American Bar Association
General Practice, Solo, and Small Firm Division
The Compleat Lawyer
Winter 1997, Volume 14, No. 1
copyright American Bar Association. All rights reserved.

Bankruptcy Law

BY ERIC W. MESSINGER

Eric W. Messinger is a sole practitioner in Scottsdale, Arizona, and a former newsletter editor of the Bankruptcy Committee of the ABA General Practice, Solo and Small Firm Division.

Even if you do not handle bankruptcy matters on a regular basis, you can help clients who are creditors or who are considering filing for bankruptcy protection by giving them a sense of the procedures and effects of bankruptcy, and by helping them to make a realistic assessment of their situation and how best to proceed.

The Creditor's Perspective
At some point, nearly all general practitioners find themselves either attempting to collect a debt on behalf of a client or advising a client on whether to try to collect a debt and how to proceed. Often, the lawyer's first step is to advise the client on what he should do the next time he extends credit.

Because the possibility of bankruptcy lurks whenever credit is extended, creditors need to be aware of what is involved in pursuing a claim in bankruptcy, and how the creditor can put herself in the best possible position to avoid losing her claim in the bankruptcy process. Creditors must begin with the recognition that secured creditors are generally more likely to recover at least part of their claim in bankruptcy than unsecured creditors.

A creditor's rights in bankruptcy court differ depending on whether the creditor's claim is secured, the nature of the security interest, and whether the debtor has filed under Chapter 7 (liquidation by a bankruptcy trustee) or Chapters 11 or 13 (reorganization pursuant to a plan of usually partial repayments approved by the bankruptcy court).

The court issues an automatic stay when a debtor files a bankruptcy petition under any chapter of the Bankruptcy Code. The stay forbids creditors from taking any further action to collect debts from the debtor directly while the bankruptcy is pending. Violating the stay can result in loss of one's claims and sanctions. Like it or not, with few exceptions, relief comes only through the bankruptcy court at this point. Accordingly, creditors must avoid taking any action that would violate the stay and are generally best advised to file, in a timely fashion, a proof of claim to have the court recognize their claims.

Chapter 7 cases are often "no asset cases," meaning that the bankruptcy trustee has concluded that after accounting for exempt property, administrative expenses, and the return of collateral, no assets will remain to pay creditors' claims. An unsecured creditor can ask the debtor to reaffirm the debt, but the debtor is under no legal obligation to do so. Creditors and their counsel should consult the Bankruptcy Code and local rules to determine how to obtain an enforceable reaffirmation agreement. Reaffirmed debts are not discharged in bankruptcy.

Secured creditors generally look to recover their collateral if the debtor does not reaffirm the debt. If an action against the debtor was pending in another court at the time the debtor filed for bankruptcy protection, the creditor may seek to have that action removed to the bankruptcy court. Creditors may also promptly seek an order from the court to lift the stay for cause, such as when the creditor can demonstrate that his interest in the property is not adequately protected (for example, if the debtor fails to maintain adequate insurance coverage), or that the debtor does not have equity in the property and that the property is not necessary to the debtor's reorganization.

With few exceptions, the automatic stay does not apply to co-debtors, guarantors, or partners of a bankruptcy debtor who have not themselves filed for bankruptcy protection. Therefore, creditors who obtained a valid co-signer's or guarantor's commitment have recourse outside of the bankruptcy court. It should also be noted that certain debts and certain debtors may be ineligible for discharge--because of fraud, for example.

Creditors who believe their claims are secured must be vigilant in protecting those claims to property in the possession of debtors in bankruptcy. If a creditor concludes that she has an interest in cash or proceeds, she must be ready to act to ensure that her interest is recognized and that such collateral is not used or dissipated without her consent. Bankruptcy litigation can be as involved and expensive as litigation in other areas, but it also can offer a very realistic means of recovering property and enforcing claims.

Secured creditors should be prepared to see their claims against debtors under Chapters 11 or 13 substantially modified in the debtor's proposed repayment plan. Debtors frequently propose to extend maturity dates, reduce interest rates, and even reduce the amount of a claim to what the debtor attempts to prove is the current fair market value of the collateral. If enough other creditors of a class vote in favor of such a plan, the plan may ultimately be confirmed over the objections of a creditor. More commonly, however, Chapter 11 and 13 bankruptcy cases do not result in confirmed and executed plans, but are converted to Chapter 7 liquidation or are dismissed.

The Prospective Debtor in Bankruptcy
When advising a client who is considering filing for bankruptcy protection, look at the client's overall circumstances. Can your client presently fund a workout acceptable to his creditors? Does she need to move quickly to prevent creditors from bringing about the closure of her business or the loss of personal or family assets she might otherwise save? Frequently, a debtor consults a lawyer only after creditors have obtained judgments and are in the process of collecting or enforcing claims. At this point, the question is probably not if the client should file for bankruptcy, but when and under what chapter of the bankruptcy code.

Clients facing bankruptcy must gather together their records and determine the identity of their creditors and the status and amounts of their debts. Not only is this necessary to determine whether and under what chapter of the Bankruptcy Code they should file, it is also generally necessary to list creditors in order to give them notice and make any discharge effective against their claims.

The prospect of stopping collection efforts, coupled with promising terms like "discharge" and "fresh start," and the ease and speed with which one can file a petition (even without completed schedules) cause some financially desperate clients to leap at the chance to file for bankruptcy protection. They must be made aware, however, that certain debts are not dischargeable in bankruptcy and some clients are ineligible for relief. Many common debts such as maintenance and support ordered in a decree of dissolution of marriage, certain unpaid tax debts, student loans, and fines and restitution ordered in criminal cases, generally are not dischargeable in bankruptcy for public policy reasons. Debts obtained through fraud, as mentioned, also may be held nondischargeable; and pervasive fraud or fraud committed in bankruptcy may disqualify the debtor from bankruptcy relief entirely.

Not only individual debts but the debtor himself may be ineligible for at least certain types of bankruptcy relief. A debtor cannot file a Chapter 7 petition if he or she has been granted a Chapter 7 discharge within the past seven years; and debtors cannot file a petition under any chapter of the bankruptcy code if a previous petition filed by the same debtor has been dismissed within the past 180 days.

For eligible debtors with dischargeable debts, timing a bankruptcy filing is important. Many debtors are aware of the importance of filing before a creditor has the opportunity to obtain and record a judgment or file a lien. It is sometimes possible to plan more extensively for bankruptcy or the possibility of bankruptcy; however, any asset protection or pre-bankruptcy planning must be evaluated in light of laws against fraudulent transfer, such as the Uniform Fraudulent Transfer Act and applicable local laws.

Fraudulent transfers (generally, transfers for less than adequate consideration done with the intent to hinder, delay, or defraud creditors) may result in liability for the lawyer as well as the client. Great care should be taken in advising clients in this area; the case law is neither clear nor consistent. While debtors are generally permitted to take full advantage of the bankruptcy exemptions, allowing, at least to some extent, the conversion of nonexempt assets (such as cash) into exempt assets (such as a homestead), overly ambitious pre-bankruptcy planning can jeopardize the right to bankruptcy relief.

Unfortunately, the risks inherent in pre-bankruptcy planning do not justify avoiding the issue entirely, since the client should be advised of options to which she is entitled. Care should be taken not to overlook basic requirements such as filing for a homestead, if the jurisdiction requires it. The general practitioner should be aware of the issues involved in pre-bankruptcy planning, but should be very cautious about giving specific advice or helping clients transfer assets.

Business clients and individuals with substantial resources usually will prefer to attempt to reorganize and at least partially repay their debts without liquidating all nonexempt assets. These clients hope to use the bankruptcy stay to forestall further collection efforts by their often intransigent creditors and buy themselves time to devise and implement a repayment plan. Filing under Chapter 11 or Chapter 13 can buy the debtor time and even permit him to reduce the amount of his debt, but the debtor should be realistic about the prospects of funding and completing a repayment plan.

Business debtors who are contemplating bankruptcy reorganization need to take into account the likely reaction of their suppliers and customers and consider what the business can do to reassure these parties of the business's continued viability. Business debtors generally are allowed to continue to manage their businesses during the pendency of the bankruptcy, and the simple fact of the bankruptcy will not tend to inspire confidence in current or future creditors. Debtors contemplating bankruptcy, especially businesses and individuals with substantial assets and claims, should recognize the possibility of long and involved litigation.

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