United States: Creditor Strategies In Bankruptcy

The number of bankruptcy filings have increased dramatically during the 1990's. Approximately 25-30% of the bankruptcies filed are Chapter 7 liquidations, 70-75% are Chapter 13 wage-earner reorganizations, and the rest are either Chapter 11 reorganizations or Chapter 12 farmer reorganizations.

Why do individuals and businesses file bankruptcy? Reasons include a desire to obtain a fresh start, to provide for an orderly liquidation of assets, to reorganize the debtor's business, to stop creditor actions, or to shed burdensome contracts and debts.

A bankruptcy case is begun by the filing of a voluntary or involuntary petition. A voluntary petition is filed by a debtor in the district where the debtor resides or has a principal place of business or where a majority of the debtor's assets are located for more than 180 days prior to the petition date. An involuntary petition can be filed under Chapter 7 or Chapter 11 of the Bankruptcy Code by a creditor (unless the debtor has more than 12 creditors, in which case you need at least 3 creditors) having undisputed, noncontingent and unsecured debts aggregating more than $10,775.00. Involuntary bankruptcy petitions are generally filed by creditors to preserve the status quo or to avoid overreaching by or favoritism of other creditors. If the debtor consents or does not object to the involuntary petition within a specific period of time, the debtor will be deemed to have consented to the petition.

In the event that a customer files a bankruptcy petition, the creditor is required to file a proof of claim in a Chapter 7 case within ninety (90) days from the date set for the first creditors' meeting and in a Chapter 13 case before the creditors' meeting, if the creditor has a secured claim. Chapter 11 has special rules for filing of proofs of claim and attention should be paid to the notice of filing sent by the bankruptcy clerk's office. Our recommendation is that proofs of claim be filed in all cases so that the creditor can share in any distributions. When filing a claim form always attach supporting documentation such as an invoice, account history, promissory note, security agreement or UCC-1 financing statement. Also send an additional copy of the claim, together with a self-addressed stamped envelope, so that the "filed" copy can be returned to substantiate the filing. Proofs of claim are required to be filed with the bankruptcy clerk's office in Chapter 7 and Chapter 11 cases and with the Chapter 13 Trustee in Chapter 13 cases.

Once a proof of claim is filed with the Bankruptcy Court, the court, at the request of the debtor or trustee, will determine whether the claim was properly filed (i.e. priority, secured or unsecured) and whether the claim should be allowed. Often, the collateral securing the claim will be valued and the portion of the claim which exceeds the value of the collateral will be treated as unsecured.

If a creditor continues to deal with a customer during the bankruptcy, the creditor will have an administrative priority claim which will be paid ahead of unsecured pre-petition creditors, but behind secured claims. General administrative claims are paid pro-rata with other administrative claims, including attorneys' fees, unless an exception for professional fees is carved out by the bankruptcy court which allows those fees to be paid first. Because it is possible for some Chapter 11 cases to convert to Chapter 7, it is recommended that creditors dealing with a debtor in bankruptcy obtain a security deposit, letter of credit or guaranty, request assurance of future performance, require C.O.D. or obtain a bankruptcy court order providing for some type of super-priority claim or the granting of a super-priority lien.

Once the petition is filed, a creditor is prohibited or stayed from taking any action against the debtor or its property to collect a debt. This "automatic stay" remains in effect until such time as the stay is lifted by the bankruptcy court, the case is closed or dismissed, a discharge entered in a Chapter 7 case or a plan of reorganization confirmed in a Chapter 11 case. A secured creditor can request that the stay be lifted if the debtor is not providing adequate protection or if the property securing the debt is not necessary to the debtor's reorganization and there is no equity in the property for the benefit of its estate. Sometimes, the automatic stay will be lifted to allow state court litigation to be instituted or continued so that a creditor's claim can be liquidated.

It should be noted that the automatic stay in Chapter 7 and 11 cases does not apply to claims which arise after the filing of the bankruptcy petition; creditors are free to pursue their rights under applicable state law. A Chapter 13 case is somewhat different. In these cases, the creditor can either file a proof of claim with the Chapter 13 office and request that its claim be paid under the debtor's plan or take appropriate action in accordance with state law.

Creditors with reclamation claims have the same rights in bankruptcy as its state law: goods can be stopped in transit upon learning of the bankruptcy filing or reclaimed if written demand is made within ten (10) days from the date of delivery (this period of time was recently extended under the Bankruptcy Code to allow for an additional ten (10) days after the filing of the bankruptcy petition for a total of twenty (20) days after delivery). Alternatively, the bankruptcy court will allow a reclamation claimant a lien on the goods in the Debtor's possession or an administrative priority claim provided there are no prior "floating" liens which may exceed the value of the goods.

Executory contracts (i.e. contracts in which there remains some performance to be done by either side) or unexpired leases can either be assumed or rejected after the bankruptcy petition has been filed. The Bankruptcy Code sets forth certain dates by which these contracts or leases should either be assumed or rejected, although this time limit can be extended at the request of the debtor following notice and hearing. Assumption of a contract requires that any default be cured or that adequate assurance of prompt cure be given. It also requires that there be assurance of future performance and provides for compensation for any damages. If a contract or lease is rejected, then the creditor has a general unsecured claim for unpaid pre-petition invoices, as well as a claim for damages for breach of contract. In addition, the creditor may have a possible priority claim for any post-petition goods or services provided the debtor.

The Bankruptcy Code provides that the debtor or bankruptcy trustee may recover certain "preferential" transfers made to or for the benefit of a creditor on account of an old debt, during which time the debtor was insolvent, and which allowed the creditor to receive more than it would have if the debtor's assets had been liquidated. The transfers must be made within ninety (90) days prior to the filing of the bankruptcy petition or one (1) year if the creditor is an insider. Transfers may include payments, the granting of a security interest or the obtaining of a judgment. If successful, the funds paid can be recovered or the lien and judgment avoided. "Preferences" excluded from recovery include transfers made in the ordinary course of business or substantially contemporaneous exchanges of value. In addition, any new value supplied by the creditor after receipt of a preferential transfer can be set off against the amount to be recovered.

The Bankruptcy Code also gives certain "strong-arm" powers to the debtor and bankruptcy trustee to set aside fraudulent transfers made or obligations incurred within one (1) year prior to the filing of the bankruptcy petition or such additional period of time as allowed under applicable state law (North Carolina has a three (3) year statute of limitations). Transfers and obligations which are deemed fraudulent are those made by the debtor with actual intent to hinder, delay or defraud his creditors or in which the debtor received less than reasonably equivalent value and was either (i) insolvent on the date that such transfer was made or obligation incurred or became insolvent as a result of such transfer obligation, (ii) left with unreasonably small capital, or (iii) unlikely to pay future debts as they matured.

Bankruptcy courts often reach different conclusions on similar issues due in part to the complexity of the Bankruptcy Code, the equitable authority of the bankruptcy courts to achieve a fair result and the different attitudes of the bankruptcy judges deciding the cases. Because of these factors, it is recommended that you consult a qualified bankruptcy attorney if you have any questions.