searching for your debtor's case on the PACER system at http://pacer.psc.uscourts.gov. This website provides links to all bankruptcy courts. PACER is the on-line file system for all federal courts, including district and appellate. It requires a subscription, but only costs 8 cents per page to view a document. It is available 24 hours a day, seven days a week, so documents can be filed even when the clerk's office is closed. Whether the debtor is going to liquidate under chapter 7 or reorganize under chapter 13 (individual) or. chapter 11 (corporations), it is important that you monitor the case and review pleadings to make sure nothing is affecting your status. Since bankruptcy courts require online filing, it is extremely easy and inexpensive to monitor and participate in a bankruptcy case. Monitoring the case also allows you to see which other creditors are involved and how much they are owed. The automatic stay comes into effect the moment that the debtor files its bankruptcy petition. Pursuant to Section 362 of the Bankruptcy Code, all debt collection attempts toward the debtor must cease at that time. This includes any actions with respect to recovering property or enforcing liens. Section 362 also provides for relief from the automatic stay if your debt is secured by collateral that is not adequately protected or if your property will not play a significant role in the debtor's attempts to reorganize. You should file a motion for relief from the automatic stay asking the court to terminate, modify, or condition the automatic stay with respect to your property. Bankruptcies move fast and it is extremely important to quickly respond to objections or other documents filed with the court that affect your interests. For example, the trustee or debtor may file an objection with respect to your claim. The court will expect you to show proof of your claim or it will disallow the entire amount or a portion thereof. Additionally, the debtor or trustee may claim that you received a preferential payment immediately prior to the bankruptcy petition. In that case, you must respond immediately or risk the court awarding judgment against you for the amount considered a preference. Soon after the filing of the bankruptcy petition, a meeting of creditors will be held pursuant to Section 341 of the Bankruptcy Code. Attendance is not mandatory, but you can appear and ask questions of the debtor and find out his plans for repayment. If you are an unsecured creditor, you may consider serving on the creditors committee. If you are a secured creditor, you may want to file a motion on the property for adequate protection of your interests. If you are currently litigating your debt in state or federal district court at the time the debtor files bankruptcy, your case may be removed to the bankruptcy court under 28 U.S.C. §1452 and Bankruptcy Rule 9027. Removal allows the bankruptcy court to monitor and control all matters related to the debtor's finances. The notice of removal is filed with the court in which the underlying case is pending. The deadlines to seek removal are found in Rule 9027(2) and (3). If the recovery or relief you seek in the underlying case will not affect the debtor's bankruptcy or it is more appropriate to let the original state or federal court hear your case, you ask the bankruptcy court to remand the case under 28 U.S.C. §1452 and Rule 9027. Remand may be important to you if the underlying court is better acquainted with your case, you are on the eve of trial, or other equitable reasons exist. If the debtor will be reorganizing as opposed to liquidating assets, you will have an opportunity to vote on the debtor's proposed plan. Prior to the dispersal of the plan for voting purposes, the debtor must make a number of disclosures regarding its finance situation including the filing of a Disclosure Statement. These forms can be viewed on PACER. It is wise to contact an attorney if you have any questions regarding your status in the case and how much you will inevitably recover. Certain issues consistently arise in most bankruptcy. The following topics are a some of the key issues to be prepared to face: Reclamation Under existing law, a seller of goods received by the debtor in the ordinary course before bankruptcy is entitled to seek reclamation of goods if the supplier makes a qualifying reclamation demand before 10 days after receipt of the goods and the debtor was insolvent at the time of receipt. The reclamation claim must be valid under applicable non-bankruptcy law (typically U.C.C. 2-702) and the seller must satisfy the additional requirements under Bankruptcy Code section 546(c). The U.C.C. sets certain relatively stringent tests for reclaiming goods, including establishing that the goods were still held by the debtor in their original form when the reclamation demand was made, and requiring that the demand identify the goods sought to be reclaimed with reasonable specificity. Bankruptcy Code section 546(c)(2) presently provides that in lieu of actually taking back the goods, the court may provide the reclamation creditor with an administrative priority or a lien. After the new bankruptcy laws take effect, a trade supplier's reclamation rights will be expanded in several important respects. First, the amendment will substantially lengthen the period that a trade creditor can make a demand, thereby expanding the universe of goods that will be subject to reclamation. Under the new law, a supplier will be able to reclaim goods sold to the debtor in the ordinary course if it demands reclamation not later than 45 days after delivery, as opposed to "before W days after receipt" under present law. Second, the new law apparently will eliminate the requirement that the reclamation claim be valid under the U.C.C. This probably means that the supplier seeking reclamation will no longer have to worry about whether the goods were still in the debtor's possession or in their original form when the reclamation demand was made, or whether the reclamation demand was made with sufficient specificity. On the other hand, the proposed amendment expressly provides that any reclamation demand is "subject to the prior rights" of a secured creditor with a security interest in the goods supplied; so if secured creditors with inventory liens are undersecured, suppliers will still presumably not be able to assert valid reclamation claims. Executory contracts Section 365(b)(l)(A) of the Bankruptcy Code has been revised from the current law, which requires that a debtor in bankruptcy must cure, or provide adequate assurance that it will cure, any default in an executory contract or unexpired lease in order to assume (or assume and assign to a third party) such contract or lease. Under the Act, this provision is amended to provide that non-monetary defaults need not be cured as a condition of assumption if it is impossible for the debtor to cure such default by performing non-monetary actions at and after the time of assumption. If the contract is a nonresidential real property lease, however, and the default arises from the failure to operate in accordance with the lease, in order for the debtor to assume or assign the lease, the default must be cured by performance at and after the time of assumption in accordance with, the lease, and any pecuniary losses associated with the default must be compensated as part of the cure. The effect of this change is to make it easier for a bankrupt tenant to assume and assign its commercial leases, provided that the lessee cures all monetary and non-monetary defaults on a post-assumption basis. The Act benefits commercial landlords by amending Section 365(d)(4) of the Bankruptcy Code, which currently provides that any unexpired lease for nonresidential real property that is not assumed or rejected within 60 days after the petition date is deemed rejected, unless, prior to the expiration of the 60-day period, the court, for cause, extends the time within which the debtor may assume or reject the lease. Under the Act, the deadline for assuming such leases has been extended to the earlier of (i) 120 days from the date of the order for relief or (ii) the date of the entry of an order confirming a plan. The court, for cause, can extend the 120-day period for no more than 90 days, and any further extensions to the time to assume can be granted by the court only with the prior written consent of the lessor. In an attempt to counter-balance the new requirements contained in revised Section 365(d)(4), the Act adds Section 503{b)(7) to the Bankruptcy Code. Section 503(b)(7) provides that with respect to any lease of nonresidential real property that is first assumed by the debtor and later rejected, the lessor's administrative expense (i.er, priority) claim will be limited to an amount equal to all monetary obligations (except for penalties) for a two-year period following the later of (i) the rejection date or (ii) the date of turnover of the property, without reduction or setoff, except for amounts actually received by the lessor from a non-debtor entity. Any claim for the remaining amounts due under the rejected lease is deemed to be a general unsecured claim under Section 502(b)(6), and is subject to the limitations set forth in that provision. Critical vendor ... Often, a creditor threatens to cease supplying its product or service to the debtor if its prepetition debt is not paid. The debtor then panics because this is one more disruption early in the bankruptcy case that could thwart its reorganization. If the lack of the product or service would severely impair the debtor's ability to operate, then the loss of the vendor is "critical." Many trade creditors have been able to negotiate for cash covering all, or a portion, of their prepetition claims in return for an agreement to continue to supply the debtor postpetition. So-called "critical vendor" motions have become common in larger chapter 11 cases, so even before this new legislation it would be unrealistic to assume that trade creditors are restricted to recovering based on their strict legal priorities. But the practice of paying "critical vendors" has recently come under attack. For example, in In the Matter of Kmart Corp., 359 F. 3d 866 (7th Cir. 2004), the Seventh Circuit Court of Appeals cast significant doubt on the practice of preferring trade vendors. In Kmart, the court upheld the district court's reversal of an order of the bankruptcy court holding that the debtor could make payments to 65 of its "critical vendors" outside of a plan. The circuit court explained that the bankruptcy court did not apply sufficiently strict evidentiary and procedural standards to justify such payments. The Seventh Circuit's ruling forced Kmart to seek disgorgement from the 65 vendors to whom it had already made payments pursuant to the bankruptcy court's order. The Seventh Circuit did not hold that such "critical vendor" payments could never be made, but instead held that the requirements for making such payments are exceedingly high. Other courts have questioned the propriety of "critical vendor" payments, either on the grounds that there is no clear statutory basis for making such payments or on the evidentiary basis that few of the so-called critical vendors are really all that critical. So while the Act's new provisions do not necessarily represent a sea change for the treatment of prepetition trade creditors, it should significantly strengthen their hand, particularly before courts that question the propriety of critical vendor payments. Creditor's Committee . The Act grants the Bankruptcy Court express authority to order the United States Trustee to change the membership of an official committee if the Bankruptcy Court determines that the change is necessary to ensure adequate representation. The Act also specifies that the Bankruptcy Court may direct the United States Trustee to increase the membership of a committee for the purpose of including a small business concern (as defined under §3(a)(l) of the Small Business Act) if the Bankruptcy Court determines that such creditor's claim is of the kind represented on the committee and that, in the aggregate, the claim is disproportionately large when compared to the creditor's annual gross revenue. Therefore, under the Act, disputes regarding membership on an official committee are now clearly within the powers of the Bankruptcy Court to adjudicate. Furthermore, the Act imposes certain obligations on official committees that do not currently exist. Under the Act, an official committee (1) is required to provide access to information to, and solicit comments from, creditors holding claims of the kind represented by the committee, and (2) may be required by the Bankruptcy Court to make additional reports or disclosures to such creditors. This provision may impact the information that a debtor provides to a committee. Administrative priority for post-petition sales to creditor Amended Section 503(b) of the Bankruptcy Code confers administrative expense priority status on all claims for "the value of any goods" received in the ordinary course by the debtor within 20 days before the bankruptcy filing. Bankruptcy Code section 1129 provides that a chapter 11 plan of reorganization cannot be confirmed unless administrative claims are paid in cash on the effective date of the plan. Thus, an administrative expense claimant has a veto over a reorganization unless it is cashed out. This is a powerful right and previously was generally restricted to post-bankruptcy claims and certain other special cases. This proposed expansion of administrative expense status will be limited to claims for goods (as opposed to, for example, claims for services, contract claims that do not relate to the supply of goods, or tort claims) supplied in the ordinary course during the 20-day window. Uses of cash collateral Under 11 U.S.C. Section 541(a), the filing of a Chapter 11 petition automatically creates an estate consisting of all property owned by the debtor at the time of filing. For any business, this property includes cash. Section 363(a) of the Bankruptcy Code defines cash and cash equivalents as "cash collateral.11 Often a secured creditor, such as a bank or federal government, holds a security interest in cash collateral. Under Section 363(c)(2), the debtor is absolutely prohibited from spending cash collateral without the consent of all parties that have an interest in the collateral, or a court order. The basis for this prohibition is that security interests are constitutionally protected property rights. This rule proscribing the use of cash collateral is simple and straightforward. Sometimes a debtor will make expenditures without the consent of the secured creditors or the authority of the court. When this happens, the entire Chapter 11 case is placed at jisk and the representative of the debtor who directed the misuse of cash collateral may face significant financial penalties. Typically, the Chapter 11 debtor files an emergency motion for the use of cash collateral when the petition is filed. Courts usually grant these emergency motions and authorize debtors to make the appropriate expenditures. Despite the authority that a secured creditor may consent to use of cash collateral through acts or failure to protect its interests, the penalties for misuse of cash collateral can be severe. Automatic stay The new law limits the application of the stay or provides that it does not go into effect, in certain circumstances, where there are serial filings under circumstances that would indicate bad faith or abusive filings. The stay terminates after 30 days if there is a filing by an individual in Chapter 7,11 or 13 (but not Chapter 12) within 1 year after the prior case (under any Chapter) was dismissed (except for a case-refiled in another chapter after a dismissal of a Chapter 7 case based on the means test), A party in interest (including the debtor) may move to extend the stay and show that the filing is in good faith. A case is presumed to be in bad faith for this purpose if more than one case was pending in Chapters 7,11 or 13 (again, not in Chapter 12) and at least one such case was dismissed for failure to file required documents without substantial excuse, to provide adequate protection, or to complete a plan, and there is no showing that the debtor's financial situation has changed so as to allow a final discharge or completion of a plan. If two or more cases under any Chapter were dismissed during the prior year, the automatic stay does not go into effect at all until the court so orders after a hearing and a demonstration that the filing was made in good faith. The same bad faith factors noted above are also applicable to this determination. The law also provides that the stay will terminate if the debtor does not timely file (i.e., within 30 days after the petition date) its statement of intent with respect to property subject to a security interest and timely (i.e. within 30 days after the first date set for the §341 meeting) complies with the stated intention. The court may extend the stay upon the motion of the trustee if the property is of the value to the estate and adequate protection is afforded to the creditor. C. PREFERENCE LIABILITY AND DEFENSES Section 547 of the Bankruptcy Code permits a trustee (or a debtor in possession) to recover from creditors payments made shortly before the bankruptcy filing where the payment gave the creditor more than other, similarly situated, creditors would get through the bankruptcy process. Debtors frequently want to protect creditors who are friends or family members from having to disgorge to the bankruptcy trustee payments made by the debtor or to pay off a credit card so they can keep it after the bankruptcy. The policy behind the statute is to diminish the advantages that a creditor might get by litigation or by aggressive collection actions that force the debtor into bankruptcy. That is accomplished by making payments received in the 90 days before the filing recoverable in bankruptcy. These payments are called "preferences." Bankruptcy Code §547 defines a preference:
Payments to a fully secured creditor are not considered preferences because the creditor didn't get more than he would have in bankruptcy, where the creditor would get the value of the collateral. Defenses to the recovery of a preference are found in 11 U.S.C. §547(c). They include:
These defenses need to be raised in an answer to a preference complaint. The burden of proof lies with the creditor to establish that despite the elements, of a preference, the transfer is protected by one or more of these defenses. The trend today seems to be for trustees or debtors in possession to sue everyone who received payment of any sort during the 90 days before filing and to sort out the merits of the plaintiffs claims later. The bankruptcy code also permits the recovery of payments on old claims owed to insiders. "Insider" is defined in 11 U.S.C. §101 and includes family members, partners, and corporations in which the debtor is a decision maker For insiders, the trustee can look back to payments made within a year of the bankruptcy filing. This provision attempts to prevent the debtor .from paying relatives and business decision makers at the expense of the trade creditors. In an insider preference action, there is no presumption that the debtor was insolvent when the payment was made and thus the proof of these kinds of actions is sometimes more complex for the trustee. Over the past several years, many businesses have been sued for recovery of preferential transfers. The Act will have a significant impact on actions by debtors and trustees to avoid preference payments. Businesses will find it easier to defend against a "preference" claim After the Act becomes law, it will be more difficult for trustees and debtors to pursue smaller, "nuisance" preference actions or other actions. For actions less than $10,000, a trustee or debtor can sue only in the judicial district where the defendant resides. Therefore, for example, if the bankruptcy case is pending in Texas but the company that received the preferential transfer is incorporated in Illinois, the preference action must be filed in Illinois if the action is for a recovery of less than $10,000. The debtor or trustee likely will be prohibited altogether from pursuing preference actions for less than $5,000 in most business bankruptcies. Another section of the Act will make it easier for defendants in preference actions to assert the "ordinary course of business" defense under Section 547. A defendant will now be able to establish this defense based on either its own history of transactions with the debtor, or standards in the parties' industries. Under previous law, a defendant was required to prove both of these elements. |
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