Bankruptcy Issues

It is a new year. We have a new President and Congress who will present us with challenges to meet and opportunities to assess. We are heading in a direction where mutual sacrifice is in and greed is out. Despite the fact that personal responsibility also is in, I suspect that lawsuits and bankruptcy filings will not be out. Accordingly, the next several months will be anything but dull. My subsequent posts will focus on positive uses for the law such as leasing, asset purchases, private funding, licensing intellectual property, construction, government contracts, and other federal funding opportunities like the Small Business Administration. However, in this post, I take one last look into the abyss and offer tools to mitigate the dissipation of receivables by another's bankruptcy.

In one way or another, bankruptcy will touch most of us in 2009. We might take some small comfort in the fact that we are sharing in this joy. The frequency of filings increased substantially in 2008 and economic analysts are suggesting that this trend will continue until the impact of the recession plays out. More businesses and commercial space will go dark as long as commercial activity continues to decline. Landlords, manufacturers, and service providers will be filing "proof of claim" forms in bankruptcy proceedings against debtor tenants, clients, and customers. "Slow paying" will push some businesses past the tipping point unable to service their debt load. Some 2008 bankruptcy creditors will become 2009 debtors. Secured lenders will take possession, liquidate,

short-sell, sell, or hire their own managers for creditor assets.

Pre-bankruptcy safeguards. No risk can be totally eliminated. Indeed risk often correlates with gain. However, a creditor's status in a bankruptcy proceeding is dictated by the pre-filing actions it took to try to protect itself. Most entrepreneurs know the conventional wisdom that the best protection against a third party bankruptcy is to require a security agreement guaranteed by assets, land, collateral, and receivables, etc. But, there are other risk reduction tools.

Commercial landlords may mitigate the risk of a tenant commercial bankruptcy by requiring personal guarantees, third party guarantees, insurance and bonds, larger rent and security deposits, stricter financial qualifications, regular financial audits, personal property securities, and a clear statement of the landlord's right to take possession. Apart from a decline in maintenance and loss of utilities for a few days, commercial tenants may mitigate some of the risks associated with a landlord's foreclosure or bankruptcy by incorporating a "subordination, non-disturbance and attornment agreement" ("SNDA") into their kase. Lenders who take possession in a foreclosure or bankruptcy action often have the right to vacate tenants, terminate leases, and/or unilaterally increase rents. A SNDA preserves the tenant's leasehold rights as long as they are not in default.

Those of us in the goods and services sector also may use tools to mitigate economic risks associated with third party bankruptcy. First and foremost, it is essential to assess the ability of prospective customers and clients to pay for the requested goods and services. There are good data bases and professional "snoops", whom I can personally recommend, that can obtain this information. Second, it is prudent for businesses practices to reduce receivable aging and balances. Taking an extremely protective position, an accountant friend no longer works on large projects without advance payment. Taking a more moderate position, service providers may employ "evergreen retainers" or break down work into task-sets and require a retainer before beginning each set. Producers of goods may resort to the ancient practice of delivering goods "COD."

When you receive notice of bankruptcy. One of my favorite lines in literature is the Red Queen's exclamation in Alice in Wonderland at the beginning of Alice's trial, "First off with her head, then the verdict." That jury had no problem with this approach to justice and neither do bankruptcy judges. They void valid debts, deeds, leases, contracts, trusts and claw-back paid out assets in "turnover" proceedings. Creditors fight like jackals over the debtor's carcass in a Chapter 7 proceeding. Creditors wrestle in a three ring circus with the debtor, other creditor classes, and members of their class to enhance their recovery in a Chapter 11 proceeding. These gruesome images notwithstanding, there is much that a bankruptcy creditor should do to protect their asset and enhance their chances of recovery. Losses can be reduced if the creditor or their legal counsel is familiar with the law, pays close attention to the process, and timely asserts rights. Here are some ofthe basics.

In Chapter 7 dissolution proceedings the court supervises a trustee's liquidation of the debtor estate (assets). Where there are no assets to liquidate, unsecured creditors are unlikely to be paid a "distribution." In a Chapter 11 re-organization proceeding, the court supervises the debtor's proposal and implementation of a reorganization plan, subject to creditor comment and the vote of the different creditor classes. If the Court approves the plan, the debtor retains possession of some of its assets, discharges some debt wiping out some creditor claims, and establishes a payment schedule to pay some creditors in full while paying others a percentage of the debt owed. As part of the reorganization, the Court may authorize the debtor's termination or renegotiation of contracts, leases, trusts and lawsuits, recovery of assets previously paid to third parties, and rescaling of operations.

At the outset of bankruptcy proceedings, a creditor should determine the type of claim it has against a debtor, its status as a creditor, and the classification of its debt. In addition, the filing of a bankruptcy typically results in a stay of all creditor actions and lawsuits against a debtor. However, some actions are not stayed, for example, a stock broker enforcement of a security right, repossession actions, enforcement of security agreements, HUD foreclosure actions, commercial landlord actions for possession of an expired lease, presentation of a negotiable instrument and giving of notice protesting dishonor, exercise of a swap agreement security provision, enforcement of a security agreement secured by real property. And, the court will sometimes allow the continuation of an action against a creditor that is deemed to be non-core" that is not related to rights addressed by the bankruptcy statute or that relates to property deemed not part of the estate.

A debtor lists its creditors in one of several defined classes. Each class is treated differently. A creditor should confirm or ensure that their claim is placed in the correct class and monitor the proposed terms for payment to members of their class.

In Chapter 11, the debtor files a written disclosure statement which provides "adequate information" regarding the debtor's financial status. The debtor or other proponent then submits a reorganization plan. The court holds a hearing to determine the adequacy of the financial disclosure and plan. A creditor should study the disclosure statement to determine its sufficiency and identifY any unreported assets or suspicious transactions.

The debtor then must assess the plan, the impact on its claim, and options. The plan states the proposed treatment of each class. Plans are voted on by each class of creditor, generally, secured, unsecured entitled to priority, general unsecured, and equity security holders. "Impaired classes" are those which the debtor proposes not to pay the debts completely or to alter a legal right. A vote of 2/3 of value of the claims and 50% of the claimants in each class is required for approval. At least one class of impaired claims must approve the plan. Any party may object to a plan.

A creditor should always evaluate the debt owed and take necessary action to avoid a bankruptcy order of discharge. A discharge of a debt renders the debtor no longer liable to pay it. The debt is deemed to be "avoided" or unenforceable. For this reason, it is critical for a creditor to monitor the bankruptcy process and fight the discharge of its debt. Objection to a proposed or apparent discharge generally takes the form of an "adversary action," a min-trial related to bankruptcy issues based upon a creditor's filing a complaint with the court.

A creditor also may initiate an "adversary action" mini lawsuit in the bankruptcy court to establish the priority or validity of their lien or security interest in order to increase the likelihood that the debtor's obligation to them will be paid. Valid liens upon property to secure payment of a debt cannot be avoided.

Most entrepreneurs accept the conventional wisdom that all unsecured debts are discharged or reduced to a pittance in a bankruptcy. In fact, the following unsecured debts are generally not dischargeable: (1) monies, property, services and credit obtained by false pretenses or fraud; (2) consumer luxury goods and services; (3) cash advance extensions of consumer credit; (4) debts not listed or scheduled unless the code requires the filing of a proof of claims; (5) fiduciary defalcation or embezzlement; (6) death or personal injury judgments caused by the operator of a motor vehicle while intoxicated;

(7) debts secured by a final court judgment; (8) debts resulting from willful and malicious injury by the debtor to another entity; (9) debts owed to pension or profit sharing plan and the like; and (10) debt for the violation of Federal securities law. However, no one is going to protect your claim for you. It is the creditor's burden to obtain a court ruling that your claim is not dischargeable.

During a Chapter 11 Bankruptcy, a creditor should always monitor the debtor-in­-possession and creditor committee's conduct. Generally, the debtor retains possession of the estate, but undertakes a fiduciary duty to the creditors. As such, the debtor-in­-possession has a duty to investigate, account for property, examine claims, and file reports. This would include investigating his or her own bankruptcy fraud, The U.S. trustee also appoints a creditor's committee, consisting of unsecured creditors. This committee investigates the debtor-in-possession's conduct and operation of the business, and participates in the formation of the reorganization plan. However, these committees have their own agenda to protect the big guys. For these reasons, creditors must do some of their own investigation.

Many sources suggest that bankruptcy fraud is rampant. Bankruptcy fraud involves any of a number of well recognized schemes whereby debtor management either (1) set up the business to siphon off assets and then hide behind a bankruptcy or (2) secreted assets when the end became apparent. A creditor must review pre-bankruptcy conduct and asset transfers and consider taking action to force disgorgement of fraudulent or otherwise improper transactions.

So, while participating as a creditor in a bankruptcy proceeding may sound like the equivalent of serving in an infantry division during an attack on the other guy's trench during World War I, there actually is much to be done to preserve, protect and keep your claim alive.

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