bankruptcy in the us part 2-the need to know concepts part 2
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28 Summer 2009
USA
Bankruptcy in the US: The Need toKnow Bankruptcy Concepts Part 2
David Conaway continues his executive summary of the “need to know” bankruptcy concepts as theyimpact creditors in business insolvencies in the US, starting with further options for remedies for creditors
Creditor RemediesMotion to Convert to Chapter 7A creditor or a creditors’committee may convert a Chapter11 case to a Chapter 7 liquidationcase if the creditor can establish“cause” and that a conversion is inthe best interest of creditors.“Cause” includes:• Substantial losses and noreasonable likelihood ofreorganisation
• Gross mismanagement of theestate
• Failure to maintain insurance orpay taxes
A Chapter 7 trustee cannotoperate the business, thus aconversion will likely result in aclosure of the business and aquicker liquidation of the assets, oran abandonment of the assets tothe secured lender.
The Chapter 7 trustee willtake control of the debtor and itsassets. A Chapter 7 trustee mayhave more incentive to pursueavoidance actions such aspreferences against creditors.
The administrative expensesof the Chapter 7 trustee and itscounsel will have priority over theChapter 11 administrativeexpenses. Moreover, theBankruptcy Code allows thetrustee to be paid as high as 3% ofthe funds distributed to creditors.
Motion to appoint atrustee or examinerA creditor or a creditors’committee can also file a motionseeking the appointment of atrustee or an examiner. A Chapter11 trustee supplants managementand assumes control of thedebtor’s bankruptcy estate andassets. An examiner does notsupplant management or takecontrol of the debtor’s estate;
rather, an examiner investigatesdiscrete issues or transactions, andreports findings to the Court andcreditors.
A creditor may seek theappointment of a trustee or anexaminer for cause includingfraud, dishonesty, incompetence orgross mismanagement, if suchappointment is in the best interestof creditors.
Claims SaleAt least up until the recenteconomic crisis, there has been avigorous market for the purchaseof bankruptcy debt, particularly inlarger bankruptcy cases. Thepurchasers are usually Wall Streetfunds seeking to purchase claims ata discount, hoping for a return onsuch investment.
Claim purchasers will onlypurchase claims that are notdisputed or contingent as toliability. Claim purchasers willusually agree to buy claims basedon the debtor’s schedules of assetsand liabilities, not on a creditors’proof of claim if it is materiallygreater than the claim listed on thedebtor’s schedules.
Executory contractsExecutory Contract is abankruptcy concept for contractsbetween a debtor and a non-debtor party where both partiesowe performance to the other. Asupply contract or other salesagreement would almost always bean executory contract. Real estateleases are also treated as executorycontracts. The Bankruptcy Codeprovisions for rejecting executorycontracts and leases are debtor-friendly which is precisely whyretailers who want to close storesoften choose Chapter 11.
The US Bankruptcy Code
provides debtors the right toassume or reject executorycontracts and leases. If a debtorrejects an executory contract, thenon-debtor party receives ageneral unsecured claim fordamages arising from the debtor’s“breach” of contract. Thus, adebtor escapes the contract withlittle cost. The debtor also has theright to assume or assign acontract. In this instance, theBankruptcy Code requires that thedebtor “cure” the contract bypaying existing defaults.
The Bankruptcy Coderequires the non-debtor party toperform its obligations under thecontract pending the debtor’sdecision to assume or reject suchcontract, provided the debtorperforms its post-petitionobligations.
Proof of claimA proof of claim is the documentby which a creditor registers itsclaim with the debtor’s bankruptcyestate, indicating the type, amountand basis for the claim.
All claims must be filed withinthe bar date set by the BankruptcyCourt.
Section 363 saleSection 363 of the BankruptcyCode allows a debtor to sellsubstantially all of its assets freeand clear of liens with liensattaching to proceeds of sale. Thisprovision allows for the quick andefficient liquidation of a debtor’sassets without having to firstresolve the extent, validity andpriority of liens on assets. Thisallows assets to be sold relativelyquickly and avoids further erosionof value due to operating losses.
Buyers of assets often favour
DAVID H CONAWAYAttorney at Law, Shumaker,
Loop & Kendrick LLP
With increasingfrequency, Section
363 sales haveproduced proceedsless than the amount
owed to securedcreditors
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USA
acquiring assets in a Section 363sale (thus requiring a Chapter 11filing) since sales to good faithpurchasers are not subject to laterchallenge.
A Section 363 sales can createan inherent tension between thesecured creditor who asserts lienson the assets being sold and othercreditors of the estate. The securedcreditor’s goal is payment of onlyits secured debt, while othercreditors seek to achieve a sale inexcess of secured debt to generateproceeds for other creditors.
With increasing frequency,Section 363 sales have producedproceeds less than the amountowed to secured creditors. These“short sales” create anadministrative insolvency whereonly secured creditors benefit fromthe sale. Many courts haverequired the secured creditor topay administrative claimsassociated with the Chapter 11proceeding to obtain the benefit ofthe Chapter 11 process andprotections. This “pay to play”rule can also include a “carve-out”for unsecured creditors.
In the recent Clear Channelcase, the Ninth Circuit (includesCalifornia) Bankruptcy AppellatePanel (BAP) ruled that in the caseof a “short sale”, the Section 363sale was not “free and clear”, andthe buyer acquired the assetssubject to the junior liens.Whether Clear Channel is anaberration remains to be seen.
Plan of reorganisationA Plan of Reorganisation is thedebtor’s contract detailing how thedebtor will satisfy pre-petitionclaims, in the form of cash, future
profits, or the debtor’s equity.If a class of creditors is
unimpaired or satisfied, that classis deemed to have accepted thePlan. For impaired creditor classes,the class must either consent to thePlan or be “crammed down”.Consent requires of the classmembers who vote, more thanhalf in number and two thirds indollar amount accept the Plan.
A debtor can “cram down” itsplan on non-consenting classes ifthe Plan is “fair and equitable,”does not “discriminate unfairly”within classes, and is in the “bestinterests of creditors,” primarilythat creditors will receive more inthe Plan than in a Chapter 7liquidation.
To be confirmed, a Plan mustalso be feasible, includingcommitted exit financing. Thecurrent credit crisis mayundermine the ability of Debtorsto obtain exit financing, and thusexit Chapter 11.
Avoidance actionsPreferencesBankruptcy Code Section 547allows the debtor to recover pre-petition payments made within 90days prior to filing as to non-insiders and within one year priorto filing with respect to insiders.The payment in question must alsobe made while the debtor isinsolvent, on account ofantecedent debt and the paymentallows the creditor to receive morethan it would in a Chapter 7liquidation.
The statute of limitations onpreference actions is two yearsfrom the petition date.
Creditors have several
substantial defenses, including thatthe payment was made in theordinary course of business, thatthe creditor provided subsequentnew value after the payment atissue, or that the paymentconstituted a contemporaneousexchange for value.
Fraudulent TransfersThe debtor can recover transfersto non-insiders within one yearprior to bankruptcy and two yearsfor insiders, that were made todefraud creditors or when thetransfer was for “less thanreasonably equivalent value”. Astatute of limitations on fraudulenttransfer claims is two years fromthe petition date.
Cross-border insolvencyTypically, a global business withassets in the United States wouldseek insolvency protection underthe laws of its country, but will alsofile an “ancillary” proceeding inthe United States.
There are many laws, treatiesand regulations that address theseissues, including Chapter 15 of theBankruptcy Code on ancillarycases, which mostly follows theUnited Nations’ Model Law onCross-Border Insolvency.
A key difference between theUS Bankruptcy Code and mostforeign bankruptcy laws is theconcept of “Debtor in Possession”.In US bankruptcy cases, it isextraordinary for a trustee orexaminer to be imposed, whilemost foreign insolvency lawsrequire the appointment of a thirdparty administrator or liquidatorwith varying degrees ofresponsibility and involvementregarding the business.
A key differencebetween the USBankruptcy Codeand most foreignbankruptcy lawsis the conceptof “Debtor inPossession”
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