Bankruptcy Basics: A Primer for Non-Lawyers
Originally published in October 2013
Copyright © 2013 Knox McLaughlin Gornall & Sennett, P.C.
Before Bankruptcy: Basic Strategies for Debt Collection
Gather Information About the Debtor
In order to make cost-effective decisions about debt collection, you need reliable information regarding the debtor’s financial condition. Start with your own file and review a summary of the debtor’s payment history and defaults. Look for trends. Review the public record for deeds, mortgages, financing statements, tax liens, judgments and/or pending complaints. Finally, request financial statements and related information directly from the debtor.
Use this information to develop a strategy. Decide whether or not to file a lawsuit. If the debtor is likely to file bankruptcy in the near future, you should act quickly to improve your position with respect to other creditors.
Move quickly to complete your collection activity before a bankruptcy is filed:
- Bankruptcy law recognizes priorities obtained before a bankruptcy is filed. Therefore, you may be able to improve your position in anticipation of bankruptcy and receive better treatment later if a bankruptcy is filed. Short of receiving payment, the main ways to improve your position are to obtain a judgment, acquire security, and/or enter into a favorable work-out agreement with the debtor.
- If you elect to file suit and you obtain a judgment in Pennsylvania, the judgment automatically becomes a lien against the debtor’s real estate in the county where the judgment is recorded. Based upon the judgment, you may also be able to seize the debtor’s personal property or garnish the debtor’s bank account. Continue to increase the pressure until the debtor concludes that it is better to pay the debt than it is to suffer the consequences of non-payment. However, if the debtor is insolvent, you may end up putting the company out of business completely. In those situations, you may accomplish more with a work-out.
- As your collection effort intensifies, the debtor may offer to make payments over time. The work-out provides you with an opportunity to require cash up-front, security for the debt or a co-signer. The work-out agreement should reflect the relative strengths and weaknesses of the debtor and creditor. A reasonable work-out plan, as opposed to a one-sided work-out plan, is more likely to withstand scrutiny in a subsequent bankruptcy.
- Whether you attempt to improve your position by enforcing a judgment, acquiring security or entering into a work-out agreement, try to complete the process before a bankruptcy is filed. If you do not complete the process, you will be treated like all of the other unsecured creditors in the bankruptcy case. Even more frustrating is the fact that certain pre-bankruptcy agreements may be avoided later by the debtor or a bankruptcy trustee. Nevertheless, your collection effort should not stop if a bankruptcy is filed.
Continue your collection activity after bankruptcy, though different rules apply:
The automatic stay in bankruptcy prevents you from taking or continuing any collection activity, except for collection activity within the bankruptcy case and within the confines of applicable bankruptcy law. Bankruptcy law provides a different set of rules which govern debt collection during the pendency of the case. Those rules are designed to benefit all creditors in their order of priority.
After consulting with counsel, you should consider taking appropriate action within the bankruptcy case. File a proof of claim. Serve on the creditors’ committee. In a few cases, it may even be appropriate to file an adversary proceeding. In any event, do not be complacent. Huge sums of money are distributed to creditors in bankruptcy cases every day.
Prevent bad credit situations in the first place:
- Be more careful when you extend credit. We have all suffered a loss because one of our customers or vendors filed for bankruptcy. Make an effort to minimize those situations.
- First, ask the company for a financial statement before extending the credit. Review the financial statement in conjunction with verified bank references and independent credit reports.
- Second, update that information on a periodic basis, especially if the company is paying your invoices more slowly than in the past.
- Third, if you anticipate a problem, require a letter of credit or cash on delivery until the debtor’s position improves.
- Finally, consult with competent legal counsel when you see a problem. With current information and good advice, debt collection can be cost-effective.
Identify some of the warning signs of a business bankruptcy:
- Loss of key customers / employees
- Material / production / operating costs higher than expected
- Legal actions against the company
- Competitive pricing resulting in loss of profits / volume
- Failure to modernize
- Failure to upgrade products / services
- Failure to maintain assets
- Dishonesty / fraud by officers or employees
- Inability to obtain new credit when needed
- Inability to collect accounts receivable
The Basics of Bankruptcy
Types of Bankruptcy
Chapter 7 bankruptcy is commonly referred to as “strait bankruptcy” or a liquidation bankruptcy. A Chapter 7 bankruptcy involves a Chapter 7 Trustee collecting the assets of the debtor, excluding any exempt assets, and then liquidating those non-exempt assets for the purpose of repaying creditors. This is called an “asset case” because there will be money available to pay creditors, usually on a pro-rata basis. If all of the assets are exempt, it is called a “no-asset case.”
In order to be eligible to file a Petition for Relief under Chapter 7, a debtor may be an individual, partnership, corporation or other business entity.
The honest but overburdened Chapter 7 debtor will receive a discharge of his or her pre-bankruptcy debts. Certain debts, however, are non-dischargeable, e.g. income taxes less than three (3) years old, intentional torts, debts for fraud, etc.
Chapter 9 bankruptcy is intended only for use by financially-distressed municipalities. Although historically Chapter 9 has not been used often, the City of Detroit, Michigan recently filed for Chapter 9 relief.
Only a "municipality" may file for relief under Chapter 9. The term "municipality" is defined in the Bankruptcy Code as a "political subdivision or public agency or instrumentality of a State."
Chapter 11 bankruptcy involves the reorganization of a business. This can involve the restructuring of debt, restructuring all or part of a business, the orderly liquidation of property or the sale of all or part of property, or a business, as a going concern.
Both individuals and corporations can be debtors under Chapter 11 of the Bankruptcy Code. However, in an individual Chapter 11 case, the discharge of debt is not entered until the Chapter 11 Plan is completed. Corporations are eligible for relief under a Chapter 11 Plan, but are not eligible to receive a discharge.
Chapter 12, not unlike Chapter 9, is a chapter with a specific intent. Chapter 12 only covers family farmers and fishermen.
In order to qualify under Chapter 12 a “family farmer” must be an individual, or individual and spouse, with less than $3,792,650 in debt. A “family fisherman” is an individual, or individual and spouse, engaged in a commercial fishing operation with less than $1,757,475 in debt.
Chapter 13 is known as the wage earner’s bankruptcy. A Chapter 13 bankruptcy involves the repayment of various debts with a possible discharge of other debts after a certain period of time, usually three to five years.
Only individuals with “regular income” can be debtors in Chapter 13. This includes an individual who operates a small business as a sole proprietor. To qualify for Chapter 13, the debtor must have regular income and debts that do not exceed $360,475. An individual with debts that exceed the statutory limit may be eligible to file for Chapter 11.
Additional considerations in cases filed under Chapter 13:
- Creditors holding claims against a Chapter 13 debtor’s principal residence, or other long term continuing debt (e.g.a mortgage claim), may be required to file updates or amendments to their claims.
- Notice of payment changes: The holder of the claim shall file and serve on the debtor, debtor’s counsel, and the trustee a notice of any change in the payment amount, including any change in the interest rate or escrow amount, no later than twenty-one days before a payment in the new amount is due.
- Notice of fees, expenses, and charges: The holder of the claim shall file and serve on the debtor, debtor’s counsel, and the trustee a notice itemizing all fees, expenses, or charges (1) that were incurred in connection with the claim after the bankruptcy case was filed, and (2) that the holder asserts are recoverable against the debtor or against the debtor’s principal residence. The notice shall be served within 180 days after the date on which the fees, expenses, or charges are incurred.
Chapter 15 is a relatively new chapter in the Bankruptcy Code. The purpose of Chapter 15 is to incorporate the Model Law on Cross-Border Insolvency.
A case under Chapter 15 is commenced by the filing of a Petition for recognition of a foreign proceeding.
The Proof of Claim
A proof of claim is a written statement setting forth a creditor’s claim. Official Bankruptcy Form B 10 is a national bankruptcy form that must be used when filing a proof of claim. A proof of claim shall be executed by the creditor or the creditor’s authorized agent with the exception that a Trustee, or even a debtor in some cases, may file a proof of claim on behalf of a creditor.
Generally, if a claim is based upon a writing (e.g. a contract or promissory note), a copy of the writing should be attached to the proof of claim. A proof of claim executed and filed shall constitute prima facie evidence of the nature, extent and validity of the claim. However, if an objection to claim is filed, the burden of proof is on the claimant to prove the nature, extent and validity of the claim.
In a Chapter 7, Chapter 12 or Chapter 13 case, a proof of claim is considered timely filed if it is filed not later than 90 days after the first date set for the official meeting of creditors (with a separate deadline for governmental units), or if the time to file a claim is modified by the Court.
The term “claim” means a right to payment, whether or not such right is reduced to judgment, liquidated, unliquidated, fixed, contingent, matured, unmatured, disputed, undisputed, legal, equitable, secured or unsecured; or the right to an equitable remedy for breach of performance if such breach gives rise to a right to payment, whether or not such right to an equitable remedy is reduced to judgment, fixed, contingent, matured, unmatured, disputed, undisputed, secured, or unsecured. The failure to file a timely proof of claim can cause a creditor to lose the ability to receive any distribution from a bankruptcy estate.
The deadline to file a proof of claim is dictated by the Federal Rules of Bankruptcy Procedure and is generally uniform unless the deadline is modified by the Court. When a proof of claim is filed, the claimant voluntarily submits to the jurisdiction of the Bankruptcy Court. This may not be a good tactical move if the claimant has received pre-bankruptcy, preferential payments from the debtor which were out of the ordinary course of business. In that case, you should consult an attorney before filing a claim.
Secured vs. Unsecured Claims:
A secured claim (creditor) is a claim against a debtor by a creditor that has a right to take and/or sell certain property of the debtor in order to satisfy all or part of its claim (e.g. real estate, inventory and accounts receivable). A creditor’s claim is only secured to the extent of the value of the collateral.
Pursuant to the Bankruptcy Code, an allowed claim of a creditor secured by a lien on property in which the estate has an interest is a secured claim to the extent of the value of such creditor’s interest in the estate’s interest in such property, and is an unsecured claim to the extent that the value of such creditor’s interest is less than the amount of such allowed claim. Thus, if the value of the collateral is less than the amount of the secured claim, the creditor may end up with a bifurcated claim which is partially secured and partially unsecured.
An unsecured claim (creditor) is a claim against a debtor for which the creditor simply looked to the financial ability of the debtor to make payments in the future. The claim is not ‘secured’ by any specific collateral and the creditor has no right to make a claim against any specific property of the debtor in bankruptcy (e.g. credit card debt). In the order of priority of claims within bankruptcy, an unsecured claim generally is last to be treated and is the last group of claims to receive any possible distribution. However, certain unsecured debts have a higher level of priority by law (e.g. child or spousal support, delinquent taxes, criminal fines, etc.).
Tools to Improve a Creditor's Position During Bankruptcy
Creditors are not helpless when a debtor declares Bankruptcy. Although the bankruptcy process typically seems pro-debtor (fresh start), there are several tools a creditor may use to protect its interests. Not every tool is available to every creditor, nor is every tool effective in every bankruptcy, but creditors (and the counsel that represent them) should know what their rights are and how to best enforce them in an appropriate case.
Some of the Most Common Tools Available to Creditors
Relief from the Automatic Stay
Under certain circumstances, a Bankruptcy Court will grant Relief from Stay to a secured creditor to allow it to use its state law rights to recover and sell property securing a debt.
Relief from the Automatic Stay may be granted for “cause” including but not limited to a lack of equity in a creditor’s collateral and the collateral is not necessary for an effective reorganization.
The Administrative Hold / Freeze
Upon learning of a Bankruptcy, some financial institutions may impose an administrative hold / freeze on the debtor’s depository accounts. In some cases, a hold may be a good idea since banks may have the right to set off a debt owed them against whatever amounts they hold in the debtor’s accounts.
However, acceptance of this practice varies by district. Some Bankruptcy courts allow the hold to last for no longer than seven days. Other courts treat a hold as being akin to a violation of the Automatic Stay. Other courts permit the hold in business cases but not in consumer cases.
A hold will only last until the debtor gets an Order allowing use of its bank accounts; HOWEVER this Order may also grant the secured creditor extra security for the use of the bank accounts and thereby further protect the creditor’s interest.
In some cases, a creditor will be entitled to set-off debts owed by the debtor against a debt owed to the debtor. There are certain procedural and substantive requirements in order to do this, i.e. mutuality (same parties, same right, same capacity), Pre-Petition debts, not transferred, not incurred for purpose of set off, no improvement in position.
Set-offs are typically used by banks since a bank owes money to the debtor to the extent of his accounts with it and the bank is a creditor of the debtor to the extent it loaned money to the debtor. If set-off is done after a Bankruptcy is filed, the process may require first obtaining Relief from the Automatic Stay.
Objections to Discharge
An Objection to Discharge is an action asking the Bankruptcy Court to deny a debtor’s discharge completely. This would work to the benefit of all creditors. It may include certain fraudulent conveyances done within a year of bankruptcy and where the debtor destroys records or hides assets.
Exceptions to Discharge
Asking the Bankruptcy Court to “except” certain debts from discharge only benefits certain individual creditors. An exception to discharge would allow an individual creditor to pursue State law rights on a specific debt after discharge is entered.
Exceptions to Discharge could include debts obtained through fraud, (i.e. where a debtor obtained money by materially failing to list all debts on a credit application); or debts involving willful and malicious injury to property, (i.e. where the debtor sells property securing debt without the secured parties’ authorization).
A Reaffirmation Agreement will re-obligate a debtor on a debt that would otherwise be discharged. After default and the Bankruptcy case is closed, a reaffirmed debt may be collected as if no bankruptcy ever occurred. Allows creditor to collect a deficiency judgment if a default occurs.
Since a creditor cannot force a debtor to execute a Reaffirmation Agreement, they are most effective when the debt is secured by collateral which the debtor wishes to retain, i.e. a car or real estate.
Reaffirmation Agreements must follow certain requirements, such as being in writing and filed with Bankruptcy Court.
Advantages and Disadvantages of Chapter 11 for a Debtor
Advantages of Chapter 11:
- Calmer atmosphere to reorganize;
- Automatic stay of actions against the debtor;
- Consolidation of claims against the debtor;
- Use of cash collateral by court order or stipulation with the secured creditors;
- Work with committee of unsecured creditors;
- Rejection of burdensome contracts and leases under the business judgment rule;
- Restructure debt;
- Bind dissenters;
- Becoming a more attractive entity for possible acquisition as a going-concern, free and clear of liens and claims; and
- Obtaining new credit secured by a first lien, priming the pre-Petition liens and secured claims.
Disadvantages of Chapter 11:
- Equity cushion is needed;
- Operating cash or credit is needed;
- Postpetition cash flow and profits are required to stay in Chapter 11;
- Debtor is limited to the ordinary course of business;
- Extensive disclosure is required;
- Employee relations may be strained;
- Public relations may be adversely effected;
- Possible appointment of a Trustee or examiner;
- Guarantors are not protected; and
- Creditors may file a competing plan after the debtor’s plan exclusive period expires.
Overall, Chapter 11 can be expensive yet cost-effective and worthwhile if the Chapter 11 case is handled properly, especially in comparison with the realistic alternatives for a struggling business.
Originally published in October 2013
Copyright © 2013 Knox McLaughlin Gornall & Sennett, P.C.