Every business lawyer needs a basic understanding of bankruptcy law. Your client can be affected by a bankruptcy in many ways: it may be a creditor in a bankruptcy case; it may need or want to do business with a trustee or debtor in a bankruptcy case; or it may be a defendant in a preference action or other bankruptcy litigation, among other possible scenarios. Your client also may face financial distress and need to explore restructuring or wind-down options, including filing for bankruptcy. A business lawyer needs to understand the basics to address common bankruptcy issues that arise in business matters.
Types of Bankruptcy
All bankruptcies are governed by title 11 of the United States Code. There are several types of bankruptcies available under title 11. Businesses are eligible to file under either Chapter 7 or Chapter 11. Chapter 7 is a liquidation case, which may be a good option if your client wants to cease doing business. Chapter 11 is a reorganization case, which is applicable if your client wants to maintain control and continue operating while restructuring its balance sheet. While Chapter 11 is known as a “reorganization” case, many Chapter 11 bankruptcy cases end in liquidation or in a sale of the business to a third-party purchaser.
When a debtor files a Chapter 7, a Chapter 7 trustee is automatically appointed to administer the debtor’s property. Whereas, in a Chapter 11 case, the debtor generally remains in possession of its property (unless a party seeks to have a trustee appointed based on a finding by the court of fraud and mismanagement). The Chapter 11 debtor is known as a “debtor in possession.” If the debtor is a business, this means that the managers of the business continue to operate the business. But because the debtor in possession has the same rights and obligations as a bankruptcy trustee, the debtor in bankruptcy has different fiduciary responsibilities than it would outside of bankruptcy. The debtor in possession in not just accountable to its equity holders, but also accountable to its creditors.
The filing of the bankruptcy case imposes an automatic stay against collection efforts on the debtor or the debtor’s property. This means that while the automatic stay is in effect, creditors cannot sue, assert a deficiency, repossess property, or otherwise try to collect from the debtor. Creditors cannot demand repayment from the debtor. Creditors who violate the stay can be required to pay actual and punitive damages and attorney’s fees.
The automatic stay is very broad and does not only apply to collection efforts, but also to any act to obtain possession of the debtor’s property or exercise control over the debtor’s property. The purpose of the automatic stay is to give the debtor a breathing spell to stop collection efforts and to permit the debtor an opportunity to attempt repayment or reorganization. However, under certain circumstances, such as a showing of good cause, creditors can ask the bankruptcy court to lift the stay. Additionally, secured creditors may ask the bankruptcy court for adequate protection from a decrease in the value of its collateral to ensure they are not unfairly prejudiced by the stay.
Proof of Claim
Creditors can assert a claim against a debtor by filing a proof of claim. A proof of claim is an official bankruptcy form that must be used. The proof of claim form recently changed, effective April 1, 2016, and can be found on the United States Courts website. A bankruptcy case will have a set deadline for when proofs of claim must be filed, referred to as a “bar date.” Any claims not filed by this deadline are barred from being asserted at a later time.
The Bankruptcy Code requires creditors to file a proof of claim if their right to payment from the debtor is contingent, unliquidated, or unmatured, except under certain circumstances. A creditor’s basis for filing a proof of claim could arise from contract rights with the debtor, tort claims against the debtor, a judgment against the debtor, or even a not-yet-filed lawsuit against the debtor. The debtor will be given the opportunity to dispute the proof of claim before the bankruptcy court “allows” the claim—i.e., finds that the creditor is entitled to payment.
Meeting of Creditors
Shortly after the commencement of a bankruptcy case, the court schedules a meeting of creditors whereby creditors are invited to attend the meeting to ask questions of the debtor under oath. This meeting, called the “341 meeting” for the section of the Bankruptcy Code authorizing the meeting, is similar to a traditional deposition. The scope of the 341 meeting, however, is not governed by traditional discovery rules. Instead, the questions mostly will be about the debtor’s assets, income, and debts.
Questions may be asked by the creditor directly, or by its representative. The meeting of creditors is a great opportunity for a creditor to find out information about the bankruptcy case without the need for formal discovery. Recognize, however, to the extent that the creditor has substantial and numerous questions or if the questions do not relate to the debtor’s financial affairs, then the creditor’s questions may be limited.
Priority of Payments
The Bankruptcy Code specifies the order in which claims are paid from the assets of a debtor’s estate. Secured creditors are paid from the collateral securing their claims. Superpriority claims are generally certain types of administrative claims. Some superpriority claims prevail over secured claims while others are paid after secured claims but before priority claims. Priority claims are certain pre-petition unsecured claims that include, among other things, certain wage claims and tax claims. General unsecured claims are paid after priority claims.
If there are insufficient assets to pay all claimants of a particular priority class in full, then distributions to pay claims of the same priority class are made on a pro rata basis. This means all creditors of the same priority class are treated alike. Equity does not get paid unless all creditors are paid in full.
A bankruptcy discharge releases the debtor from liability for certain specified types of debts which means that the debtor is no longer legally required to pay such debts. In a Chapter 7 case, the bankruptcy court generally grants the discharge promptly on expiration of the time fixed for filing a complaint objecting to discharge and the time fixed for filing a motion to dismiss the case for substantial abuse (60 days following the first date set for the 341 meeting). In a Chapter 11 case, a discharge is granted when the Chapter 11 plan is confirmed. However, if the Chapter 11 plan provides for the liquidation of the debtor’s property, then no discharge is granted.
Making collection demands on discharged debtor violates the order granting discharge and the creditor can be liable for damages and sanctions.
If your business client is a landlord or a tenant, a personal property lessor or lessee, a service provider, or a business that requires services to be provided, then issues about executory contracts are likely to arise. Executory contracts are contracts where material nonmonetary obligations have yet to be performed. The Chapter 7 trustee or debtor in possession has special rights with respect to executory contracts and leases. Specifically, they can decide whether to perform or refuse to perform under an executory contract or lease. Deciding to perform is known as assumption, and refusing to perform is known as rejection. Until the decision to assume or reject is made (or the contract is otherwise rejected by operation of the Bankruptcy Code), the counterparty must continue to perform under an executory contract or lease or be deemed to be in violation of the automatic stay. Counterparties to an executory contract, however, must be paid for goods or services provided under the executory contract during the Chapter 11 case until the executory contract is rejected.
Rejection is treated like a material breach of the contract; however, the only remedy for the counter-party is to assert a claim for rejection damages, which is treated as a pre-petition general unsecured claim, in pari passu with the debtor’s other pre-petition general unsecured claims.
In a Chapter 11 case, the U.S. Trustee can appoint an official committee of general unsecured creditors which is commonly known as the “creditors’ committee.” The creditors’ committee is comprised of a representative cross-section of the debtor’s unsecured creditors and has a fiduciary duty to all unsecured creditors to maintain the estate’s value, consults with the debtor in possession on administration of the case, investigates the debtor’s conduct and operation of the business, and participates in formulating a plan. Attorneys and other professionals retained by the creditors’ committee are compensated from assets of the debtor’s estate. Individual committee members are not charged directly.
The creditors’ committee’s role includes, among other things, providing access to information to creditors not appointed to the committee. So the creditor’s committee is a great source of information for creditors in a Chapter 11 bankruptcy case. The creditor’s committee is also charged with soliciting and receiving comments from creditors not appointed to the committee. Cost-conscious creditors may be able to piggy-back on work performed by the creditor’s committee, such as by joining in an objection filed by the committee, to protect their positions.
Chapter 11 Plan
The Chapter 11 plan is the culmination of the Chapter 11 process and is considered a binding agreement between the debtor and all of its creditors and stakeholders. The debtor in possession has a certain exclusivity period where it alone can propose a plan; after that period, other creditors can propose their own plan.
The Chapter 11 plan provides the details for the debtor’s reorganization or liquidation including, among other things, the treatment of all claims and interests in the debtor. The treatment of claims can vary widely from distributing cash to the claim holder, converting the claim to equity (or some other interest), or simply canceling out the debt.
With some exceptions, creditors are generally entitled to vote on the Chapter 11 plan. These creditors (or their counsel) will receive a solicitation package that includes a disclosure statement. A disclosure statement is a prospectus-like document that provides relevant background information and summarizes the major terms of the Chapter 11 plan. The solicitation package will also include a ballot to vote on the plan. If the Chapter 11 plan is approved by the bankruptcy court, then the plan is binding on all creditors and stakeholders.
If a creditor wants to object to a Chapter 11 plan, it is not sufficient to just vote against the plan. The creditor must file an objection and state the specific basis for the objection.
Preferences are certain transfers of a debtor’s property made by an insolvent debtor within 90 days of bankruptcy (or one year, if to an insider). Preferences are transfers made by the debtor on account of an antecedent debt. This means that even though the debtor owed a debt to the creditor, the creditor may have to pay the amount back as a preference. The purpose of the preference action is to prevent the debtor from preferring certain creditors’ claims over others just before the bankruptcy filing—or to prevent one creditors from demanding payment on the eve of the debtor’s bankruptcy to the other creditors’ detriment. Instead, through preference actions, the bankruptcy court attempts to provide equality of distributions among all the creditors.
A creditor sued for a preference has many possible defenses. The creditor may defend the preference by showing, among other things: (1) that the transfer was in the ordinary course of financial affairs between the debtor and the creditor, (2) the transfer was made according to ordinary business terms, (3) the transfer was a contemporaneous exchange of value, or (4) that the creditor gave new value to the debtor after the creditor received the preferential transfer.
The Bankruptcy Code’s substance and procedure may be foreign territory for business clients and lawyers alike. It is best to consult a bankruptcy practitioner for insight into your client’s specific facts and circumstances. But every business lawyer should have at least a basic understanding of the core bankruptcy concepts. For a more detailed look at these concepts, the ABA Business Law Section hosted an “In the Know” webinar, co-sponsored by the Business Bankruptcy Committee, on June 30, 2016, titled Bankruptcy Basics: What Every Business Lawyer Needs to Know About the Bankruptcy Process. The speakers discussed the fundamentals of bankruptcy practice for business lawyers including details on the bankruptcy process; how the bankruptcy process impacts various parties in interest and the basics of bankruptcy litigation. Access the webinar archive here.
The authors wish to thank Judith Greenstone Miller, Jaffe Raitt Heuer & Weiss, P.C., Chair of the Membership Subcommittee of the Business Bankruptcy Committee, and Donald R. Kirk, Carlton Fields, Vice-Chair of the Membership Subcommittee of the Business Bankruptcy Committee.