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Introduction to Bankruptcy Law
Bankruptcy is a federal body of law concerning the relationship between a debtor and creditors. Specifically, bankruptcy law provides several methods for a debtor to recover from financial situations that are overwhelming to the individual’s continued well-being or existence. The bankruptcy process differs for individuals and businesses. This chapter introduces the bankruptcy system. It introduces the applicable bankruptcy laws and key provisions. It begins by explaining the types of bankruptcy — Chapters 7, 11, and 13. It then explains the method for initiating and processing a bankruptcy filing. It explores the role of the debtor, creditors, bankruptcy court, and trustee and the rights of each during the bankruptcy process. This includes the trustee or debtor in possession’s right to stop collection efforts; the right to disaffirm contracts; the right to recover certain prior payments made to creditors, etc. A key concept throughout the bankruptcy process is the priority of secured and unsecured creditors. Lastly, it explains the rights and obligations of the parties at the conclusion of the bankruptcy process. For further written and video explanation, discussion and practice questions, see Bankruptcy Law (Intro)
What is “Bankruptcy”?
Bankruptcy is both a status and system of laws aimed at protecting individuals and businesses (collectively, “individual”). An individual is bankrupt when she is insolvent or the value of her debts exceeds the value of her assets. The bankruptcy system is a body of laws that allows for the elimination or restructuring of an individual’s debt. The underlying objective of the system is to rehabilitate and allow for the future prosperity of the individual. The bankruptcy process is the subject of this chapter. For further written and video explanation, discussion and practice questions, see What is "Bankruptcy"?
Types of Business Bankruptcy
The primary classifications for bankruptcy are as follows: Liquidation - Liquidation bankruptcy is the process by which the assets of an individual or business are liquidated or sold in an effort to generate funds to pay creditors. Any debts owed to creditors after the liquidation of assets and payment to creditors is discharged. Reorganization - A reorganization bankruptcy is a process by which the individual or business establish a plan to pay all secured debts and as much of its unsecured debts as possible during a set period of time (usual 5 years). The terms of the plan, including how much is paid to each creditor are based upon a number of factors, such as the amount of recurring, disposable income of the debtor. The unpaid portion of any unsecured debts are erased after the end of the payment plan period. The business may continue operations throughout this process. Voluntary vs Involuntary - The bankruptcy process begins either with a debtor filing a voluntary petition or creditors of the debtor filing an involuntary petition. A debtor who qualifies under the law and wishes to do so may file a voluntary bankruptcy petition. In other situations, a creditor (or creditors) of a business debtor who meets the statutory requirements may force the debtor into involuntary bankruptcy. The process for initiating an involuntary bankruptcy is discussed separately. While the process for liquidation bankruptcy is similar for individuals and businesses, reorganization bankruptcy for each is distinct. Throughout this chapter, we focus on business bankruptcy; however, many of the concepts applicable to business bankruptcy apply equally to individuals. For further written and video explanation, discussion and practice questions, see What are the types of business bankruptcy?
Participants in Bankruptcy Process
The primary participants in the bankruptcy process are as follows: Debtor - The debtor is the individual or business entity seeking or filing for bankruptcy protection. Creditor - A creditor is any individual owed a debt or obligation by the debtor. Creditors may include individuals, businesses (or other entities), or holders of securities (debt or ownership interests) of a business debtor. Bankruptcy Trustee (or Debtor-in-Possession) - The bankruptcy trustee is a representative elected (or appointed) to represent the interests of creditors of the bankrupt debtor. The trustee is charged with assembling the assets of the debtor’s estate and either selling those assets or administering those assets in accordance with a plan of reorganization. The trustee must meet numerous statutory qualifications, including being independent and disinterested from the debtor or creditors. The role of the trustee varies a bit between personal and business bankruptcies and liquidation and reorganization bankruptcies. Personal & Business Liquidation Bankruptcy - The trustee automatically takes control over the debtor’s estate, liquidates the non-exempt assets, and distributes the proceeds to creditors. This process is the same in a personal and business liquidation. Personal Reorganization Bankruptcy - The trustee accounts for all of the assets of the debtor, assists in the development of a plan of reorganizations, and administers an approved plan for the reorganization of debts and payment of creditors. Business Reorganization Bankruptcy - Generally, a business debtor remains in possession of the assets of the bankruptcy estate. The debtor is known as a “debtor-in-possession” (DIP). The DIP serves the same function as the trustee but manages its assets and operations in accordance with the rules laid out by bankruptcy law. In this case, a trustee is only appointed when creditors of the estate petition the court to do so in an attempt to protect their interests. This normally happens when the debtor-in-possession fails to act in accordance with bankruptcy law or fails to otherwise adequately protect the interests of creditors. Bankruptcy Court - The bankruptcy court is a federal court charged with administering the bankruptcy process. Much of the bankruptcy process is handled by the trustee or debtor-in-possession. The court generally steps in to review and approve liquidations and plans of reorganization, grant discharges of indebtedness, and adjudicate disputes between or among debtors and creditors. For further written and video explanation, discussion and practice questions, see Who are the participants in the bankruptcy process?
Key Concepts in Bankruptcy Process
Below are some key concepts and definitions to understand prior to continuing with this chapter. Filing for Bankruptcy - Filing for bankruptcy means submitting a bankruptcy petition along with all supporting documents to the bankruptcy court. For individuals, a bankruptcy filing is voluntary (optional for the individual). A business bankruptcy may be voluntary or involuntary. In a voluntary petition, the bankruptcy court will review the initial filing for completeness. If accepted, the court will initiate the bankruptcy process. If applicable, the court will then forward the case to the office of the trustee. In a business reorganization, the debtor-in-possession will begin exercising the authority granted a trustee under the bankruptcy law. In an involuntary bankruptcy filing, the debtor has the option of agreeing with the petition or contesting the petition before the bankruptcy court. Bankrupt Estate - Upon filing bankruptcy, the court will issue an “order of relief”. This order serves to form the bankruptcy estate. The bankruptcy estate includes all non-exempt assets and debts of the debtor at the time of the bankruptcy filing. Basically, the debts and assets of the debtor are held in trust and managed for the benefit of creditors. Assets acquired or debts incurred after the filing of bankruptcy may be excluded from the bankruptcy estate, absent a specific bankruptcy law allowing the estate to incur the debt or claim an interest in the asset. Automatic Stay - The automatic stay is an important protection afforded a debtor and the bankruptcy estate. Once the court issues the order of relief, the law grants the debtor a stay from all collection efforts by creditors or their representatives. The stay of proceeding places penalties on any creditor who seeks to collect a debt incurred prior to the bankruptcy filing. This provision gives the debtor the ability to assemble debts and develop a plan for liquidation or reorganization. Meeting of Creditors - Once the order of relief is issued, creditors have the opportunity to meet to examine debtor records and discuss claims against the estate. This meeting is more common in business bankruptcies than in individual bankruptcies. In chapter 7 cases, the trustee will orchestrate the vote to elect a permanent trustee. Creditor Priority - Priority in bankruptcy refers to the order in which creditors of the debtor or bankruptcy estate are paid. Generally, secured creditors must be paid in full from the liquidation or reorganization, or the asset(s) securing the secured creditors’ claims must be surrendered to them. Once secured creditors are paid, unsecured creditors are paid in their established order of priority. Unsecured debtors with similar priority are treated as a class. If each unsecured debtor in a class is not paid in full, each member of the class receives payment based upon an equal percentage of her debt. Creditor priority may be established by the nature or type of the debt, the timing or order in which the debt is incurred, or the contractual provisions associated with the debt. Generally, unsecured creditors only receive payment of a fraction of their total claim (if they receive anything at all) due to the scarcity of assets in the bankruptcy estate. For this reason, creditors often argue over their priority. Discharge - The debts of the debtor that are included in the bankruptcy estate are generally discharged after the successful completion of the bankruptcy process. This means that the debts are satisfied and the creditors cannot later seek repayment of these debts. Whatever amount the debtor receives as payment on the debt from the bankruptcy estate is final. The type of bankruptcy will determine whether a creditor receives a single payment (in a liquidation) or whether the debtor receives installment payments for a period of time (in a reorganization). For further written and video explanation, discussion and practice questions, see Key concepts behind the bankruptcy process?
Rules Governing Bankruptcy Process
The rules governing the bankruptcy process are contained in Title 11 of the US Code of Statutes. The relevant sections of the bankruptcy code are organized as follows: Chapter 1 – General Provisions – Definitions, Powers of Court; Chapter 3 – Case Administration; Chapter 5 – Creditors and Claims; Chapter 7 – Liquidation; Chapter 9 – Municipal Bankruptcy; Chapter 11 – Reorganization; Chapter 13 – Individual Reorganization. Bankruptcy law is augmented by common law interpretation of statutes and regulations by federal bankruptcy courts. Further, state priority laws and exemptions are integrated into the bankruptcy process. For further written and video explanation, discussion and practice questions, see What rules govern the bankruptcy process?
Authority of Bankruptcy Court
The bankruptcy court has authority to hear any case arising under the bankruptcy system. Generally, the role of the court is simply to approve a plan of liquidation or reorganization. The court’s role expands when there is some level of dispute between debtor and creditor. In a dispute, the bankruptcy court does not allow for a jury trial. A bankruptcy judge, appointed pursuant to Article I of the US Constitution, is charged with hearing the case. Matters arising under the bankruptcy system commonly include administration of the bankruptcy estate, allowance of claims against the estate, counterclaims by the estate against claimants, exemptions of estate property, and matters relating to confirmation of a plan of reorganization. The court may also enter appropriate orders and judgments as provided for under the bankruptcy code. For further written and video explanation, discussion and practice questions, see What the authority of the bankruptcy court?
Authority of Trustee or Debtor in Possession
As previously discussed, the trustee in bankruptcy plays an important role in the administration of a bankruptcy case. The general authority of the trustee includes: affirming or disaffirm contracts with the debtor which are yet to be performed; setting aside fraudulent conveyances from the bankruptcy estate; voiding certain preferential transfers of property by the debtor to creditors; suing those who owe the debtor an obligation that is not paid; and setting aside statutory liens on property taking effect upon the filing of bankruptcy. Remember, the trustee in bankruptcy plays a primary role in all individual bankruptcies and business liquidation bankruptcies. Trustees are only appointed in business reorganizations in limited circumstances. It is the responsibility of the DIP to administer the bankruptcy estate. The authority of the DIP is discussed separately. For further written and video explanation, discussion and practice questions, see What is the authority of the trustee (debtor in possession) in bankruptcy?
Assets included in “Bankruptcy Estate”
The assets of the bankruptcy estate include all legal and equitable interests of the debtor in property at the commencement of the bankruptcy case. A legal interest means any legal right to the exclusive use and enjoyment of the property. An equitable interest includes any rights or claims to the ownership of property based upon principles of fairness. So, if a debtor has the ability to make a valid demand or claim for ownership rights in property, that property becomes part of the bankruptcy estate. This may include rights to sue or collect debts from others. Property of the estate also includes property that the debtor acquired within 180 days of filing for bankruptcy if acquired with proceeds or profits from property of the estate. Property excluded from the estate includes any income derived from the services of the debtor performed after the filing for bankruptcy protection, equitable powers that the debtor may exercise for others, educational IRA plans, 529 plans, and certain ERISA qualified retirement plans. Federal bankruptcy law allows for certain exemptions of property from the estate based upon state law. State statutes regarding what constitutes a property interest of an individual is generally determinative of whether property indeed belongs to the debtor. Certain agreements will attempt to thwart the provisions of the bankruptcy code by limiting the transfer of property to debtors or divest debtors of ownership in property upon the filing of bankruptcy. These agreements are generally ineffective to prevent such property from becoming property of the bankruptcy estate. For further written and video explanation, discussion and practice questions, see What assets of the debtor are included in the "bankruptcy estate"?
“Automatic Stay” in Bankruptcy
The automatic stay under Section 362 of the Bankruptcy Code protects debtors from ongoing collection efforts (during the pendency of the bankruptcy case) against property included in the bankruptcy estate. Specifically, creditors are prohibited from the following conduct: efforts to collect, assess, setoff, or recover a claim against a debtor arising before the bankruptcy filing; commencing or continuing a judicial, administrative, or other action to collect the debt; enforcing a judgment against the debtor’s property; obtaining possession or control over assets included in the bankruptcy estate; or creating, recording, or enforcing a lien against the debtor’s property. Some limitations to the protections afforded under section 362 include: commencement or continuation of criminal actions and certain actions for domestic support; commencement or continuation of actions by governmental units pursuant to its regulatory power (such as tax liability); or creation or perfection of a statutory lien for certain types of real property. The stay of proceeding will continue until the case is closed, dismissed, or discharge is granted. The court may also relieve or modify a stay generally or for a specific creditor for cause, for lack of adequate protection of a secured creditor’s interest, or if the debtor has no equity in the subject property and it is not necessary for the reorganization of the debtor’s estate. If a debtor violates a stay, any collection action can be undone. Further, if a debtor willfully violates the stay, the debtor may recover any attorney’s fees incurred in challenging the collection action, as well as potential punitive damages. For further written and video explanation, discussion and practice questions, see What is the "automatic stay" in bankruptcy?
What is a “Claim” of Creditors?
A claim is a notice to the trustee of the debtor’s estate that the debtor owes a fixed amount to the claimant. Claimants are creditors of the estate. For liquidation bankruptcies and personal reorganization bankruptcies, creditors of the estate must submit a proof of claim within a specific period of receiving notice of the bankruptcy filing. A creditor that fails to file a claim against the estate is barred from later collecting that debt if the bankruptcy filing proceeds to discharge of the debtor. Below are several important aspects about claims against the bankruptcy estate: Proofs of Claim - At the commencement of a bankruptcy case, the debtor is required to provide a list of all assets and debts to be included in the estate. The debtor must also identify all creditors holding these debts. Creditors are then given notice of the debtor’s bankruptcy case with instructions on how to submit a claim. Creditors must then submit a proof of claim attesting to the court the nature and amount of the claim. If a creditor submits a secured claim, she must include evidence of a security interest. Creditors in Chapters 7 and 11 bankruptcies must file the proof of claim within 90 days of learning of the bankruptcy case. In Chapter 11 cases, the court will establish a “bar date” by which creditors may file a proof of claim; but, filing a proof of claim is not necessary to receive a distribution from the debtor’s estate. All creditor claims are generally allowed, unless the claim is challenged by the debtor, trustee, debtor-in-possession or by other creditors. Disputing Proofs of Claims - When a creditor submits a claim against the bankruptcy estate, other parties in interest (such as the debtor, trustee, DIP, or other creditors) can file an objection to the claim. If a third-party opposes the claim, this creates a “contested matter” which is adjudicated in a proceeding before the bankruptcy court. The objecting party must demonstrate that the claim is not valid. If the party presents some evidence against the claim, the claimant will have to introduce evidence to support her claim. A trustee or debtor in possession generally pays based upon the amount of claim “allowed” by court. Secured and Unsecured Claims - A secured claim is the amount of a debt equal to the “value” of creditor’s interest in assets of the estate. The claim is bifurcated and is secured to extent of the value of the collateral. Any amount of the creditor’s claim beyond the value of the collateral is classified as an unsecured claim. The amount of a claim is generally the debt owed at the time of filing, including all amounts that accrue pre-petition, interest, late charges and attorney’s fees. A debt generally does not receive interest during the pendency of the bankruptcy without special exception. Debts arising after the filing of bankruptcy are not included in the bankruptcy estate. The only post-petition debts included in the bankruptcy estate are the administrative expenses of managing the estate or instances of post-petition financing. These claims generally receive administrative priority over the unsecured claims. The difference between the allowed claim amount paid to the creditor and the amount of the creditor’s claim is the amount of the debt discharged in bankruptcy. For further written and video explanation, discussion and practice questions, see What is a claim by creditors of the bankruptcy estate?
“Voluntary” vs “Involuntary” Bankruptcy
A bankruptcy case begins when either a debtor voluntarily files for bankruptcy or creditors petition to subject a business debtor to bankruptcy. Voluntary Bankruptcy - Any business may voluntarily file for a liquidation or reorganization bankruptcy at any time. While a liquidation bankruptcy causes a business to dissolve, a reorganization bankruptcy allows a business to continue operating. For an individual to file for reorganization bankruptcy under Chapter 13, she must have regular income and have unsecured debts not exceeding $307,675 and secured debts of less than $922,975. The requirements for a business to undertake a reorganization bankruptcy under Chapter 11 are discussed in greater detail below. In a liquidation bankruptcy under Chapter 7, the primary limitation is that an individual (not a business) must meet a “means test”. The means test limits the ability of individuals to file for bankruptcy if the individual has recurring revenue (income) above a certain amount. The amount is determined by the state’s median income for its citizens. The purpose of this test is to prevent individuals who have sufficient income to pay debts from using a liquidation bankruptcy to wipe away debts and defraud creditors. Involuntary Bankruptcy - An involuntary bankruptcy, as the name implies, is involuntarily imposed upon the debtor. One or more creditors of a business debtor may commence an involuntary bankruptcy action against a debtor by filing a chapter 7 or chapter 11 petition with the bankruptcy court. To commence this action, the following conditions must be present: three or more business creditors must have good faith, non-contingent claims against the debtor totaling $15,325 or more (beyond the amount of any secured debt), or if the debtor has fewer than 12 creditors, a single creditor holding a good faith, non-contingent claim against the debtor of $15,325 or more. These provisions are in place to make certain that no single creditor can undermine a business’s operations by petitioning for involuntary bankruptcy without meeting minimum standards. The court may award damages against a creditor for filing an involuntary bankruptcy in bad faith. If the debtor fails to successfully defend a petition for involuntary bankruptcy, the court will order relief against the debtor. If the debtor contests the involuntary filing, the court will only subject the debtor to bankruptcy if: The debtor is not paying its debts as they come due, or Within 120 days prior to filing the action, the court appoints a custodian over the assets of the debtor with the purpose of enforcing a lien. It is important to remember that any debts that the debtor fails to pay in a timely manner must be good faith debts that are not subject to dispute or controversy. The danger for a creditor seeking to place the debtor in involuntary bankruptcy is, if the court dismisses the action (other than pursuant to agreement of all parties), the court may award court costs and attorney’s fees against the creditor. If the creditor acted in bad faith, she may be subject to actual damages suffered by the debtor, as well as punitive damages. For further written and video explanation, discussion and practice questions, see What is voluntary and involuntary bankruptcy?
What is the “Chapter 7 Bankruptcy” Process?
The Chapter 7 bankruptcy process is fairly straightforward. It involves the following steps: Filing - The debtor files a voluntary petition or is the subject of an involuntary petition. Bankruptcy Estate - Initiating the bankruptcy process creates the bankruptcy estate containing all of the debtor’s non-exempt assets. Also, the automatic stay halts all collection efforts against the debtor. The trustee in bankruptcy is appointed or elected and charged with identifying and assembling assets of the bankruptcy estate. Proofs of Claim - At the time of filing, creditors of the debtor are put on notice of their rights to put in a claim against the bankruptcy estate for any debts owed them by the debtor. Secured creditors must be paid in full from the estate or have the property serving as collateral for the debt surrendered to them. Once secured creditors are paid to the extent of the value of their security interest in collateral, unsecured creditors are paid based upon their priority. Higher priority creditors will be paid before lower priority creditors. All creditors in a given class of debtor will be paid an equal percentage of their claims. Liquidation - The trustee will sell or liquidate all available assets of the bankruptcy estate to generate funds to pay estate debts. Discharge - Once all assets of the estate are liquidated and creditors paid, the court will enter an order discharging the debtor of all debts identified in the bankruptcy proceeding. Failure to submit a claim after receiving notice will cause a claim to be discharged. If a creditor is not notified of the bankruptcy proceeding, that creditor’s claim against the debtor will not be discharged. This process is fairly linear in nature. It is common for bankruptcy cases to be dismissed at any stage of the proceeding for failing to move forward in accordance with the court’s order. For further written and video explanation, discussion and practice questions, see What is the "Chapter 7" bankruptcy process?
What is the “Chapter 11” Bankruptcy Process?
Chapter 11 bankruptcy (Chapter 11) seeks to reorganize or restructure the debts of the debtor without liquidating all of the debtor’s assets (as under Chapter 7). The objective is to allow the business to continue operations in an attempt to maximize the value of the business to all stakeholders. Chapter 11 follows a similar process to that of Chapter 7, with the following notable differences: Bankruptcy Estate - Filing for bankruptcy protection creates the bankruptcy estate. At this point, the court does not appoint a bankruptcy trustee to collect and manage the assets of the estate. Rather, the debtor remains in control of the business operations and all business assets. The DIP is vested with the same authority as a trustee in a Chapter 7 bankruptcy. This includes authority to use or even sell assets for the benefit of the estate, accept or reject contacts, and seek post-petition financing for the business. All of this authority is limited, however, by the objective of the DIP to control the estate for the benefit of all creditors. Proof of Claims - A creditor of the bankruptcy estate is generally not required to submit a proof of claim. Rather, the DIP is required to account for and identify all debts of the estate. The DIP must give all creditors notice of the bankruptcy filing. Secured creditors may be concerned by the DIP’s use of the collateral securing their claim in the continued operations of the business. If so, they can challenge DIP actions in the bankruptcy court. Unsecured creditors may organize and request the bankruptcy court recognize the group as a creditors committee. The purpose of the creditors committee is to represent the interests of all creditors in negotiations with the DIP. Plan of Reorganization - The DIP must put forward a plan of reorganization. This plan must pay off all secured creditors within the term of the plan. Further, the plan must be voted upon and accepted by at least one class of “impaired” unsecured creditors under the plan that is not paid in full. Lastly, the bankruptcy court must approve the plan. If the plan is not reasonable or the DIP cannot possibly achieve these objectives, the plan may fail and the bankruptcy case could be dismissed. Filing for bankruptcy protection under Chapter 11 can be a useful tool for business. As such, businesses have developed special purpose bankruptcies to achieve a specific business objective. For example, a business may use chapter 11 to escape certain types of tort liability. Further, if a company has a single prevailing asset, a company may liquidate the large asset, but otherwise go through the chapter 11 process. This is common when the debtor has a large single real estate asset. For further written and video explanation, discussion and practice questions, see What is the "Chapter 11" bankruptcy process?
What is the Authority to “Accept or Reject a Contract?”
The authority of the debtor in possession (DIP) is similar to that of a bankruptcy trustee. The objective of the DIP is to guard the interests of creditors by reshaping the bankruptcy estate to allow the business to continue operations. In doing so, the DIP is vested with the following important powers. Accept or Reject Contracts - The DIP may accept or reject contracts of the debtor that have not yet been performed or are on-going. In this way, the DIP can get rid of contracts that are oppressive or cause losses to the business but can retain contracts that are beneficial and necessary for the reorganization of the business. This rule invalidates provisions in a contract restricting, conditioning, or prohibiting a debtor’s rights to assign a contract. To retain or assume a contract, the DIP must provide adequate assurance of continued performance and must cure any defaults under the contract. The court may impose timelines and restrictions on the termination or any modifications to existing contracts. Further, there may be limitations on the ability of the debtor to later assign an assumed contract (such as a requirement for assurance of future performance). Lastly, any contract that has been terminated pre-petition may not be assumed in bankruptcy. For further written and video explanation, discussion and practice questions, see Accept or reject contract?
What are “Avoiding Powers”?
Avoiding Powers - The DIP exercises the avoiding powers of a bankruptcy trustee. This is known as the “strong-arm” powers. The strong-arm authority allows the DIP to: Avoid Preferential Conveyances. There are several exceptions or defenses that protect conveyances that may otherwise qualify as preferential, including: Contemporaneous Exchanges of Value, Payment in the Ordinary Course of Business; Purchase Money for Collateral; Extending New Value; Floating Liens; Avoid Fraudulent Conveyances. If the DIP successfully challenges and avoids a transfer, she may recover the actual property transferred or the value of the property transferred. There are limits on the ability of the trustee to recover from a transferee who receives the property in exchange for value (such as payment of a preceding debt) and in good faith without knowledge of the voidability of the transfer. For further written and video explanation, discussion and practice questions, see Avoiding powers?
What is a “Stay of Proceeding”?
This broad authority gives the DIP power to continue operations with existing creditors without being subjected to debt-collection practices that may thwart the reorganization of the estate. The DIP’s authority trumps any rights to collection or agreement not to contest a debt that is present in the debt agreement. Upon request of a party in interest and after notice and a hearing, the court may grant relief from the stay. The justifications for relieving the stay are as follows: No Equity in Property, For Cause. The primary limitations of the automatic stay are that it does not stop certain criminal actions, paternity suits, collection of domestic support obligations, or actions by a governmental unit exercising its police and regulatory power. The police or regulatory power exception should be narrowly construed when the actions result in financial penalty or forfeiture. Courts generally employ two tests to determine whether the stay should apply in these situations: Pecuniary Purpose Test, Public Policy Test. One factor that the court will consider is whether relieving the stay would cause irreparable harm to the bankruptcy rehabilitative process. For further written and video explanation, discussion and practice questions, see Stay of Proceeding?
What is the “Use of Business Assets?”
Use of Business Assets - The DIP may use assets of the business in on-going operations. This includes the use of business cash in the “ordinary course of business”. This authority also includes using, selling, or leasing the business’s assets. If an asset will be “permanently impaired” or the use of assets is challenged by a creditor of the estate, the court must specifically approve its use. Special issues arise when the DIP seeks to lease or sell business assets in the course of business. Physical assets of the business generally serve as collateral for one or more classes of secured creditor. In this situation, the secured creditors may demand adequate protection of their interests from the DIP. This means the DIP may have to take measures to ensure that the bankruptcy estate’s use of the assets in on-going operations does not prejudice the secured status of the creditors. Adequate protection may be provided by: Payments, Second Lien, Other Relief. Also, to the extent of any surplus value in the collateral, the secured creditor is entitled to interest and reimbursement of attorneys
What is “Post-Petition Financing”?
Post-Petition Financing - The DIP may establish unsecured credit (incur debts) in the ordinary course of business following the filing of bankruptcy. This practice creates new obligations for the bankruptcy estate that are often superior or have priority over payment of the existing debts. This is known as “administrative expense priority”. These debts must be actual, necessary costs and expenses of preserving the estate. This ability is limited by the rule that an equity owner in the business cannot retain any value in a Chapter 11 bankruptcy until all other creditors are paid. The court may, however, grant an exception when a current shareholder extends new credit to the bankruptcy estate. While authority to secure post-petition financing is extremely important in reorganizing the bankruptcy estate, it can have a detrimental impact on existing shareholders who lose priority in favor of the post-petition creditors. If the DIP is unable to obtain credit, even with the promise of administrative expense priority, the court may, after notice and hearing, order: Super-priority Administrative Expense; Lien on Unencumbered Property of the Estate; Junior Lien on Encumbered Property of the Estate. The court may only authorize a junior lien on encumbered property if the DIP is unable to otherwise obtain such credit and there is adequate protection of the senior lien holder. For further written and video explanation, discussion and practice questions, see Post-Petition Financing?
Appointment of “Trustee” or “Examiner”
In certain circumstances, the bankruptcy court will appoint a bankruptcy trustee to supervise the actions or conduct of the debtor in possession (DIP). Generally, however, there is a strong presumption against appointment of a trustee. To overcome this presumption, creditors must show “cause” why the appointment is necessary. Cause includes situations involving fraud, dishonesty, incompetence, or gross mismanagement of the affairs of the debtor by current management, either before or after the commencement of the case. The bankruptcy court will look at the “totality of the circumstances” to determine the need for a trustee. An alternative to appointing a trustee is the appointment of a “corporate examiner”. The examiner serves a role similar to special counsel to the DIP. This action allows management to continue running the business while having activities monitored by the examiner. For further written and video explanation, discussion and practice questions, see What is appointment of a "trustee" or "examiner" in business bankruptcies?
What is a “Plan of Reorganization”?
The DIB has an exclusive 120-day period to file plan of reorganization. The court may enlarge or reduce the exclusivity period “for cause”. The DIB has exclusive control over the case early on and may take a first stab at the terms of the proposed restructuring. The bankruptcy code provides guidelines for the contents of the plan of reorganization as follows: Mandatory Provisions - The mandatory provisions to include a plan are as follows: Classes of Claims, Equal Treatment of Classes of Creditors; Secured Claims classified separately unless the creditors have common rights; Unimpaired Classes; Plan of Implementation. Permissive Provisions - The plan of reorganization may include any of the following provisions: Impair a Class; Executory Contracts; Sale of Property; Handling Claims; Other Provisions. Notice of the Plan - Before the plan can be distributed to creditors and interest holders, the court must approve a disclosure statement for distribution. The disclosure statement must contain adequate information about the debtor and the bankruptcy filing. This generally includes: description of debtor’s business; history of debtor’s business; current financial information, including the financial statements; description of plan and execution game plan; liquidation analysis; management retention and compensation; pro forma operations projections; summary of pending or planned litigation, transactions with insiders, and tax consequences if plan is confirmed. Once the disclosure statement is approved by the court, the DIP may solicit acceptances from creditors and interest holders. The DIP must send the plan, disclosure statement, and ballot to all known creditors and parties in interest. Acceptance of the Plan - To approve the plan, a class of impaired creditor must accept the plan and it must be approved by the court. A class of creditors accepts the plan if approved by at least two-thirds (2/3) of the total claims and one-half (1/2) of the total of allowed claims of the class. “Unimpaired” classes of creditor are not entitled to vote on the plan. An unimpaired creditor will receive full payment of its claim under the plan. It is conclusively presumed that unimpaired creditors accept a proposed plan. If a class receives no dividend under the plan (no payment), it is deemed to have rejected the plan. Once approved by a single class of impaired creditors, the bankruptcy court must hold a hearing to determine whether the plan can be confirmed. The plan must meet the following elements for court approval: Best Interest, Administrative Priority, Priority Claims, Feasible. For further written and video explanation, discussion and practice questions, see What is a "plan of reorganization"?
What is a “Cramdown” of Reorganization Plan?
The plan of reorganization must be approved by at least one class of impaired creditor, excluding votes cast by corporate insiders. If any class of impaired creditor has not accepted the plan, the court, on request of the proponent of the plan, shall confirm the plan “if the plan does not discriminate unfairly, and is fair and equitable, with respect to each class ... that is impaired under, and has not accepted, the plan”. This is known as “cramdown”, as the plan is being forced upon impaired creditors who voted against plan approval. In the event of a cramdown, the court will determine whether treatment of each class is “fair and equitable”. Even in a cramdown, the following attributes of the plan must be true: Secured Creditors – Secured creditors must retain a lien on collateral or proceeds and receive deferred cash payments equal to present value of the collateral or receive the indubitable equivalent of its claim. Unsecured Creditors – Unsecured creditors must be paid in full or no holders of junior claims may receive any payment. For further written and video explanation, discussion and practice questions, see What is "cramdown" of a reorganization plan?
Relief of Debts
Unless otherwise stated, confirmation of the debtor in possession’s plan of reorganization discharges the debtor from any debt that arose before the date of the plan’s final confirmation. The plan will specifically identify any post-petition debts that are not a part of the bankruptcy estate. If a creditor with a pre-petition debt fails to file a proof of claim, its debt will also be discharged as part of the bankruptcy process. Due process rights limit the ability of the court to discharge debts of claimants who did not receive notice of the bankruptcy filing. Unless otherwise indicated in the plan, confirmation vests all of the property of the estate in the debtor free and clear of all liens and encumbrances. Following plan confirmation, the debtor is in complete control of the business and able to continue operations. For further written and video explanation, discussion and practice questions, see To what extent does the bankruptcy process relieve a debtors debts?
Flashcard - Study Quiz
Flashcard – Study Quiz