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Bankruptcy and Business Planning

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BOISE, IDAHO

Part 1:

A practitioner should consider two main points when a client inquires about bankruptcy relief from his creditors:

a.       Bankruptcy should not be the first reaction to a situation; and

b.       An unplanned Chapter 11 is almost doomed to disaster at the outset.

These are not mutually exclusive. In fact, considering them as a whole is required. A short discussion of the bankruptcy process is important, because only by knowing the basics, and what a lawyer can do for a client, can a non-bankruptcy alternative be considered in its proper context.

AN OVERVIEW OF BANKRUPTCY:

1.       GENERAL    Debtor-creditor law is usually creditor oriented. There are few if any debtor relief laws in state law. Allowing a debtor certain exemptions, and a right to redeem secured property in certain circumstances, are usually the only “debtor’s rights” laws there are. When I studied bankruptcy, it was a topic of “creditor’s rights.”

With the passage of the 1978 Bankruptcy Code, the impact was to equalize to a large degree at least the rights of all parties. Bankruptcies proceed in a different court. All creditors and other parties are participants, active or not. The court attempts to “level the playing field” and to recognize that debtors, junior creditors, and equity security holders have rights. If you are a debtor’s counsel, it reduces the “golden rule”--He Who Has The Gold Makes The Rule.

There are four commonly used chapters of Title 11 to the United States Code, Chapters 7, 11, 12, and 13. Under any of them a debtor may file a bankruptcy petition and the debtor/creditor relationship will change substantially. Chapter 7 are liquidation proceedings while cases under chapters 11, 12 and 13 give debtors reasonable opportunity to work out a repayment plan with creditors. There are more detailed explanations elsewhere on this site.

In a Chapter 7 case, the trustee has the duty to collect and reduce to money the property of the estate, to facilitate its disbursement to creditors. In a Chapter 13, the trustee considers the nature of the debtor’s property and assets, determines “Chapter 7 value,” (also known as the ‘best interests of creditors’ test’), reviews the Debtor’s income along a guideline required by the 2005 amendments to the Code known as the “Means Test,” and then concludes whether the proposed Plan is confirmable.

The process is similar, but more involved, in a Chapter 12. In Chapter 12 case for family farmers and Chapter 13 for individuals with regular income, the debtors’ income is used to und a Plan. As in a Chapter 11 proceeding, a debtor in Chapter 12 or Chapter 13 case retains control of the assets of the estate, but the case will be dismissed if a plan is not confirmed within a reasonable time after filing.

In a Chapter 11 and a Chapter 12 case, the debtor remains in control of the assets of the estate, as a “debtor in possession” and has almost all of the same powers and duties as a trustee.  In Chapter 11, the debtor in possession will remain such unless a trustee is appointed If the debtor is guilty of gross mismanagement, or if it is in the best interest of the creditors, the court, after notice and a hearing, may appoint a trustee to manage the estate. Further, if the assets of the estate continue to diminish under the debtor’s management, or if there is an apparent inability to effectuate a plan of reorganization, the case may be dismissed or converted to Chapter 7.

2.       AUTOMATIC STAY           The commencement of any bankruptcy proceeding creates an estate consisting of basically all of the debtor’s legal or equitable interests in any sort of property. A trustee is immediately appointed. After a debtor files a petition for relief, the Code automatically stays all actions which would interfere with property of the estate or the debtor. The stay is not a total insulator, however. The action of government entities, for example, under the police power, are not stayed. The courts have ruled that both seeking to obtain, as well as enforce, monetary awards by a government agency are stayed.

Section 362 of the Code operates as an automatic stay of any action against the debtor that was or could have been commenced before the bankruptcy petition was filed, including actions to foreclose on property in the debtor’s estate and any act to obtain possession of property of the estate. The stay prohibits continuation of current foreclosure or repossession remedies.

While very broad, the automatic stay in Chapter 7 or 11 cases does not protect entities other than the debtor nor does it protect the debtor from being sued on causes of action that did not exist prior to the commencement of the bankruptcy proceeding. If a corporation files bankruptcy under Chapter 7 or 11, and a corporate officer or another has personally guaranteed a debt, the stay has no effect on any legal action based on the guarantee. Likewise, a Chapter 11 bankruptcy of a partnership does not stay actions against its partners. The only stay of actions against co-debtors is in chapter 12 and 13 cases. The limited co-debtor stay applies only to civil actions to collect consumer debts.

A creditor can move for relief from the automatic stay for cause, or in cases in which the debtor lacks equity in property which is necessary for an effective reorganization. The only justification for continuing the stay when the debtor lacks equity is that the property is needed to continue the debtor’s business affairs in a Chapter 11, 12 or 13 proceeding. In determining whether a debtor has equity in property, for the purpose of determining whether a party is entitled to relief rom stay, “equity” is the difference between property value and the total amount of the liens.

In cases where the debtor needs the property for reorganization , but lacks equity, the interests of creditors must be adequately protected to maintain the stay. In Chapter 7 cases, where reorganization is irrelevant, courts have held that relief from the stay must be granted where the debtor has no equity in the proper

3.       USE AND SALE OF PROPERTY In a Chapter 11 case, unless a trustee is appointed, the debtor-in-possession is authorized to continue operating its business in the ordinary course. All rights and duties of a trustee apply equally to the debtor-in-possession. The debtor’s rights to operate its business include the use of its creditors’ collateral without obtaining permission, except for “cash collateral.” With regard to “cash collateral” (generally cash or cash equivalents, such as accounts receivable), the debtor may not use, sell, or lease it unless:

a. Each entity that has an interest in such cash collateral consents; or

b. The court, after notice and a hearing, authorized such use, sale, or lease.

If a debtor is unable to procure consent of a secured creditor to use cash collateral, the debtor should be prepared to file a request for the use of it, as otherwise the debtor will probably not have funds to operate. The bankruptcy courts across the country have acknowledged that a successful reorganization of the debtor may be dependant upon its use of creditors’ cash collateral and therefore are willing to shorten notice requirements.

4.       ADEQUATE PROTECTION         If a debtor is using other than cash collateral, the creditor has the right to move for stay relief and seek adequate protection if the stay relief is denied. Adequate protection, therefore, is an integral part of bankruptcy litigation, whether arising in automatic stay litigation, the use of cash collateral, or a debtor or trustee’s obtaining credit. In as “non-legaleze” as we can say, it’s paying or giving the creditor something to keep it in the same economic position that it is before–cash payments for interest and/or depreciation are one way, but not the only way. Giving a replacement lien in post-petition collateral is another way that’s often used, and there are still others depending on the circumstances.

5.       WHAT IS A “SECURED” CLAIM?The value of property in bankruptcy is a flexible concept and even depends upon the nature of the motion sought. Values determined in one regard do not preclude a second valuation for other purposes. Value of property to be retained by the debtor in a going concern concept will be different than fair market value of property on a liquidating creditors side. Both parties should remember in the context of valuation that the thing to determine is “fair market value.” Fair market value is traditionally defined as the value to be paid by a willing buyer to a willing seller neither under compulsion to act. However, fair market value in the context of a liquidating creditor will often be lower and must take into account his costs of liquidation. The debtor however, is not entitled to the costs of liquidation and so forth in determining the value of property to be retained by him under the provisions of a plan. For purposes of the valuation of property in schedules, ‘retail’ value should be used. Remember, it’s not REPLACEMENT COST for NEW items. Value is for USED items, depending on condition. There are many guidelines such as NADA or Kelly, Machinery Trader or Iron Planet, etc., to assist in valuations.

The difficulty in determining claims is the definition. A claim is secured by the amount of the debt or the value of the property securing the debt, whichever is less. (11 U.S.C. 506) In other words, if a creditor has a combine secured for a $30,000 debt but the combine is only worth $20,000 that creditor has a $20,000 secured claim and a $10,000 unsecured claim. This concept, i.e., that of a “secured claim”, runs throughout the entirety of a title 11 proceeding whether it be under a chapter 7, 11, 12 or 13.

Another notion is “add ons” to a secured claim. These include charges for default interest, costs, attorneys fees and so forth. If the note or other agreements so provides these may be added on and may continue throughout the bankruptcy process so long as there is an equity in the property. Once the equity cushion disappears so do these charges: there is simply no longer any collateral to which these charges can attach.

6.       AVOIDANCE POWERS. 11 U.S.C. 544, 547, AND 548: In order to achieve one of the primary goals of the bankruptcy system, which is the equality of distribution among creditors, Congress has included in the Bankruptcy Code “avoiding powers” which allow debtors-in-possession and trustees to set aside transfers and obligations. The debtor-in-possession or trustee is entitled to act as a bona fide purchaser, to take priority over unperfected liens, to avoid preferential payments, and to cancel fraudulent transfers.

Trustee as Lien Creditor: The Bankruptcy Code gives a bankruptcy trustee or debtor-in-possession the power of a hypothetical lien creditor on personal property as of the commencement of the bankruptcy proceeding. If a creditor has not perfected a security interest in personal property as of the date of commencement of the bankruptcy proceeding, the bankruptcy estate may set aside the security interest. A bankruptcy trustee or debtor-in-possession has the rights of a hypothetical bona fide purchaser of real property. If a debtor has transferred property to a third party but the deed has not been recorded, the bankruptcy trustee or debtor-in-possession will take free and clear of the unrecorded interest. The same situation would apply for an unrecorded deed of trust or mortgage. The trustee and the debtor in possession have the avoidance powers without regard to any knowledge they may have of unrecorded transactions. This occurs more than one would believe in vehicle title cases, where the lien is required to be noted on the title certificate itself. Simply ‘holding the title’ doesn’t work.

Voidable Preferences: Although there is nothing unlawful about a debtor preferring some creditors over others, the Bankruptcy Code provides a mechanism by which certain preferred payments will be returned to the estate so that a creditor does not receive more than it would receive if it shared with creditors in a Chapter 7 liquidation. Transfers made within ninety (90) days before the filing of the bankruptcy petition, and transfers made to insiders within one year from the date of the bankruptcy petition may be avoided.

To consider the transfer a preference, it must enable the creditor to receive more than it would have received under the bankruptcy distribution scheme if the transfer had not been made. There are some types of transactions that are either not preferences or not subject to avoidance, as set forth in the statute.

In cases where the debtor paid by check, the Supreme Court has held the effective date of a check is usually the date the check was cashed, as the debtor could have stopped payment on the check before that date.

Fraudulent Transfers and Obligations: A trustee or debtor in possession may challenge a transfer or obligation by using the fraudulent transfer provisions of the Code. The trustee or debtor in possession may avoid any transfer of an interest of the debtor’s property, or any obligation incurred by the debtor, that was made or incurred on or within two years before the date of filing of the petition under either of two circumstances. First, the transfer or obligation may be avoided where it was incurred with actual intent to hinder, delay or defraud the debtor’s existing or future creditors. Second, the transfer or obligation may be avoided where the debtor received less than a reasonably equivalent value and was insolvent, became insolvent as a result of such transfer, was engaging or about to engage in business with unreasonably small capital, or intended to incur or believed that it would incur debts beyond its ability to pay.

Also, the trustee or debtor in possession may seek to avoid fraudulent transfers and obligations by using state law. The bankruptcy court has jurisdiction to hear and determine fraudulent transfer actions based on state law.

Post-petition Transfers: These transfers of property of the estate, paid post-petition on a pre-petition debt are avoidable. Unlike the other statutes, there are almost no defenses.

Setoffs: Creditors may offset prepetition debts owed by debtors against prepetition debts which they owe to the debtors. This is not a preference. However, it is not valid to offset postpetition debts against postpetition or prepetition debts, nor to offset prepetition debts against preference claims. Court decisions hold that preferences are not subject to setoff, nor can a setoff be done without violation of the automatic stay.

However, there is another type of “setoff” that has received the blessings of the Supreme Court, which is the “administrative freeze.” That is the situation which occurs when a bank refuses to allow withdrawal from an account, although the account itself is not technically set off. Therefore, there is no violation in a bank’s refusal to honor a debtor’s demand for payment of his account balance, while the bank awaited the results of its stay relief motion seeking the right to set off the account. It is interesting to note that the Court also held that the bank account was not money belonging to the depositor and held by the bank; it was simply “a promise to pay, from the bank to the depositor. The best rule is for a debtor to NOT have an account with a bank of which he is a creditor.

7.       THE EFFECT OF CONFIRMATION       In Chapter 11, 12 and 13 cases the goal is to obtain a confirmed plan of reorganization. The effect of the confirmation under any of these chapters is to bind the debtor and all creditors. They are in effect statutory rewrites of the contracts in existence between the debtor and all the creditors and are res judicata as to value, payment and so forth.

Confirmation of any of these chapters requires that the creditor receive deferred cash payments totaling at least the value of the secured claim. In a chapter 11 proceeding a secured creditor is generally allowed to vote as an unsecured creditor for his deficiency. If the unsecured creditors vote to accept less than the full payment, a partially-secured claimant’s unsecured portion is likewise bound as the rest of the unsecured claims would be. Confirmation for any class requires 50% in number and 2/3 in amount of the creditors in that class who vote.

If, however, the unsecured creditors vote to reject the plan as proposed, then confirmation under the “Absolute Priority Rule” mandates that the unsecured claims receive full payment. Contrast this rule with the rules in chapter 12 and 13 cases, where unsecured creditors simply have to receive more than they would receive if the case were liquidated under chapter 7. There is no requirement, unless the chapter 7 value of the debtor’s property would mandate full payment if the debtor were liquidated, that unsecured claims be fully paid or paid with interest except in the context of a chapter 7 case in which there is a surplus of assets. With the expansion of the Chapter 13 jurisdictional dollar limits, more small family businesses which are not incorporated will use Chapter 13. There is also a great deal of interest in individual chapter 11 cases, for Debtors whose claims exceed the chapter 13 limitations.

Confirmation of the plan revests all of the property of the estate in the debtor free and clear of the claims of any creditors except as specifically provided for in the plan. This is true regardless of the chapter. Thus, a confirmation order is a final order and modifies the rights of the parties. In order to get confirmation of a plan under any case the debtor must show that he is acting in good faith. If he is in a chapter 12 or 13 case there must also be the acquiescence, or resolutions of objections of, the trustee. As a condition of confirmation of any of these chapter proceedings all administrative expenses including post petition payables must be paid in full as of confirmation of the plan or as agreed on a longer period of time between the debtor and that particular creditor.

As confirmation of a plan under chapter 11 allows a case to be closed, the court can entertain a motion to reopen the case to afford further relief. In the alternative, the parties can go to state court to enforce their rights under the terms of the plan under the “new contract” theory. A chapter 12 or 13 case is not considered closed until final payoff of the plan so the bankruptcy court retains full and exclusive jurisdiction over cases under those chapters.

Part 2:

PRE-BANKRUPTCY PLANNING If you haven’t read Part 1, please do so!

The first thing that must be done is to determine what is the “Chapter 7 value” of the debtor’s business. That is a shorthand way of saying that the attorney must determine what the various creditors would receive in a liquidation. The secured creditors would get the value of their collateral; senior creditors first, and so forth. Junior secured creditors may of course be totally or partially unsecured (senior secured creditors may find themselves in the same situation).

Tax authorities may or may not have their taxes either paid or discharged. Some types of taxes are dischargeable to individuals (remember that corporations and the like are never discharged except in Chapter 11 and 12 cases). Income taxes which are over three years old (the rules vary depending on the date of the return, the date of assessment, etc., so this is merely a “shorthand” rule) may be dischargeable, as are penalties and some interest. Trust fund taxes never go away. Property taxes generally become a lien on the property and follow the property.

Unsecured creditors may or may not receive a dividend. There literally may be nothing left for them. Anticipated administrative costs should be calculated. Potential preferences may be sought–find out what was paid not on a cash basis, or what liens were granted not for new value or for contemporaneous exchanges, within the last ninety days (one year re insiders.) Preferences are recoverable in bankruptcy proceedings and nowhere else. Fraudulent conveyances are recoverable under the Uniform Fraudulent Transfer Act, which mirrors Code section 548.

An examination should be made of “who’s screaming and how loud?” Are there several lawsuits threatened? Is the bank or financial institution threatening immediate foreclosure or repossession? Are taxing creditors levying? Are trade creditors refusing to supply necessary product? Are there state remedies which are available to the debtor or to creditors.

Finally, discussed last here but of paramount importance–IS THERE A BUSINESS TO SAVE? DOES IT HAVE ENOUGH CAPITAL REMAINING TO SURVIVE?   A hard rule of life is that most Chapter 11 cases DO NOT WORK.

This happens for a variety of reasons; sometimes bad management, sometimes the business world has passed them by. Remember Danny DeVito’s movie titled “Other Peoples’ Money?” At the height of the story, DeVito told a story about the last buggy whip company in America. It was the oldest, the best, and survived because it made the best product. BUT WHO WANTED ONE TODAY?

But by and large, most businesses don’t make it because they’re broke at the outset of the reorganization. “NO CASH, NO COLLATERAL” as one practitioner used to say, but it’s true. If a business does not have enough cash assets or equivalents left, it cannot function, automatic stay or not–it can’t make the hurdle of being able to handle postpetition debts. In a Chapter 11, payment of postpetition expenses is necessary. A business has no future if it goes further “in the ditch” even in a reorganizational mode with protection of the Code.

Looking at a similar problem, is there enough unencumbered value, or enough equity cushion, to provide the necessary adequate protection for the secured creditors? The courts will allow debtors to function, but not if the secured creditors go further behind as a result. Adequate protection must maintain the status quo.

Are there surplus assets which can be liquidated? Remember that the goals of a Chapter 11 are to “Clean Up, Lean Up, and Get Out!”

Several years ago, Circle K filed for bankruptcy in Phoenix, Arizona. It’s still a great case study. Circle K, as you may know, was one of the first “convenience store” chains. The company not only sold food and beverage items, but also dispensed millions of gallons of gasoline.

While Circle K was still solvent, it filled all of its gas tanks, well knowing that gasoline wholesalers usually demanded payment within ten days. It then filed Chapter 11 with full tanks, with suppliers being only unsecured creditors, and the “reclamation right” period ran before they knew of it. Considering the profit on gasoline, that was a brilliant move on their part. Moreover, Circle K bought enough gasoline that it was still able to work with the same suppliers on a close-to-COD basis, because it had enough money from the unpaid suppliers to “float” gasoline purchases. This gave Circle K time to sell off the owned stores and lease them back if they chose, reject unprofitable leased sites, and scale back to those stores which were profitable.

Circle K’s plan was confirmed. Unsecured creditors received cents on the dollar, and many of the major secured creditors did substantial workouts. Literally millions in preferences were recovered and reallocated.

Coast-To-Coast Hardware did a similar thing. Coast-To-Coast today is not the same company it was five years ago; the old company sold all its franchise agreements to a new company, sued many of the suppliers for preferences, and sued the franchise holders for money owed on franchise fees. It did this for the benefit of the bank. Sprouse-Reitz stores did a Chapter 11 prepackaged liquidation plan while its shelves were full for the holiday retail rush. If the goals was to pay the creditors the most the debtor could do, and stay in business “As Is” Coast-To-Coast and Sprouse-Reitz cases could not be considered a success. But these companies determined that they couldn’t keep on in the market “As Is” and so scaled back, collected what they could, and paid the creditors back more than they could have done otherwise. This isthe goal of a Chapter 11 case.

ONE COMMON THEME EMERGES: those companies did their planning before the case was filed–they made the determination that “business as usual” was a potential disaster, and took advantage of the automatic stay to hold off the creditors while they “leaned up.” They did so while they had sufficient assets to offer adequate protection, and to operate in the meantime. The gain of keeping the going concern cannot be overestimated.

            What are the tax consequences of a workout, bankruptcy, or liquidation? It is important to know what these consequences may be. Generally speaking, a foreclosure is treated as a sale, the debtor-owner must recapture his depreciation and pay tax on the gain and the recaptured depreciation. “Debt forgiveness income” is another of those “traps for the unwary.” Under Section 108 of the Internal Revenue Code, a discharge of an indebtedness outside of the bankruptcy context is usually treated as creating income to the extent of the debt forgiven. This is one of the worst types of tax, because it creates a tax obligation which is not dischargeable in bankruptcy while the debtor has no funds to pay it.

Compare that with the bankruptcy taxation aspects, in which the estate pays the tax out of available funds and the debtor will only have tax consequences to the extent that he receives property of the estate out of the bankruptcy. In other words, if foreclosure or surrender of goods in exchange for debt is likely, the tax consequences of bankruptcy may make this more attractive. In Chapter 12, the benefit is even more outstanding–any sale of assets in a chapter 12 allows the tax claim only as a general, unsecured, dischargeable claim.

WORKOUTS

Out of court settlements with creditors are the only successful alternatives to bankruptcy. But these are not without difficulty.

The three types of “workouts” are: 1) assignments for the benefit of creditors; 2) receiverships; and 3) extension agreements. It can be argued that bulk sales and corporate liquidations also are workouts, as will be discussed.

ASSIGNMENTS        Assignments for the benefit of creditors are traditionally more than just an assignment of an account to one creditor. The procedure involves assigning designated assets to a party who liquidates them and pays creditors pro rata. However, there is no “debt relief” or discharge entered, and creditors can still sue. In other words, that system only works in small cases where the creditors are in accord. Because of its complexity, cost, and uncertainty as to result, the procedure is seldom used.

BULK SALES and, CORPORATE LIQUIDATIONS          A procedure formerly existed under UCC Article 6, discussing bulk sales, which has now been repealed in Idaho. The debtor would give notice of the sale of all or substantially all of his assets to his creditors, with notice that the creditors will be paid from the “pot.” However, the cases were split on whether a creditor could ignore the procedure, sue, get a judgment, and jump ahead of the remaining creditors. Surprisingly, the cases were about evenly split, with some courts holding that remedy to be possible, and others that such was inequitable. This, then, only works when creditors either acquiesce or fail to act. Creditors can assert that the bulk sale is really a fraudulent conveyance and pursue the parties under that statute, or they can simply sue on their debts. The repeal of the Bulk Sales Act does not eliminate the possibility of that type of transfer being deemed fraudulent if not for a fair consideration.

A similar procedure can be used in the context of liquidations under State law. Corporate law allows liquidation of a corporation if provisions are made for the payment of creditors.

RECEIVERSHIPS     Receiverships are a state law procedure where a custodian is appointed by the court. The designated property then becomes property of the court and the receiver answers to the court. They are expensive, however, and do not get debt discharge. They do, however, protect the property from other attachments.

Receivers may be appointed to protect mortgaged property, to dispose of property subject to a judgment, or in cases where the property involved is in danger of being lost, removed or materially injured. The test for appointment of a receiver includes: inadequacy of the security; potential of fraudulent conduct; imminent danger of the property or its value being damaged; inadequacy of legal remedies; probability that harm to plaintiff by denial of appointment would outweigh injury to the opposing parties; probability of success on the merits; and the protection of the plaintiff’s interest by a receivership.

Receivers, however, do not have the power to carry on the business unless authorized and directed by the court to do so.

WORKOUT AGREEMENTS           Workout agreements can either be with each separate creditor or with creditors as a whole. If the debtor can get concurrence of all of his creditors, he can, in effect, create a “do-it-yourself” bankruptcy, with a creditors’ committee to oversee the handling of the assets and the disbursement of the proceeds. However, this still causes the same problems–any creditor can sue for a judgment, and the tax consequences can be severe.

As a practical matter, the only way a workout agreement will work is when the creditors are few in number, and a major financial institution has security in the bulk of the debtor’s liquid assets. Workout agreements are usually overreaching, because of the “Golden Rule” discussed previously. The only leverage the debtor has, in practicality, is the threat of a viable Chapter 11. If the debtor has knowledge of his bankruptcy rights and remedies, and the institutional lender knows the same thing, the parties are often more motivated to deal fairly with one another.

The financial institution definitely has motivation to get such an agreement, and they customarily include such clauses as: mandatory arbitration; concession of amount due; waiver of jury trial; waiver of “lender liability” claims; and ratification of prior agreements. On the debtor’s part, they include reduction of interest rates; the ability to determine how collateral will be sold; waiver of deficiency claims; conversion of a “called” note to a termed-out debt; the ability to use cash collateral for continued operations; and the avoidance of bankruptcy.

The financial institutions, and the debtor, still bear the risk of bankruptcy. The lender will be most concerned about potential unsecured claims filing an involuntary petition, the possibility of preferences in payment or the granting of additional security, and the potential loss in value. Consequently, a lender may well agree that it is its best interests to allow some money to go to the debtor and to unsecured creditors, to reduce these risks.


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