A NEW WORLD: BANKRUPTCY LAW FOR THE NON-BANKRUPTCY LAWYER

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What Is Bankruptcy? • Bankruptcy is a court-supervised process pursuant to which

debtors (individuals and businesses) are able to adjust their debts and legal obligations.

• Bankruptcy is intended to provide a fresh start for debtors; many Bankruptcy Code provisions are directed at this purpose.

• Bankruptcy is also intended to promote fair treatment among creditors and other interested parties. Note, this does not mean that creditors will be treated objectively fairly as concerns their rights against the debtor.

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Why Should You Care?

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Bankruptcy Courts• Bankruptcy courts are units of federal district courts. Petitions, filed in

bankruptcy court, commence a case.

• Bankruptcy cases are automatically referred to bankruptcy courts from district courts.

• Bankruptcy cases cannot be filed in state courts.

• Appeals from bankruptcy courts do not go directly to the circuit court of appeals.

• Rather, bankruptcy court appeals may go to the district court or a Bankruptcy Appellate Panel. A party may opt out of a BAP appeal and go the district court.

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Common Bankruptcy Types: Chapter 7

• Chapter 7 governs the process of liquidation.

• Businesses and individuals may file Chapter 7 cases.

• Upon filing, a bankruptcy estate is created.

• A Chapter 7 trustee is appointed to liquidate the assets of the estate. Management, if it is a corporate debtor, is no longer in control of the business.

• The Chapter 7 trustee sells the debtor’s property and distributes the proceeds to the creditors. If no valuable assets exist, the trustee will deem the case a “no asset” case and abandon the property back to the debtor.

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Common Bankruptcy Types: Chapter 11• Chapter 11 governs the process of reorganization.

• Businesses and individuals may file Chapter 11 cases.

• Upon filing, a bankruptcy estate is created. The bankrupt company is called debtor-in-possession (or DIP).

• No trustee is immediately appointed in a Chapter 11 case. Management, if it is a corporate filing, remains in control of the DIP and may continue operating the business, including employing professionals, addressing creditor claims, and filing reports to the courts.

• The DIP has the exclusive right, for a time, to file a plan of reorganization.

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Other Bankruptcy Types:Chapters 9, 12, 13 and 15

• Chapter 9: Adjustment of debts of a municipality.

• Chapter 12: Adjustment of debts of family farmers and fishermen with regular incomes.

• Chapter 13: Adjustment of debts of individuals with regular incomes.

• Chapter 15: Ancillary and other cross-border cases.

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Commencing a Case (Chapters 7 or 11)• To commence a case, a debtor must:

– Be eligible.

– File a petition (businesses must have corporate authority for the filing).

– Pay the filing fees.

– File schedules of assets and liabilities.

– File a statement of financial affairs.

– File a schedule of executory contracts and unexpired leases.

– File a schedule of current income and expenditures.

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Priority of Claims• Secured

• Post-petition goods and services provided to the debtor– Administrative Claims

• Wages and salaries of employees

• Employee benefit plans

• Consumer deposits

• Taxes (state, local and federal) and any fines

• General unsecured claims

• Equity

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Who are the Parties in Interest?

• Debtor/debtor-in-possession

• Secured creditor

• Unsecured creditor

• U.S Trustee

• Case Trustee

• Examiner

• Creditors Committee

• Professionals

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• U.S. Trustee is the watchdog over the bankruptcy process, responsible for overseeing bankruptcy cases and monitoring debtors.

• In Chapter 7 cases, the U.S. Trustee:

– Appoints and supervises the Chapter 7 trustee.

– Monitors professional fee requests.

– Reviews the case for crimes, abuse and bad faith filings.

– Determines eligibility of individual debtors.

U.S. Trustee in Chapter 7 Cases

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• In Chapter 11 cases, the U.S. Trustee:

– Conducts initial debtor interview and meeting of creditors (the 341 meeting).

– Reviews monthly operating reports, which advise parties of the debtor’s ongoing business operations.

– Reviews professionals’ applications for employment and fees.

– May request dismissal, conversion or appointment of Chapter 11 trustee when debtor fails to meet obligations under the Bankruptcy Code.

U.S. Trustee in Chapter 11 Cases

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• In Chapter 7 cases:

– A bankruptcy trustee is automatically appointed.

– Trustee’s duties include:

• Conducting meeting of creditors;

• Collecting and liquidating assets; and

• Paying creditors in order of priority.

• In Chapter 11 cases:

– Appointment of a trustee must be requested by motion.

– Appointment of a trustee requires notice and a hearing, and is rarely granted.

– Grounds for appointment include gross mismanagement, fraud, dishonesty, incompetence.

Bankruptcy Trustee

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• The Bankruptcy Trustee stands in the shoes of the debtor.

• The Bankruptcy Trustee has power to:

– Compel creditors into returning estate property to trustee (a so-called turnover action).

– Set aside certain transfers (and recover the transferred property), particularly:

• Preferences; and

• Fraudulent transfers.

Bankruptcy Trustee (in Chapter 7 and 11 Cases)

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Creditors’ Committee• Committees are appointed by the U.S. Trustee in many (but not all)

Chapter 11 cases.

• Committees consist of willing unsecured creditors. Usually committees have seven unsecured creditors appointed, balancing size of claim and creditor type (e.g., trade, bond, union).

• Committee rights include:

– Consulting with the debtor concerning the case.

– Investigating financial condition of the debtor

– Participating in formation of plan of reorganization

– Hiring professionals to assist in the exercise of the above powers.

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Bankruptcy Estate• All Debtor’s legal and equitable interests in property presently held,

including community property, will be considered the Bankruptcy Estate.

• Courts view the term expansively. It is important to remember when considering the automatic stay.

• Bankruptcy estate also includes property transferred in a “voidable” transaction; and

• Property Debtor obtains within 180 days after filing (so-called after-acquired property).

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• To receive a portion of debtor’s estate, each creditor must file a proof of claim.

• Claims based upon writing must be supported by the writing.

• Properly filed claims are presumptively valid. Burden shifts to trustee or debtor to object.

• Improperly filed claims do not enjoy a presumption of validity and the burden of establishing the claim remains with the creditor.

• Filing proof of claim submits a creditor to the bankruptcy court’s jurisdiction.

• Secured creditors may have to file claims too.

Creditors’ Claims

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• Administrative and priority claims get paid before “normal” unsecured claims (losing out only to secured claims in the priority hierarchy). Often times administrative claims are “paid in full.”

• Typical “good-and-services” creditors will have two important ways to obtain administrative priority:– 20 Day Claims - “the value of any goods received by the debtor within 20 days

before” the date a bankruptcy petition was filed “in which the goods have been sold to the debtor in the ordinary course of such debtor’s business” (e.g., invoices related to shipments made during the 20 days prior to a bankruptcy).

– Reclamation Claims - reclamation demand for goods received by a debtor within 45 days of its bankruptcy - provides some credit protection, additional negotiating leverage, and the ability to recover some goods shipped during the 45 days prior to a bankruptcy filing.

Creditors’ Administrative Claims

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• Debtor must file a statement of intention regarding secured collateral. Debtor may reaffirm a debt.

• Chapter 7 trustee gathers and liquidates available assets. Individual debtors may exempt certain property from the bankruptcy estate (exempt property will not be administered by the Chapter 7 trustee).

• Secured creditors will be given their collateral or the proceeds of the sale of their collateral.

• Unsecured creditors will receive payment ratably according to their priorities. A senior class will be paid in full before a junior class will be paid anything.

• If property remains after all creditors are paid in full, it will be returned to the debtor (or shareholders).

Chapter 7 Distribution of Property and Assets

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• Debtor must determine whether to reaffirm debt.

• Debtor agrees to pay a debt in bankruptcy by executing a reaffirmation agreement.

• Typically, vehicles and houses are the subjects of reaffirmation.

• Reaffirmation occurs before a discharge is granted.

• Reaffirmation disclosures are required, including that debtor’s counsel has reviewed debtor’s budget and can afford the reaffirmed debt.

Chapter 7 and 11: Reaffirmation of Debt

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• Discharge releases individual debtor from personal liability for certain debts (corporate debtors receive a discharge in Chapter 11 reorganizations).

• Liens pass through bankruptcy unaffected if not avoided or satisfied.

• Dischargeable debts vary among the chapters.

• Not all debts are dischargeable, for example:

– Taxes

– Student loans

– Child support and alimony

– Loans for luxury purchases (property will be sold)

– Debts not listed on bankruptcy schedules

• Creditors may object to discharge to have a debt determined non-dischargeable. Grounds include fraud and other dishonesty as well as willful and malicious injury.

Discharge of Debts

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Involuntary Bankruptcy• Creditors may file a Chapter 7 or 11 petition against a debtor.• If a debtor has 12 or more creditors, three creditors must file the

petition.• If a debtor has fewer than 12 creditors, only one creditor is

needed.• Debtor may contest the petition; creditors must establish:

– Debtor is not paying debts as they come due, or– Debtor has substantially all of its assets seized by a custodian

within the 120 days preceding the involuntary filing.

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Involuntary Bankruptcy• If the creditors prevail, an order for relief is entered and debtor

remains in Chapter 7 or 11.

• Creditors determine whether a liquidation or reorganization is sought in the involuntary petition. Debtor may request conversion of the case (often this is handled consensually, even where debtor contest the involuntary petition).

• If debtor prevails, case is dismissed and creditor(s) may be required to pay costs, attorneys’ fees; in cases of bad faith filings, punitive damages may be awarded.

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Automatic Stay• One of the most important aspects of bankruptcy. Allows the debtor

“breathing room” to make decisions in time of crisis.

• In both Chapter 7 and 11 cases, the automatic stay applies. It arises immediately upon filing a petition.

• Generally, the automatic stay is an automatic injunction prohibiting creditors from starting or continuing actions to collect debts.

• Prohibited actions including court cases, enforcing or perfecting liens, setting off mutual debts, and taking actions to obtain debtor’s property.

• Damages will be assessed against creditors for knowingly violating the automatic stay.

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Relief from the Automatic Stay

• A creditor, typically secured, can obtain relief from the automatic stay.

• The creditor essentially has two options:

– Prove “cause,” which may include lack of adequate protection; or

– Prove

• that the debtor has no equity in the property; and

• the property is not necessary for an effective reorganization.

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Adequate Protection• Adequate protection applies to protect the value of a creditor’s interest

in property. It is often applied when the value of the property is declining in value (e.g., debtor is using cash collateral to sustain operations).

• Adequate protection includes:

– Periodic or lump sum payments to the creditor holding the interest in the property;

– Additional or replacement liens (e.g., a lien on cash proceeds of the sale of property)

– Other relief resulting in the indubitable equivalent of the creditor’s interest in property.

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• The Bankruptcy Code permits a bankruptcy estate to recapture certain payments made before bankruptcy was filed. Preference actions recover property transferred to a creditor in preference over others.

• Cause of action:

– Transfer of property

– To or for the benefit of a creditor

– On account of an antecedent debt

– Made while the debtor was insolvent

– Made within 90 days before filing (one year for insiders)

– Transfer must allow creditor to receive more than it would in a liquidation (nearly always true for unsecured creditors).

Preference Actions

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• Ordinary course payment: Transfers made in the ordinary course of business, consistent with prior transfer in timing, amount and circumstances are not subject to preference liability.

• Subsequent advance or new value: Goods or services provided to a debtor on an unsecured basis after receipt of a preference function as an offset against preference liability.

• Contemporaneous exchange: A transfer is not preferential if the transfer was intended to be a contemporaneous exchange and, in fact, was substantially contemporaneous (no antecedent debt).

Three Common Defenses to Preference Actions

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• It is unlawful for a debtor to transfer property with the intent—actual or constructive—to hinder, delay or defraud creditors.

• Fraudulent transfer actions prevent a debtor from placing property beyond the reach of creditors.

• Cause of action

– Transfer made within two years before bankruptcy petition filed;

• Made with actual intent to hinder, delay or defraud creditors; or

• For which debtor received less than reasonably equivalent value; and

• Was or became insolvent because of the transfer;

• Was left with inadequate capital; or

• Believed it was incurring a debt it could not pay as it matured.

Fraudulent Transfers

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Chapter 11 Reorganization

• Chapter 11 is typically used by businesses that want to continue operating (i.e., to reorganize).

• Reorganization is effected by a plan of reorganization. Debtor has a limited, exclusive right to file plan of reorganization.

• Plan of reorganization addresses payment of debts, continuation of business, ownership, and release of debts.

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Typical Chapter 11 Events• First-day motions: Payment of critical vendors; use of cash collateral,

post-petition financing; continuation of insurance; wages and benefits.

• Motion to assume and reject contracts and leases.

• Claims resolution and settlements of disputes and litigation (Rule 9019 motions).

• Disclosure Statement approval (required before voting on, and confirmation of, plan).

• Plan of Reorganization Confirmation (the heart of the reorganization process).

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Plan of Reorganization• Debtor must file the plan within 120 days after filing the bankruptcy

petition.

• Debtor must obtain acceptance and Confirmation of the plan within 180 days of filing plan.

• Both time frames may be extended, but not indefinitely.

• If debtor’s exclusive right to file plan (the exclusivity period) lapses, any party in interest may file a plan.

• Competing plans greatly increase the uncertainty (and cost) of reorganization.

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Plan Confirmation

• Parties may vote to accept or reject plan (and separately may object to confirmation), but all are bound by a confirmed plan.

• Only one accepting class of impaired claims is needed before plan may be confirmed (pursuant to cramdown).

• Plan must be “fair and equitable” to all parties.

• Designate classes of claims and interests.

• Specify the treatment planned for each class.

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FACULTYJason DeJonker

Co-Chair of Bankruptcy, Workouts & Business Reorganization Practice Group, Seyfarth Shaw LLP JDeJonker@seyfarth.com

312-460-5220

Catherine PotterSenior Vice President, Secretary and General Counsel, Capital Automotive LLC

clpotter@cox.net703-717-8556

Gulam ZadeGeneral Counsel, LogicForce Consulting

gzade@logicforce.com615-238-3539