Mark Bratt Bankruptcy

CHAPTER THREE: The Automatic Stay A. The Automatic Stay Under section 362(a), the filing of the bankruptcy petition automatically enjoins creditor activity because the filing itself ―operates as a stay.‖ -362(a)(4) - The automatic stay prohibits creditors with liens from enforcing them. -362(a)(3), (4) & (6) - Secured parties cannot seize their collateral, nor can they sell off collateral that was seized before the bankruptcy petition was filed (see sections). -362(a)(3), (4) & (6) - Real estate mortgagees cannot foreclose, nor can they obtain appointment of receivers to oust the debtor from possession of the real estate. -362(a)(3) - Landlords cannot evict debtors for any prepetition failure to pay rent or for other breaches. 362(a)(1) & (2) - ―All entities‖ are prohibited from suing the debtor on prepetition claims, from continuing to prosecute suits filed prepetition, and from enforcing judgments entered prepetition. Creditors cannot take any steps to collect prepetition debts—they cannot even telephone the debtor to demand, encourage, or beg fro repayment (see section 362(a)(6)). What about for the government? Under section 362(b)(4) there is an explicit exception to the automatic stay for governmental (state and federal) enforcement of police and regulatory powers, so the automatic stay does not fully protect the debtor. B. Supplemental Injunctive Relief Under Section 105(a) The section 362 automatic stay ordinarily does not protect guarantors or other co-debtors. If guarantors or other co-debtors are not given a ―breathing spell‖ then creditors can indirectly suffocate the corporation. Thus, section 105(a) gives the court the power to enter ―any order necessary or appropriate to carry out the provisions of this title,‖ and provide that breathing spell. C. How Long the Stay Continues In a chapter 11 case, the discharge of the automatic stay occurs when the plan of reorganization is confirmed (see section 1141(d)). Significantly, the discharge itself, like the automatic stay, operates as an injunction (see section 524(a)). In some respects, the discharge picks up where the automatic stay leaves off. D. Relief From the Automatic Stay A secured creditor’s usual routine is to file a motion for relief that first claims entitlement to relief under section 362(d)(2)—the debtor lacks equity in the property, which is not necessary to an effective reorganization. If both of these conditions are proved, the property is useless to the bankruptcy case. If either condition is not proved, however, there is no relief under section 362(d)(2). In the usual case, the debtor lacks any equity in the property. The fight concerns whether or not the property is needed for reorganization, and the issue most often narrows to whether or not reorganization is possible within a reasonable time. -To prevail under section 362(d)(2) during the early days of a case, the debtor is not required to present a plan. The debtor is obliged only to make some showing, albeit well founded, that a reorganization is possible. -If no reorganization is in prospect, the collateral cannot be necessary for an effective reorganization, because it does not seem that there is going to be an effective reorganization. 1 However, if relief under section 362(d)(2) is denied, the secured creditor commonly argues in the alternative for relief under section 362(1)—for cause based on lack of adequate protection of its interest in the property. If the creditor is prevented from pulling its collateral out of the bankruptcy and enforcing its interest under state law, the value of its interest in the property must be ensured. In the absence of adequate protection, relief must be granted under section 362(d)(1) even though the collateral is property that is necessary for reorganization. -How to provide adequate protection when there is depreciation? Section 361(1) and (2) allows a debtor to provide adequate protection to a creditor by making periodic payments to the creditor equal to the depreciation or by giving the creditor an additional lien on other property sufficient to make up for the depreciation. Postpetition Interest Undersecured creditors do not accrue postpetition interest on their claims (see section 506(b)). The automatic stay prevents them from foreclosing, getting their money out of the collateral, and reinvesting it, thus costing them the interest they could have earned on the money if there were no stay. But that loss of interest is a price the law forces the undersecured creditor to pay in order to facilitate reorganization. For oversecured creditors, section 506(b) allows interest to accrue on oversecured debts to the extent there is an equity cushion. Once accumulated interest has consumed this surplus equity, the right to interest ceases. Single Asset Real Estate In single asset real estate situations, section 362(d)(3) forces the debtor to take one of two actions within 90 days after the order for relief in order to keep the stay in effect. The debtor must either file a plan ―that has a reasonable possibility of being confirmed within a reasonable time,‖ or else begin paying secured creditors monthly an amount equal to interest on the value of their liens. -Note: Section 362(d)(3) applies both to oversecured and undersecured creditors. -Real property is ―single asset real estate‖ only if it is a single property or project from which the debtor derives substantially all of the debtor’s gross income. -It is not ―single asset real estate‖ if the debtor operates any substantial business on the property other than the business of operating the property and other than activities incidental to operating the property. -Even if all of those requirements are met, the property still is not ―single asset real estate‖ unless the mortgage debts total $4 million or less. -The application may be avoided by the debtor if they convey two or more small distressed properties to a single entity and then file a petition. With two properties generating gross income for the debtor, neither property would be ―single asset real estate.‖ -Alternatively, debtors may give out mortgages to friendly creditors to get above the $4 million mark. E. The Scope of the Automatic Stay (and Section 105 Injunctions) Section 362(a)(3) stays ―any acts to obtain possession of property of the estate or of property from the estate or to exercise control over property of the estate.‖ The meaning of (a)(3), especially the meaning of ―property of the estate,‖ largely affects the width of the stay, the size of the protection it gives the debtor, and the odds of successful reorganization. The more 2 property that the stay protects, the more property the debtor gets to keep during the bankruptcy, at least during the critical first days of the case. -If the debtor’s rights under a contract are property of the estate, section 362(a)(3) prevents the other party to the contract from freely canceling it because of the debtor’s bankruptcy. Cancellation would be an act to ―obtain property from the estate or to exercise control over property of the estate‖ as that phrase is broadly construed. CHAPTER 4: Finding the Cash to Continue Operations A. Continuation of the Operation of the Business Section 1108 provides the general rule that the trustee may operate the debtor’s business unless the court orders otherwise. Section 1107(a) makes clear that his power to operate the business applies to a debtor in possession as well. However, sometimes management lacks the foresight to retrench operations of the business. In that event, creditors or the U.S. trustee may seek to obtain a court order to restrict operation of the business. Sections 1107(a) and 1108 empower the court to restrict the debtor in possession’s operation of the business but do not provide a standard by which the court is to make that determination. In most circumstances, court will defer to the business judgment of the debtor in possession. Even the continuation of substantial losses will not serve as a basis to terminate the operation early in the chapter 11 process in many cases (see section 1112(b)(1) – there must be an absence of a reasonable likelihood of rehabilitation). B. Supervising the Operation of the Business Who supervises the operation of the business? Creditors committee, U.S. Trustee, the court. (1) Section 1103(c)(2) empowers the creditor’s committee to investigate the financial condition and operation of the business. (2) The U.S. trustee is also empowered to supervise the operations of the business (see 28 U.S.C. section 586(a)(3)). (3) The court may supervise the operation of the business (see sections 105(a), (d) and 1108). C. Use, Sale, or Lease of Property of the Estate Section 363 provides the standards that determine whether the debtor can continue to use cash and other property to operate its business with or without the consent of the creditor. There are two inquiries: (1) Is the use of property in or out of the ordinary course of business? (2) Is the property ―cash collateral‖ or property other than cash collateral? ―Cash collateral‖ is defined in section 363(a) essentially to include cash and cash equivalents in which the estate and a secured creditor have an interest. While accounts receivable are not cash collateral, proceeds of accounts receivable upon collection will constitute cash collateral, even if collected after commencement of the chapter 11 case. As a general proposition, if the business of the debtor is authorized to be operated, the debtor in possession may enter into transaction in the ordinary course of business without a court order and without the consent of any affected secured creditor. If, however, the debtor in possession desires to use, sell, or lease cash collateral in the ordinary course of business, section 363(c)(2) requires the debtor in possession to obtain the secured party’s consent or a court order 3 authorizing the use of cash collateral. The court should authorize the use of cash collateral without the consent of the secured party only if the court determines that the secured party’s property interest is adequately protected in accordance with section 363(e). If the use, sale or lease or property occurs outside the ordinary course of business, different rules apply. Specifically, section 363(b)(1) requires a sue, sale, or lease out of the ordinary course of business to be done ―after notice and a hearing.‖ Once notice is given under Rules 2002(a)(2), 6004 and section 102(1), unless a party in interest requests a hearing, no court order is required. Therefore, the burden is on an interested creditor to request a hearing and raise an objection to the purchase under section 363(e). 1. Sale Free and Clear of Liens Where property of the estate is encumbered by a lien, the property can be sold either subject to or free and clear of the lien. -When sold subject to the lien, the purchaser may lose the purchased collateral through foreclosure by the secured party if the debtor’s obligation to the secured party is not timely paid. -When sold free and clear of liens, adequate protection must be provided and one of the five subparts of section 363(f) must authorize the sale: -363(f)(1): If applicable nonbankruptcy law permits the sale of property free and clear of the lien, then the debtor will be able to sell the property in bankruptcy free and clear of liens to the same extent it could outside of bankruptcy. -363(f)(2): The secured creditor consents to the sale in the bankruptcy proceeding or on a prepetition security agreement. -363(f)(3): The price at which the property is to be sold is greater than the aggregate value of all liens encumbering the property. This standard appears to require the estate to have an equity in the property. -363(f)(4): If there is a bona fide dispute as to the lien. -363(f)(5): If the secured creditor could be compelled, in a legal or equitable proceeding, to accept a money satisfaction of the lien. This standard is unclear. 2. Sale of All or a Substantial Portion of Assets Outside of a Plan In order to obtain needed cash, or to get rid of business operation that are losing money, the debtor in possession may need to sell a substantial portion of the property of the estate before confirming a plan of reorganization. Although section 363 authorizes the sale of property of the estate, courts are split whether the debtor in possession may sell all or a substantial portion of the assets of the estate during the case outside the context of a chapter 11 plan. 3. Protecting the Purchaser in a Sale Section 363(m) protects a purchaser of property from the estate. Unless an objector obtains a stay pending appeal, the reversal on appeal of the order authorizing the sale will not affect the validity of the sale to a good faith purchaser. D. Obtaining Credit to Run the Business The bankruptcy Code provides four different rules that govern the obtaining of credit during a chapter 11 case. 1. Obtaining Unsecured Credit in the Ordinary Course of Business The easiest way for the debtor in possession to minimize the amount of cash necessary to run the business is to maintain or obtain unsecured trade credit repayable in the ordinary course of business. Section 364(a) allows the trustee or debtor in possession to obtain credit in the 4 ordinary course of business without a court order or a hearing. Credit so obtained is an administrative expense entitled to priority under sections 503(b) and 507(a)(1). The holder of the administrative expense claim is entitled to be repaid in full in cash on the effective date of any confirmed chapter 11 plan unless the holder agrees to other treatment (see section 1129(a)(9)(A)). -The lender extending trade credit must be particularly sure that the credit is extended in the ordinary course of business. While the bankruptcy code does not define ―ordinary course of business,‖ the courts typically examine the ―horizontal‖ and ―vertical‖ dimensions of a debtor’s business to make the determination. The horizontal analysis is an external industry-wide comparison of the debtor’s business and other similar businesses to determine whether the transaction is ordinary for this type of business. The vertical dimension examines the reasonable expectations of parties in interest who have dealt with this debtor. If either dimension of the test is not satisfied, the disputed transaction is not in the ordinary course of business. -If the court finds that the creditor has extended credit outside the ordinary course of business without court approval, it is possible that the creditor’s claim will be treated as an unsecured prepetition debt. 2. Extension of Unsecured Credit Outside the Ordinary Course of Business Section 364(b) permits the debtor in possession ―after notice and a hearing‖ to obtain credit outside the ordinary course of business. The credit is entitled to priority as an administrative expense. Bankruptcy Rule 4001(c) requires a motion to obtain credit out of the ordinary course of business to be served on the creditor’s committee not less than fifteen days before the hearing and on such other entities as the court may direct. The motion must be accompanied by a copy of the agreement governing the extension of credit. If necessary, the court can authorize an emergency extension of credit to the extent necessary to avoid irreparable harm during the fifteen days before the hearing. -Where the notice is incomplete or inaccurate, some courts have voided the order authorizing the extension of credit. -Although emergency borrowings may be made on short notice or an ex parte basis, this relief will not be available where the debtor has created the emergency by postponing the request to obtain credit until the last minute. 3. Obtaining Superpriority or Secured Credit Under Section 364(c) Section 364(c) permits a debtor in possession ―after notice and a hearing‖ to obtain secured credit or credit entitled to a superpriority administrative expense under certain circumstances. First, the debtor in possession must demonstrate that unsecured financing under section 364(a) and (b) is unavailable. -There is not a duty to seek credit from every possible lender, but some effort is required. If financing is unavailable, section 364(c) authorizes the debtor in possession to obtain credit on three additional bases or a combination of those bases. (1) The postpetition credit may be granted priority over ―any or all‖ administrative expenses, which is known as the section 364(c) superpriority administrative expense. The order granting superpriority status should specify which administrative expenses the superpriority will be senior. (2) Under section 364(c)(2), a lender may extend postpetition credit secured by a lien on property of the estate that is unencumbered. -Permits debtor in possession to obtain postpetition secured credit only if unsecured financing is unavailable under section 364(a) and (b). 5 (3) Under section 364(c)(3), a lender may extend credit secured by a junior lien on property of the estate that already is encumbered. -Permits debtor in possession to obtain postpetition secured credit only if unsecured financing is unavailable under section 364(a) and (b). Cross-Collateralization Frequently a lender will be willing to extend postpetition credit only if the lender’s prepetition loan is secured by all assets that will serve as collateral for the postpetition loan. This is called ―cross-collateralization.‖ Lenders desire cross-collateralization when their prepetition loan may be undersecured. Although the Bankruptcy Code contains no specific prohibition of cross-collateralization, courts are split on the propriety of the device. Some courts interpret section 364(c) to permit the granting of a superpriority or a lien only with respect to credit that is extended postpetition after court approval. Other courts, however, permit cross-collateralization where it is in the best interest of creditors, the financing is made on the best terms possible, no alternative financing is available, and absent the financing the business will be irreparably harmed. 4. Obtaining Credit Secured by a Senior Lien Under section 364(d) If the debtor in possession is unable to obtain postpetition credit on any other basis, section 364(d) provides for the extension of credit secured by a ―priming lien,‖ a lien that is senior or equal to existing liens that encumber property of the estate. In this situation, the court must determine that the interest of any other secured creditor with a lien encumbering the property is adequately protected, an issue on which the debtor in possession bears the burden of proof under 364(d)(2). -The classic instance to authorize a borrowing secured by a senior lien occurs in a real estate case with a half-built building when the construction lender is reluctant to supply additional financing to complete the building project. The court may determine that the completion of the building—made possible by a section 364(d) borrowing secured by a senior lien—will so greatly enhance the value of the collateral that the primed creditor’s position will be improved. -Threat of filing a motion under section 364(d) to obtain a ―priming‖ loan can be used by the debtor in possession to encourage existing lenders to extend postpetition secured credit. 5. Protecting the Borrowing Pending Appeal Section 364(e) protects a lender from reversal on appeal of an authorization to obtain credit. In particular, the reversal or modification on appeal of a borrowing order will not affect the validity of the borrowing or any priority or liens so granted unless the borrowing order is stayed pending appeal, as long as the entity extended the credit in good faith. Thus, if an appellant fails to obtain a stay pending appeal, courts have dismissed the appeal as moot upon a showing that the creditor has extended credit in reliance on the order. CHAPTER 5: Turning the Debtor Around—The Business Issues A. Causes of Business Failure 1. Economic Conditions: Recessions, Competition, and Technological change. 2. Inside Underlying Causes: a. Overextension of Credit to their customers b. Insufficient Management: 6 -Inadequate sales -Improper pricing -Inadequate handling of receivables and payables -Excessive overhead expenses and operating costs, and excessive interest charges on long-term debt -Over-investment in fixed assets and inventories -Insufficient working capital, including a weak cash position -Unbalanced capital structure, that is, an unfavorable ration of debt to equity -Inadequate insurance coverage -Inadequate accounting methods and records c. Insufficient Capital (many times this is because of rapid expansion) 3. Outside Influences: Governmental actions 4. Fraud and Dishonesty B. Tools to Diagnose Business Failure Altman business ratio 1. X1 = Working capital (current assets – current liabilities)/Total assets 2. X2 = Retained earnings/Total assets 3. X3 = Earnings before interest and taxes/Total assets 4. X4 = Market value of equity/Book value of total debt 5. X5 = Sales/Total assets PUBLIC COMPANIES Z = 1.2X1 + 1.4X2 + 3.3X3 + .6X4 + 1.0X5 Firms that have a Z-score of greater than 2.99 clearly fall into the nonbankrupt sector, while a Zscore less than 1.81 would indicate a likely future in bankruptcy. PRIVATE COMPANIES Z = .717X1 + .847X2 + 3.107X3 + .420X4 + X5 Firms that have a Z-score greater than 2.9 clearly fall into the nonbankrupt sector, while a Zscore less than 1.23 would indicate a likely future in bankruptcy. CHAPTER 6: Controlling and Supervising the Reorganization A. The Debtor in Possession The ―debtor in possession‖ is simply the term that describes a debtor in a chapter 11 case in which no trustee is serving (see section 1101(1)). The debtor in possession is the same entity, which existed before the filing of the bankruptcy petition, but is empowered by virtue of the Bankruptcy Code to deal with its contracts and property in a manner it could not have employed absent the bankruptcy filing. Key to those rights and duties is the role of the debtor in possession (or trustee, if appointed) as ―the representative of the estate,‖ under section 323. The representative of the estate is vested with the power under section 363 to use, sell, or lease the property of the estate; under section 365 to borrow money or obtain credit on behalf of the estate; under section 365 to assume or reject executory contracts and unexpired leases of the debtor on behalf of the estate; under 7 section 502 to object to claims made against the estate; under section 506(c) to recover out of secured creditor’s collateral the expenses incurred by the estate in preserving or disposing of the collateral, to the extent of any benefit to the secured creditors; under section 542 to recover possession of property of the estate from others; under sections 544, 545, 547, 548, 549, 550, and 553 to use the avoiding powers to recover property for the estate; and under section 1108 to operate the business for the estate. -Appointment of a trustee should be the exception, rather than the rule and grounds for appointment of a trustee must be shown by clear and convincing evidence. 1. Ordinary Course Transactions Under section 363(c) the debtor is entitled to enter into transaction in the ordinary course of business without a hearing, as long as they do not involve use of cash collateral. -Collective bargaining agreement? Depends on the approach. (1) One approach is to look at both horizontal and vertical to determine if it is ordinary course: (a) Horizontal: Broad – look at all companies in the same industry; (b) Vertical: Narrow – look at the individual company’s history. (2) Second approach is to look to see if it is a day-to-day operation to determine if it is ordinary course. -Scarberry says collective bargaining agreements are not ordinary course. - Severance packages to managers? These are not typically considered ordinary course transactions because they are many times conflict of interest. 2. Appointment or Election of a Trustee for the Case The debtor in possession and its managers owe a fiduciary duty to both the shareholders and to the creditors. When situations arise where management does not live up to this expectation, they can be replaced under section 1104(a). This section governs the appointment of a trustee to oust the debtor from possession. It provides that the court shall order the appointment of a trustee if the standards in either section 1104(a)(1) or (a)(2) are met. If the court orders the appointment of a trustee, then the U.S. trustee after consultation with parties in interest will appoint the trustee for the case under section 1104(d), although the creditors may choose to elect a trustee under 1104(b). Note that the U.S trustee may not appoint himself or herself as trustee for the case, that the appointment is subject to the court’s approval, and that the trustee for the case must be one disinterested person (see section 1104(d) and Rule 2007.1(b)). If, within 30 days after the court orders appointment of a trustee, a creditor requests an election, the U.S. trustee in the case. -Only holders of allowable general unsecured claims may vote, and only if their claims are undisputed, fixed, and liquidated (see section 702(a)(1)). Neither insiders nor anyone else with an interest materially adverse to the interest of the other general unsecured creditors may vote. -Under 702(b) no election will be held unless creditors holding 20% in amount of the claims entitled to vote appear at the meeting (in person or proxy), and request that the election be held. Then no election will be valid unless 20% actually do vote, and one person receives the votes of the holders of a majority in amount of the claims that are voted (see section 702(c)). 8 Section 1104(a)(1) calls for the court to order appointment of a trustee for case, which specifically includes fraud, dishonesty, incompetence, or gross mismanagement by current management, either before or after the commencement of the case. -Since every bankruptcy case involves a certain level of incompetence or mismanagement, courts have required a finding of more than simple mismanagement. Section 1104(a)(2) calls for the court to order appointment of a trustee when it is in the interest of creditors, any equity security holders, and other interests of the estate. -Note: Short of ordering the appointment of a trustee, the court can order appointment of an examiner under section 1104(c) who will investigate the debtor’s actions, and who may be given authority under section 1106(b) to take over some of the duties. B. Creditors’ and Equity Security Holders’ Committees Under section 1103 the official committee or committees appointed by the U.S. trustee have a broad mandate to be involved in the case. The committees are entitled to investigate anything relevant to the case or to the formulation of a plan, including specifically the debtor’s conduct and financial condition, the operation of the business, and the desirability of continuing it. The committees are entitled to participate in the formulation of a plan of reorganization, to determine whether to support or oppose any plan, to communicate recommendations to the creditors or equity security holders represented by each committee, and to solicit votes on the plan. The committees may select, with the court’s approval, attorneys and other professionals to assist them in carrying out those functions (see section 1103(a)). The reasonable fees of those professionals for actual and necessary services will paid by the estate as a cost of administration. -The U.S. trustee appoints an official unsecured creditors’ committee in every chapter 11 case. It usually consists of persons willing to serve who hold the seven largest unsecured claims (see section 1102(a) and (b)(1)). -Each committee member seemingly is invited to seek to protect whatever economic interests it may have by acting as a voice for those interests. -On the other hand, each committee member owes fiduciary duties of care and loyalty to the entire class represented by the committee, not just to that part of the class with economic interests similar to the interests of the committee member. -It is not clear how this conflict should be resolved. Perhaps, each committee member is entitled to assert its own interests as long as it does so in an open and honest way without harming the overall interests of the entire group. CHAPTER SEVEN: Executory Contracts A. Executory Contracts and Unexpired Leases 1. Section 365 Section 365 governs the treatment of executory contracts and unexpired leases to which the debtor is a party. It states that the trustee or debtor in possession subject to the court’s approval may assume or reject any executory contract or unexpired lease of the debtor. Many courts require the nondebtor party to the contract to continue performing its obligations under the contract while the debtor in possession decides whether to assume or reject the contract. The Supreme Court has held that an executory contract is not enforceable against the debtor in possession until and unless it is assumed. 9 -Many courts have followed the traditional understanding by holding that rejection frees property of the estate from claims for specific performance of executory contracts. -Other courts have specifically held that rejection does not terminate the rejected contract or lease (Andrew/Westbrook argument). It is unsettled whether the debtor’s rights under an executory contract become property of the estate immediately upon the filing of the petition, or only if and when the contract is assumed. An executory contract or unexpired lease is, in a sense, both an asset and a liability, created and linked together by the parties’ agreement. The debtor’s prepetition executory contracts and unexpired leases gave the debtor rights—but they also imposed obligations on the debtor. 2. The Need to Take Advantage of the Debtor’s Contracts and Leases If chapter 11 debtors could not take advantage of their rights under prepetition contracts and leases, reorganization would often be difficult or impossible. Therefore, section 365(a) permits the debtor in possession to take the benefit of prepetition contracts and leases for the estate by assuming them. Section 365(e)(1) even protects the debtor in possession’s rights to assume such a contract or lease by prohibiting enforcement of a contractual provision that would allow the nondebtor party to modify or cancel the contract or lease due to the bankruptcy filing or due to the debtor’s financial condition. 3. The Executory Contract as a Package of Benefits and Burdens If the contract or lease is assumed under section 365(a), the estate then becomes entitled to the debtor’s rights under the contract or lease, but also succeeds to the debtor’s obligations; those obligations become obligations of the estate itself, and thus have an administrative priority. Thus, if the benefits of the contract exceed its burdens, the debtor in possession (or trustee) will likely seek court approval to assume the contract; if the burdens exceed the benefits, the debtor in possession (or trustee) will likely seek court approval to reject the contract. The rejection will constitute a breach, which, under section 365(g)(1), will be considered to have occurred immediately before the filing of the petition. The nondebtor will then have a general unsecured claim for damages for breach of contract (unless the nondebtor party has a secured claim as a result of having taken a security deposit or lien to secure performance of the contract). -If there has been a prepetition or postpetition default, in order to assume the contract or lease the debtor usually must either cure the default or give adequate assurances that the default will be cured and usually also must compensate the nondebtor party for losses caused by the default (see section 365(b)). -Some courts say that if the debtor neither assumes nor rejects the executory contract or lease, then it will be deemed to ride through the bankruptcy proceeding and the debtor would still be bound by the contract. -Other courts have treated the nondebtor rights as claims, even though there was no assumption or rejection. 4. The Meaning of Executory While it does not always matter whether a contract is considered to be executory or not (sometimes you can either reject or ignore – both resulting in a prepetition claim for damages), sometimes it does: 10 (1) If a contract is executory but is neither assumed nor rejected, it may ride through the case and be binding on the reorganized debtor. (2) If a contract is not executory because the nondebtor party has completely performed, then the nondebtor party will simply have a claim in bankruptcy for the value of whatever it is entitled to under the contract. (3) If a contract is not executory because the debtor has completely performed, the estate has an asset—the right to performance from the nondebtor party. (4) If the contract is executory, and hence subject to being rejected, the debtor may be able to eliminate a right to specific performance that might otherwise survive the bankruptcy case. (5) Some courts treat the debtor’s ability to reject a contract under section 365(a) as a kind of avoiding power, rather than simply as the right to decline to make the contract the estate’s contract. If rejection constitutes an avoiding power, the debtor may have a greater ability to affect the nondebtor party’s rights if the contract is found to be executory and thus subject to being rejected. Definition of executory contract: If either the debtor or the nondebtor party has fully performed, there is no reason to allow such an election, and the contract should not be considered to be executory. As a result, under Professor Countryman’s definition a contract is executory only if the obligations of both the bankrupt and the other party to the contract are so far underperformed that the failure of either to complete performance would constitute a material breach excusing performance of the other. Put another way, each party must be capable of materially breaching for a contract to be executory. 5. Five Exceptions to the Package Approach a. Ipso Facto Clauses Ipso facto clauses terminate or modify the debtor’s rights under a contract or lease due to the insolvency or financial condition of the debtor, due to the commencement of the debtor’s bankruptcy case, or due to the appointment of a trustee in bankruptcy. Section 365(e)(1) precludes such clauses from having any effect after commencement of the bankruptcy case. Section 365(b)(2) provides that when a debtor in possession assumes a contract or lease, the debtor in possession need not cure a breach of an ipso factor clause, need not compensate the nondebtor party for any damage caused by a breach of an ipso facto clause, and need not provide assurances that an ipso facto clause will be complied with in the future. b. Penalty Rates and Incurable Nonmonetary Defaults In order to assume an executory contract or an unexpired lease, a debtor in possession need not cure a breach of a provision relating to the satisfaction of any penalty rate or provision relating to a default arising form any failure by the debtor to perform nonmonetary obligations under the executory contract or unexpired lease. c. Provisions that Prohibit, Restrict, or Condition Assignment The code permits the debtor in possession to assign a contract or lease despite any provision in the contract or lease that would prohibit, restrict, or condition assignment; such contractual provision are unenforceable in bankruptcy (see section 365(f)(1)). d. Release From Liability on Assigned Contracts Outside bankruptcy, the debtor could not escape liability on a contract (or lease) by assigning its rights and delegating its duties to another. If the assignee failed to perform, the debtor would be liable on the contract or lease. Inside bankruptcy, there is a different 11 result; the reorganized debtor likely will not be liable for any future breach by the assignee. -Note that in order to assign the contract, the debtor in possession must first assume it. That obligates the estate on the contract and generally would make any damages for breach of the contract administrative expenses. However, if the contract is then assigned, the estate and the debtor in possession (or trustee) are relieved from any liability for any breach of the contract that occurs after the assignment (see section 365(k)). The courts have interpreted this section as if it provided for the reorganized debtor to be relieved of liability. e. Restrictions on Use of Leased Premises The fifth exception deals with provisions in leases that restrict use of the premises, and that could, as a practical matter, prevent assignment. Some courts have held that a use limitation is not enforceable against an assignee who takes an assignment in bankruptcy, unless the landlord shows that lack of enforcement would jeopardize the economic position of the landlord and/or the landlord’s other tenants. B. Rights and Obligations Pending Assumption or Rejection Is a contract enforceable by the debtor against a creditor while the debtor is deciding whether to assume or reject? CHAPTER EIGHT: Avoiding Secured Claims (And Other Transfers and Obligations) A. Fraudulent Transfers The purpose of fraudulent conveyance law is simple: it protects a debtor’s unsecured creditors from reductions in the debtor’s estate to which they look for their security. 1. Transfers Fraudulent Under Bankruptcy Law, Section 548 Section 548 empowers the trustee to avoid a transfer of the debtor’s property, or any obligation incurred by the debtor, that was fraudulently made or incurred on or within one year before the filing of the bankruptcy petition. A transfer is avoidable: (1) Where the debtor made the transfer or incurred the obligation with actual fraudulent intent. (2) In four instances of constructive fraud: -The first three are where the transfer was made for less than reasonably equivalent value, and the debtor: 1. was or thereby became insolvent 2. was engaged in business with an unreasonably small capital 3. intended to incur debts that would be beyond the debtor’s ability to pay. -The fourth kind of constructively fraudulent transfer is any transfer of partnership property to a partner in the debtor if the debtor was or thereby became insolvent. 2. Transfers Fraudulent Under State Law, Section 544(b) Section 544(b) allows a trustee (or debtor in possession) to invoke state fraudulent conveyance law to avoid a transfer. This is especially useful when the state law condemns a wider range of transfers than section 548. Section 544(b) is particularly useful when the allegedly fraudulent transfer or obligation was made or incurred more than one year before the filing of the bankruptcy petition, in which case section 548 is inapplicable. 12 -Note: If the trustee succeeds in avoiding a transfer or obligation under section 544(b), the entire transfer or obligation is avoided even if that would not have been the result under state law. B. Unperfected Transfers Federal law effectively gives the trustee or debtor in possession the status of two classes of claimants of property who claim through the debtor as of the time of bankruptcy: (1) a lien creditor with a judicial lien on all property that a contract creditor could subject to such a lien under state law, and (2) a bona fide purchaser of real property from the debtor to whom the transfer is made and perfected as of the time of bankruptcy. Why is this important? Third parties’ prepetition liens and interests in property that could be defeated (under state law) by a judicial lien creditor of the debtor, or by a purchaser of real estate from the debtor, are avoidable by the trustee if at the time of bankruptcy the interests are subordinate to the claim of such a lien creditor or purchaser. C. Preferences Bankruptcy law avoids some transfers for its own reasons, even though the transfers are perfectly legitimate and unassailable under state law. One example is section 547(b), which defines and condemns prepetition transfers that are preferences. The section defines a preference as: (1) Any transfer of an interest of the debtor in property; (2) To or for the benefit of a creditor; (3) For or on account of an antecedent debt owed by the debtor before such transfer was made; (4) Made while the debtor was insolvent; (5) Made on or within 90 days before the date of filing of the petition, or within one year of the filing if the creditor is an insider; and (6) That enables the creditor to receive more than the creditor would receive in a Chapter 7 distribution of the bankruptcy estate had the transfer not been made. However, there are eight limited exceptions to 547(b) which are collected in section 547(c) which cannot be avoided by the trustee even though the transfer is a preference. 1. Indirect Preferences A guarantee of debts owed to a creditor, on behalf of a debtor makes the guarantor a creditor of the debtor. This is because a guarantor has the right to be reimbursed by the principal debtor for any payment the guarantor makes on the guarantee debt. Therefore, a guarantor is a ―creditor‖ under the terms of 547(b). Therefore, when a transfer is done that lowers the debt that is being guaranteed, the guarantor indirectly benefits. This is called an ―indirect preference‖ because the transfer was not made to the debtor but did benefit him/her indirectly. In this situation, section 550(a)(1) permits the trustee or debtor in possession, when a transfer is avoided, to recover the value of the property from ―the initial transferee of the transfer or the entity for whose benefit such transfer was made.‖ D. Postpetition Transfers—Mainly, After-Acquired Collateral 13 Postpetition transfers of estate property are usually avoidable if they are not authorized by the Code or the bankruptcy court (see section 549(a)). CHAPTER NINE: Claims Against the Estate CHAPTER ELEVEN: Proposing a Plan of Reorganization—Exclusivity, Classification, and Impairment A. Proposing a Plan of Reorganization – Exclusivity, Classification, and Impairment Section 1123 requires three basic elements be included in a plan for reorganization. (1) First, the plan should designate classes of claims and interests (see section 1123(a)(1)). As required by section 1122(a), only claims that are substantially similar are placed together in the same class. However, this does not require that you place all substantially similar claims in the same class. Secured claims should each be placed in a separate class because they are not substantially similar. (2) Second, the plan should specify how each class will be treated (see section 1123(a)(2) and (3)). Each claim or interest in a particular class is treated the same as every other claim or interest in the same class, as required by section 1123(a)(4). Additionally, the plan should provide the treatment required by the Code for claims that are not eligible to placed in classes—administrative expense claims and priority tax claims (see 1123(a)(1) and 1129(a)(9)(A) and (C)). Further, the plan should also specifically identify any classes that are not impaired under the plan, as required by section 1123(a)(2). (a) Holders of allowed claims or interest in impaired classes are permitted to vote on the plan (see section 1126(a) and (f)). The plan can be confirmed consensually under section 1129(a) only if all impaired classes accept the plan by the required majorities (see section 1126(c) and (d) and section 1129(a)(8)). (b) Holders of claims or interests in unimpaired classes are not eligible for protection under the ―fair and equitable‖ standard of section 1129(b). (c) Since almost all plans will impair at least one class, the plan cannot be confirmed consensually or in a cramdown unless at least one impaired class of claims accepts the plan, not counting acceptances of insiders. Thus the debtor must try to make sure that the plan creates and impairs at least one class of claims that will accept the plan without the aid of insiders’ acceptances (see section 1129(a)(10) and (b)(1)). (3) Third, the plan should provide adequate means for implementing its terms (see section 1123(a)(5)). Although the Code does not require it expressly, the plan should set an effective date. An effective date must be set so that the court can make the finding required by the best interests of creditors test in section 1129(a)(7), which refers to ―value, as of the effective date of the plan‖ (and, if a cramdown is needed, the finding required by section 1129(b)(2), which also refers to the effective date). Rule 3020(e) provides for a ten-day stay of the order confirming the plan (unless the court orders otherwise). Then, if the plan is confirmed, objecting parties will have that same ten day period in which to file a notice of appeal (see Rule 8002(a)). 14 B. Exclusivity and the Filing of Plans Section 1121(a) permits the debtor to file a plan at any time. Parties other than the debtor cannot file a plan unless a trustee is appointed, or unless the debtor fails to file a plan within 120 days after the order for relief, or unless the debtor fails to obtain acceptances of its plan from all impaired classes within 180 days after the order for relief (see section 1121(b) and (c)). The 120 day and 180 day ―exclusivity periods‖ can be reduced or extended by the court ―for cause‖ (see section 1121(c)). -The 120-day exclusivity period is designed to give the debtor the time that is needed to prepare for filing a plan. -Extending/shortening the 120 exclusivity period: If an unusually large company were to seek reorganization under chapter 11, the court would probably need to extend the time in order to allow the debtor to reach an agreement. If, on the other hand, a debtor delayed in arriving at an agreement, the court could shorten the period and permit creditors to formulate and propose a reorganization plan. -If the debtor does not use the exclusivity period well so to make progress toward a successful reorganization then undersecured creditors are likely to be successful in obtaining relief from the automatic stay under section 362(d)(2). -The 180-day period is designed to give the debtor the time that is needed to obtain acceptances of its plan from all the impaired classes. In the typical case, neither acceptances nor rejections can be solicited until a disclosure statement has been approved and distributed to the creditors and interest holders, so that they can cast informed votes. If there are amendments to the plan then there needs to be amended disclosure statements prepared, approved and distributed, and parties who have already voted may need to be given an opportunity to change their vote. C. Classification of Claims and Interests Under section 1123(a)(1), the plan must designate classes of claims and interests. If most general unsecured creditors support the debtor’s plan, then the debtor may draft he plan so that all general unsecured creditors are placed in one class. The plan supporters may then be able to outvote the plan opponents so that the class accepts the plan. As a result, the debtor may be able to confirm the plan consensually under section 1129(a) and avoid the need for a section 1129(b) cramdown. -A class of claims accepts a plan if, out of the claims in the class that are voted, two thirds in dollar amount and more than half in number are voted in favor of the plan (see section 1126(c)). -A class of interests accepts the plan if, out of the interests that are voted, two thirds in amount accept (see section 1126(d)). If too many general unsecured creditors oppose the plan, a single class made up of all general unsecured claims would reject the plan. In such a case, there is no way to divide up the general unsecured claims into classes all of which will accept the plan; thus consensual confirmation will not be possible (see section 1129(a)(8)). The debtor must be sure that the plan creates at least one impaired class of claims that will accept the plan (not counting acceptances of insiders); otherwise the plan will not be confirmable even in a section 1129(b) cramdown (see section 1129(a)(10) and (b)(1)). 15 Section 1122(b) permits the plan to create a separate administrative convenience of class of small-unsecured claims. Section 1122(a) prohibits the plan from placing two claims or interests in the same class unless they are substantially similar, and seems to characterize section 1122(b) as an exception to its rule. However, section 1122(a) does not explicitly require that all substantially similar claims be placed in the same class. D. Impairment of Classes The purpose of a plan of reorganization is to restructure the debtor’s debts, not to leave the creditors unaltered. It should come as no surprise then that section 1123(b)(1) permits the plan to ―impair‖ almost any class of claims or interests. Section 1123(a)(5) explicitly permits the plan to extend due dates, change interest rates, and change other terms of debt instruments; to cancel or modify the terms of the agreements; and to modify any lien. Section 1123(b)(5) specifically authorizes the plan to modify the rights of holders of secured and unsecured claims, or to leave their rights unaffected. In fact, the plan can include any ―appropriate‖ provisions that are not inconsistent with the Code (see section 1123(b)(6)). That includes provisions that alter the rights of creditors in ways not specifically mentioned in section 1123. -For example, the plan may of course provide less than full payment of unsecured claims. There is, however, a limit on how much less: any creditor who does not accept the plan and whose claim is in an impaired class must receive at least as much value as a liquidation would provide (see section 1129(a)(7) (known as the best interests of creditors test)). Further, protections apply under section 1129(b) if the impaired class does not accept the plan— the ―fair and equitable‖ standard and the ―no unfair discrimination‖ standard. In particular, if an impaired class of unsecured claims does not accept the plan, then holders of claims in that class must receive property of a value equal to the full allowed amount of their claims or else no holder of any claim or interest in a junior class can receive or keep any property on account of the holder’s claim or interest (see section 1129(b)(2)(B) (fair and equitable requirement)). Even though the Code places firm limits on how little value the plan can give to unsecured creditors, it places almost no limit on the form of that value. Provisions requiring general unsecured creditors to take promissory notes or voting stock in the reorganized company are ―not inconsistent with the applicable provisions‖ of the Code, and hence they are permissible (see section 1123(b)(6)). The debtor has less discretion with regard to how to treat holders of secured claims. Each secured claim will typically be in its own class; thus if a holder of a secured claim rejects the plan, the holder’s class will also reject it, thus triggering application of the fair equitable standard with regard to that class. As applied to classes of secured claims that do not accept the plan, that standard usually requires the plan to provide (1) that the holder of the claim retain its lien on the collateral for the amount of the allowed secured claim and (2) that he holder receive cash payments over time that total at least the allowed amount of the secured claim and have a present value as of least the allowed amount of the secured claim and have a present value as of the effective date at least equal to the lesser of the amount of the allowed secured claim and the value of the collateral (see section 1129(b)(2)(A)(i)). -The debtor cannot require a secured creditor to take stock in the reorganized debtor as payment on its secured claim. 16 -If there are substantial secured claims in a chapter 11 case, much of that debt may have to be given to the secured creditors, unless they can be convinced to take voluntarily some of their value in the form of the debtor’s stock. The result is that unsecured creditors may have no choice but to accept most of their value in the form of stock, if there is to be a reorganization. -Note: If the creditor is undersecured and makes the section 1111(b)(2) election to have its entire claim treated as secured, then the present value of the payments need only equal the value of the collateral, not the entire amount of the secured claim (see section 1129(b)(2)(A)(i)(II)). Nevertheless, the creditor is entitled to receive a total number of dollars equal to the amount of its allowed secured claim, which will be the entire amount of the debt if the 1111(b)(2) election is made. How can a class be left unimpaired? Section 1124 gives the drafter of a plan only two ways to leave a class unimpaired: (1) by leaving the rights of holders of claims or interest in the class completely unaltered by the plan, or (2) by leaving the holders’ rights unaltered by the plan except for curing defaults, reinstating maturity dates, and compensating the holders for reasonable reliance on whatever nonbankruptcy rights they may have had to accelerate their debts (see section 1124(1) and (2)). -A cure will require at least that any missed payments of money be made up; compensation for reasonable reliance on acceleration rights should at least include compensation for costs a creditor may have incurred in attempting to collect an accelerated debt, including costs of attempts to foreclosure on collateral. The required payments may not be made over time under the plan; they must be made on or before the effective date of the plan. 17