BANKRUPTCY I. Individual Debt Collection Outside of Bankruptcy What rights does a particular party have against the debtor? What rights (priority) does a creditor have against other creditors? Three Types of Creditors: 1. Secured Creditors 2. Lien Creditors 3. General Creditors Involuntary Creditors (tort victims): generally have no priority over other creditors. A. Rights of General Creditors 1. General Rule = Go to Court: Unless a creditor has taken a security interest (collateral to secure the loan), it typically has to go to court to enforce its claim. a. Self-Help Remedies (repossession): not available to unsecured creditors. 2. Pre-Judgment (Provisional) Remedies: plaintiff may “attach” defendant’s assets at the beginning of lawsuit by having the sheriff seize the assets or by public filing. a. Ensures that the assets will be available to satisfy a judgment. b. Establishes priority over later claimants to those assets (if claim is reduced to a judgment, priority right dates back to time of attachment). c. Only available in suit for a money judgment. d. May Require: 1) Notice to defendant 2) Hearing before judicial officer 3) Danger that defendant will abscond with or otherwise dissipate assets 4) Plaintiff to post a bond to cover defendant’s possible damages 3. If Plaintiff Wins in Court Gets a “Judgment” a. Judgment is then “docketed,” which means it is recorded on a “judgment roll.” b. Plaintiff Obtains an Interest in Property: 1) Fixtures (personal property affixed to realty): treated like real property 2) Real Property: requires recording (“docketing”): a) In most states, a judgment alone creates a lien on realty (“judgment lien”). (1) Judgment lien ≠ immediate possession (2) Judgment lien = right to go after the property (3) Lien creditor’s priority right dates from time of docketing judgment b) In many states, judgment must be docketed in each county where property is located.
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3) Personal Property: plaintiff takes possession or gives notice: a) California Rules (1) Creation of Judgment Lien (a) Cal. Code Civ. Pro. §697.510: Judgment lien on personal property is created by filing a notice with the Secretary of State. (2) Priority (a) Cal. Code Civ. Pro. §697.590(b): Judgment lien priority dates from time filing is first made (or date of attachment if attached prior to judgment). (b) In conflict between security interest and judgment lien, interests rank according to priority in time of filing or perfection. (c) Other States Priority Rules: lien creditor’s priority right dates from the time of levy or dates back to time of writ of execution or delivery of writ to sheriff. b) Levy (1) Docketing of judgment = right to obtain “writ of execution” (2) Writ of execution directs sheriff to levy defendant’s property (seize and sell it to pay judgment or prohibit movement or sale of the goods). (a) State law may limit seizure of certain property (home, pension funds, life insurance proceeds, household goods, tools of trade). c) Garnishment: plaintiff forces defendant’s debtors to pay money directly to plaintiff. (1) Federal law may limit extent to which a single creditor may garnish an individual’s wages and bars garnishment of Social Security payments. 4. State-Supervised Sale of Defendant’s Assets: Senior creditors are paid first, then junior creditors (lower priority), then debtor receives anything remaining. 5. Fraudulent Conveyances: Creditor may levy on property in the transferee’s hands. a. Intentional Fraud: Transfers made or obligations incurred with the intent to delay, hinder, or defraud creditors are fraudulent and void as against creditors. b. Constructive Fraud: Insolvent debtors cannot make transfers without receiving “fair consideration” or “reasonably equivalent value.” 1) Applies to dividends and stock re-purchases, not to payment to a creditor (unless actual fraudulent intent). B. Rights of Secured Creditors 1. Security Interest: contingent property interest that ripens only if debtor defaults; gives creditor priority over other creditors if proper notice is given. a. Security Agreement: separate agreement from a promissory note; gives creditor rights in the property upon default without having to secure a judgment.
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2. Security in Real Property a. Mortgage: a security interest in real property (“mortgagor” = debtor; “mortgagee” = creditor) b. First Trust Deed: trustee holds deed to land in trust for creditor until debt is paid c. Priority 1) Properly Recorded Security Interest: Once creditor records its security interest properly in the real estate records, its priority right as against the world (including future purchasers) dates from time of filing. 2) Failure to Record/Improper Recording: If creditor fails to file (or files improperly), it loses to other claimants, except perhaps those with actual notice of its claim. d. Foreclosure: procedure to obtain possession of land upon default. 3. Security in Personal Property a. 2-Steps to Priority: 1) Attach: extend credit + enter into valid security agreement a) UCC §9-203(a): security interest attaches to collateral when it becomes enforceable against debtor (unless postponed in time by agreement). b) UCC §9-203(b): security interest is enforceable against the debtor and third parties only if: (1) Value has been given; (2) Debtor has rights in or power to transfer rights in collateral; and (3) Debtor has executed (signed) a security agreement or delivered possession or control over the collateral. c) Property exempt from execution by unsecured creditors is generally available as collateral for secured debt. d) Any general creditor may become a secured creditor—no new consideration is necessary. e) Right to repossess accrues upon attachment (need not perfect). 2) Perfect: taking possession of the collateral or making a public filing (may file prior to attachment) a) UCC §9-310(a): Generally, a financing statement (“UCC-1”) must be filed to perfect a security interest. (1) Must accurately: (a) Identify debtor; and (b) Describe collateral (not details of the transaction, though). (2) Exceptions: collateral in possession or control, PMSI, statutory lien.
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b) Priority Rights (1) UCC §9-322(a)(1): First security interest to file or perfect has priority over conflicting perfected security interests. (2) UCC §9-322(a)(2): Perfected security interest has priority over conflicting unperfected security interest. (3) UCC §9-322(a)(3): First security interest to attach or become effective has priority over conflicting unperfected security interests. (4) UCC §9-317(a): Lien creditor has priority over a secured party if the person becomes a lien creditor before the secured interest is perfected. b. Extent of Security Interest 1) UCC §9-201: Security agreement is effective between parties, against purchasers of collateral, and against creditors. 2) UCC §9-203(f): Attachment of security interest in collateral gives the secured party rights to proceeds of the sale of the collateral. 3) UCC §9-320(a): Buyer of goods in ordinary course of business takes them free of a security interest, even if the security interest is perfected and the buyer knows of its existence. c. Purchase Money Security Interest (“PMSI”): if creditor lends money to purchase a piece of property: 1) Creditor may take a security interest in and repossess the property, even if it is exempt from a levy by unsecured creditors (e.g., tools of trade). 2) PMSI is perfected upon attachment (creditor need not file or take possession). 3) UCC §9-317(e): if person files a financing statement in respect of a PMSI before or within 20 days of delivery of the collateral, security interest takes priority over rights of a buyer, lessee, or lien creditor which arose between the time of attachment and filing. d. Self-Help (repossession): 1) Allowed if it does not cause “breach of the peace” (i.e., if debtor does not object—simple trespass is usually a breach of the peace). 2) Creditor must sell the collateral in commercially reasonable manner and return any proceeds in excess of its claim. 3) Creditor may bring an action, like any other general creditor, for a deficiency judgment if proceeds are less than its claim. e. Interests After-Acquired Property 1) Creditor may take a security interest in current and future assets. 2) Purchase money lender may have a “superpriority” over the security holder if it files promptly (maybe before debtor takes possession of the new goods) and notifies the security holder.
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II. Bankruptcy as a Collective Debt Collection Remedy A. Purposes of Bankruptcy and the Butner Principle 1. Bankruptcy Policies a. Saving Creditors Costs of Destructive Race to Debtor’s Assets: When a debtor has too few assets to pay its creditors in full, bankruptcy law forces diverse creditors to work together and stops the destructive and expensive race to assets. Each creditor has a chance to establish the amount and priority of its claim. b. Helping Individual Debtors Overburdened with Debt: Allows individuals a fresh start. 1) Chapter 7: Individuals give up non-exempt assets to creditors, and they receive a “fresh start” free from the burden of past obligations. 2) Chapter 13: Individuals restructure their obligations, keep non-exempt assets, and pay creditors some of what they owe them out of future earnings; creditors receive at least what they would have received under Chapter 7. c. Reorganizing Capital Structure of Firms in Financial Distress: Allows corporations that are economically viable the chance to reorganize while respecting the rights of the investors. Chapter 7 (Liquidation) v. Chapter 11 (Reorganization): 1) Chapter 11 may help firms in financial distress but not economic distress. 2) Economic Distress: firm is unable to compete in the marketplace regardless of its capital structure (the business itself is not viable—economic distress occurs even if the firm has no creditors). 3) Financial Distress: firm is unable to generate sufficient revenue to pay its debts (the firm’s capital structure has caused its problem—financial distress only occurs if the firm has creditors). 2. The Butner Principle Butner v. U.S. (U.S. 1979): Bankruptcy law respects rights and obligations that exist outside of bankruptcy unless a specific bankruptcy provision or policy requires a different rule. “Congress has generally left the determination of property rights in the assets of the bankrupt’s estate to state law. Property interests are created and defined by state law. Unless some federal interest requires a different result, there is no reason why such interests should be analyzed differently simply because an interested party is involved in a bankruptcy proceeding.”
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B. Road Map to the Bankruptcy Code 1. “Notice and Hearing” §102: One need only give “such notice as is appropriate in the particular circumstances.” If no party requests a hearing or if the court finds that there is insufficient time for one, an actual hearing is not necessary. 2. Judge’s “Necessary and Appropriate” Power §105: Bankruptcy judge has power to “issue any order, process or judgment that is necessary or appropriate to carry out the provisions” of the Bankruptcy Code. (Power must derive from some other provision of the Code.) 3. Case Administration: Court scrutinizes hiring of lawyers and other professionals. §327(a): Debtor’s attorneys must be disinterested. §704: “Trustee” is principle officer in Chapter 7 (represents bankruptcy estate, manages estate’s assets, protects creditor’s rights, has powers to bring actions debtor could have brought outside of bankruptcy). §1101: “Debtor in Possession” (“DIP”) = debtor (usually the old managers) §1107: DIP in Chapter 11 has powers and duties of a trustee. §1108: Trustee (DIP) may operate debtor’s business. §§363-364: DIP may sell, use, lease property or borrow money in ordinary course of business. 4. Chapter 7: simple liquidation of a bankruptcy estate’s assets applied to pay allowed claims essentially in order of non-bankruptcy priority. 5. Chapter 13: debtor proposes an “adjustment” of his obligations, to keep some or all of his property, and to repay some or all of his pre-bankruptcy obligations out of future income. Creditors are entitled at least to what they would have received in Chapter 7. 6. Chapter 11: business firm proposes a plan of financial reorganization. §1141: If plan is approved, the plan binds the debtor, and all pre-filing creditors and interest-holders.
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C. Accounting 1. Assets – Liabilities = Owners’ Equity (or Net Worth) a. Assets: Properties, resources, and claims owned or controlled by an entity. b. Liabilities: Amounts owed by entity to others in the form of debts, accounts payable, and other obligations. c. Owners’ Equity: Owners’ interests in the enterprise (net worth). d. Revenues: Amounts an entity generates by selling goods it is in the business of selling or receiving fees for performing services it is in the business of rendering. e. Expenses: Costs incurred by the entity in order to generate its revenue for which the entity does not receive an equivalent asset in return. f. Current Assets: Convert to cash within a year. g. Current Liabilities: Payable within a year. 2. Accrual v. Cash Accounting a. GAAP / Accrual Method / Matching Principle: revenue is recorded when earned; expenses are recorded when incurred—regardless of when cash is received or disbursed. b. Cash Method: transactions are recorded when cash is received or cash is paid in respect of the transaction. 3. Historic Cost v. FMV Accounting a. GAAP / Lower of Historic Cost or Market: Assets are recorded at the lower of historic cost or market value. Asset values are not increased to reflect increases in market value. b. FMV Accounting: Shows true net worth by reflecting current market values of assets; may fluctuate greatly over time due to changes in market conditions.
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III. Commencement of the Case A. Eligibility for Bankruptcy 1. Potential Debtor a. §109(a): Only a “person” that resides or has a domicile, a place of business, or property in the U.S. or a municipality may be a debtor under the Code. 1) §101(41) “Person”: includes individual, partnership, and “corporation”— does not include governmental unit or trust. 2) §101(9) “Corporation”: includes association having powers and privileges that a private corporation has, joint-stock company, unincorporated company or association (LLC), and business trust—does not include simple trust or limited partnership. a) Trust (may not be a debtor): a legal entity in which a person gives another the beneficial interest in assets without at the same time granting control over the assets. b) Business Trust (or Massachusetts Business Trust) (may be a debtor): a way of doing business that predates the modern corporation in which investors would pool their money and appoint a trustee to operate the business. c) Illinois Land Trust (1) In re Treasure Island Land Trust (Bankr. M.D. Fla. 1980): The basic distinction between business trusts and non-business trusts is that business trusts are created for the purpose of carrying on some kind of commercial activity for profit; the object of a non-business trust is to protect and preserve the trust res. (a) Court dismissed the bankruptcy of putative debtor which the SEC classified as a business and which had characteristics of a corporation. Court concluded that debtor could not argue substance over its chosen form, which debtor attempted to structure to avoid corporate or business trust status. 2. Insolvency: Debtors other than municipalities need not be insolvent to file bankruptcy. a. §101(32) “Insolvency”: total debts > FMV total assets
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3. Eligibility by Chapter a. §109(b) Chapter 7: a “person” may be a debtor unless it is a railroad, insurance company, or bank. (Railroads use special provisions of Chapter 11, and banks and insurance companies may not be debtors under the Bankruptcy Code). b. §109(c) Chapter 9: available only to municipalities. 1) §101(40) “Municipality”: a political subdivision or public agency or instrumentality of a State. 2) §101(52) “State”: includes D.C. and Puerto Rico, except for defining who may be a debtor under Chapter 9. c. §109(d) Chapter 11: available to anyone who may be a debtor under Chapter 7 (including partnerships and individuals) plus railroads but not stockbrokers or commodities brokers. d. §109(e) Chapter 13: available to individual with regular income with unsecured debts < $269,250 and secured debts < $807,750. B. Filing the Bankruptcy Petition 1. Voluntary Cases a. §301 (§302 for joint spousal filing): Filing of a petition by an entity that may be a debtor under a chapter of the Code commences a voluntary case under such chapter and constitutes an order for relief (allows court to administer the case). 1) No requirement of insolvency.
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2. §303: Involuntary Cases a. b. c. d. Only available for Chapters 7 and 11. Cannot bring against farmer or non-profit corporation. Only against “person” eligible to be a debtor under the chapter. Brought by 3 or more entities: 1) Each of which holds a claim (or is an indenture trustee representing a holder); a) That is not contingent or subject to a bona fide dispute; and b) Such claims aggregate at least $11,625 more than the value of any lien held by holders of such claims. (1) Claims must be at least under-secured by $11,625 in the aggregate (each claim need not be under-secured—if any claim is over-secured, this amount does not reduce the amount by which another claim is under-secured): Holder 1 40,000 65,000 (25,000) Holder 2 12,000 11,000 0 Holder 3 800 700 0
Value of collateral Loan balance Under-security
These 3 holders hold claims which aggregate $25,000 more than the value of any lien. (2) If all three holders are unsecured, and their claims ≥ $11,625, they can file an involuntary bankruptcy. 2) May be brought by 1 holder if there are < 12 such holders. e. Commencement of involuntary case ≠ order for relief. 1) Court will issue an order for relief if petition is not controverted by debtor; 2) If petition is controverted, the court will order relief if the debtor is generally not paying debts as they become due (or if within 120 days of the petition, a custodian has been appointed to administer debtor’s assets). a) If court dismisses the case, debtor may seek costs and attorney’s fees from the petitioners (if in bad faith, damages and punitive damages).
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3. Agreement Not to File Bankruptcy a. General Rule: A debtor cannot generally waive the right to file bankruptcy. U.S. v. Royal Business Funds (2d Cir. 1983). b. In re Kingston Sq. Assoc. (Bankr. S.D.N.Y. 1997): “Bankruptcy proof” provision in borrower’s bylaws gave lender’s representative on borrower’s board of directors a vote to block voluntary bankruptcy filing. Borrower solicited creditors to file an involuntary bankruptcy circumventing board of directors. Court denied dismissal and did not reach issue whether provision was void as against public policy. Collusive Filing: In certain circumstances, collusive filing of a bankruptcy case is a fraud upon the bankruptcy court’s jurisdiction and therefore susceptible to immediate dismissal. • Although this was a collusive filing, it was in the best interests of creditors and the estate to keep the case in bankruptcy (see BC §1112). Only the lender would have benefited from a dismissal.
C. Dismissal and Abstention 1. Abstention a. §305: Bankruptcy court has unreviewable right to dismiss or suspend a case if the court believes that it is in the best interests of creditors and the debtor or a foreign proceeding is pending. b. In re Colonial Ford (Bankr. D. Utah 1982): Court dismissed case where debtor filed Chapter 11 instead of following an agreed-upon work-out plan which called for sale, refinancing, or foreclosure of real estate by a certain date. Section 305 applies in voluntary and involuntary cases and embodies the policy of encouraging work-outs. Where the work-out is comprehensive and designed to end (rather than perpetuate) debtor-creditor relations, dismissal is appropriate. Consider these factors: 1) 2) 3) 4) 5) 6) 7) Speed; Economy; Freedom from litigation; Fairness; Priorities in distribution; Capacity for dealing with frauds and preferences; Importance of discharge to debtor.
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2. Chapter 11 Dismissal or Conversion a. §1112: Bankruptcy court may dismiss a Chapter 11 case or convert it to a Chapter 7 case (except for farmers or non-profits)—whichever is in the best interests of the creditors and the estate—for cause, including: 1) Continuing loss to or diminution of the estate; 2) Inability to propose, confirm, or effectuate a plan; 3) Unreasonable and prejudicial delay by the debtor. 3. Chapter 7 Dismissal for Substantial Abuse by Debtor a. §707(b): Bankruptcy court may, sua sponte or on U.S. Trustee’s motion, dismiss a Chapter 7 case for substantial abuse and deny debtor a discharge. IV. The Automatic Stay A. Creditor Actions and the Automatic Stay 1. §105(a): general equity powers allow injunctions to avoid “irreparable harm” 2. §362(a) a. Filing Petition Stays “All Entities” b. Related to Pre-Petition Debts c. Stops: 1) Commence or continue actions; 2) Collect, assess, recover a claim; 3) Enforce judgments; 4) Gain possession or control of debtor’s property; 5) Create, perfect, or enforce liens; 6) Set-off any debt; 7) Tax Court proceedings. d. Not Applicable to: 1) Actions Against Third-Parties (maybe §105(a) would be) 2) Election of New Board of Directors: may be enjoined only for “clear abuse” (willingness to risk rehabilitation to win bigger share for equity—not just getting more bargaining power) or if shareholders act in capacity as creditors. Marvel Holding Cos. Bondholders Committee v. Chase
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B. Scope of the Automatic Stay 1. §362(d): Relief from Automatic Stay: a. §362(d)(1): For cause, including lack of adequate protection b. §362(d)(2): In action against property: 1) Debtor has no equity in the property 2) Property is not necessary for effective reorganization • Debtor must show that the property is essential for an effective reorganization that is in prospect (reasonable possibility of successful reorganization in a reasonable time). Timbers of Inwood (dicta)
2. Non-Creditor Termination of Non-Executory K: a. Insurance company cannot terminate pre-paid insurance K (under 30-day notice provision) because directly related to Bankr. filing. Cahokia Downs 1) Violated the policy of bankruptcy and spirit (not letter) of §363(l). b. Law school allowed to terminate at-will lease (considered a license) because it acted in good faith and would have terminated regardless of Bankr. M.J.&K. C. Exceptions from Automatic Stay: 1. §362(b)(1): Criminal Actions 2. §362(b)(4): Government’s Police or Regulatory Power: a. For a Non-Money Judgment, May: 1) Commence/continue action; 2) Enforce; 3) Obtain property because of; or 4) Collect. b. NextWave (2d Cir): Bankr. Ct. lacks Jx to review FCC regulatory decisions on granting of licenses (even if revocation conditioned on financial default) c. NextWave (S.Ct.): FCC action in revoking the licenses violated §525, which prohibits a government from discriminating against someone (including denying a license) solely because the person failed to pay a debt dischargeable in Bankr. or was a debtor in Bankr. d. Nicolet: May bring suit to fix damages for environmental law violation—may not collect on judgment. Government acting on regulatory (not pecuniary) interest. 1) If government orders a clean-up, this would be an administrative expense.
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V. Claims Against the Estate A. §101(5) “Claim”: a. Any right to payment; b. A right to an equitable remedy if breach of performance gives rise to a right to payment. c. Shares in the distribution of debtor’s assets, d. But may not look to debtor’s post-Bankr assets or income. 2. Settlement related to violation of environmental laws = claim because breach results in $ damages. Kovacs B. When Claim Arises (4 Rules): 1. S.O.L. may begin to run upon discovery, but claim may “arise” prior to that. 2. Piper Aircraft Test: a. Events occurring before confirmation create a relationship (such as contact, exposure, impact, or privity) between the claimant and debtor’s product; b. Basis for liability is debtor’s pre-petition conduct in designing, manufacturing, and selling the allegedly defective or dangerous product. 3. Accrued State Law Claim Test (Rejected by MAJ): Claim arises for Bankr. when it accrues under state law. 4. Conduct Test: Claim arises when the conduct giving rise to the alleged liability occurs. 5. Pre-petition Relationship Test: Requires some pre-petition relationship, such as contact, exposure, impact, or privity, between the debtor’s pre-petition conduct and the claimant in order for the claimant to hold a §101(5) claim. C. Allowing Claims 1. §501 “Proof of Claim”: filed be creditor (or debtor on creditor’s behalf)—must be timely a. Claim is allowed unless party in interest objects. §502(a). b. Claim need not be fully matured (loan payments not yet due = claim). 2. Burden of production and persuasion for state tax claim is substantive under state law and followed by Bankr. Ct. Raleigh v. Illinois 3. Bankr. Ct. can use general equitable powers to disallow punitive damages claims that would frustrate a successful reorganization. (rare departure from Butner principle) A.H. Robins
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D. Estimating Claims 1. §502(c): Bankr. Ct. may estimate claims for purposes of allowance: a. Present Probability Method: Present Value of (Total Possible Claim x %Likelihood of Success) = Estimate b. Ultimate Merits Method: If more likely than not that claim will be unsuccessful (based on ultimate merits), estimate = zero Bittner v. Borne (court required waiver of discharge, though) E. Secured Claims 1. §544 allows trustee to abandon property (allow secured party to foreclose). a. Secured party remains an unsecured creditor for amount of claim > FMV collateral. 2. §506(a): An allowed claim secured by a lien on property in which the estate has an interest (or that is subject to set-off) is a “secured claim” to the extent of the value of the interest (or set-off right). Any remaining amount is an “unsecured claim.” a. In Cramdown, FMV of Collateral = Debtor’s Cost of Replacement (what a willing buyer in debtor’s trade, business, or situation would pay to obtain like property from a willing seller) -- not foreclosure-sale value ACC v. Rash 3. §506(b): An over-secured (but not under-secured) creditor may receive interest on its claim during bankruptcy and also be paid reasonable expenses it incurs—if it had a K right to security for these expenses—up to the amount of the over-security. F. §507(a)(1) “Administrative Expenses”: Costs of the bankruptcy proceeding and the expenses of running the business are paid first out of assets available for general creditors, and general creditors share what is left. 1. Administrative expenses do not have priority over secured claims. §§506(c), 507(a).
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VI. The Bankruptcy Estate A. Debtor’s Interest In Property 1. §541(a): Filing a petition creates an “estate” comprised of all of the debtor’s interests in property + proceeds/offspring from estate property + future income for corp. a. Chicago Board of Trade: debtor’s interest in property comes in to the estate subject to all pre-petition claims/restrictions imposed by K or law (Ct. did not follow Butner, though; IL S.Ct. ruled seat on Board of Trade ≠ property). 1) Intellectual property usually comes in to estate subject to limitations. b. Begier v. IRS: Funds paid to IRS for withholding and excise taxes were not property of the debtor prior to payment—they were held in trust for the IRS even though not physically segregated—therefore not subject to avoidance. B. Ipso Facto Modifications 1. §541(c)(1): Debtor’s interest in property comes into the estate (may not go to a thirdparty though) ignoring any agreement, instrument, or non-bankr. law that: (A): restricts or conditions transfer, or (B): gives an option to change the debtor’s interest because of debtor’s financial condition, filing a bankr. petition, etc. 2. Applicable non-bankr. law only triggers §541(c)(1)(B) if it is conditioned on financial condition or bankr. of debtor (not a general condition that company is no longer operates in a certain industry). L. Lou Allen VII. Executory Ks
§365: Trustee (subject to approval) may assume or reject any executory K or unexpired lease of the debtor. A. Executory K Defined: a K under which the obligations of the debtor and other party are so far unperformed (at time of filing) that failure of either to complete performance would constitute a material breach excusing performance of the other. 1. K represents both an asset and a liability (and either a net asset or net liability). 2. Obligation to fund escrow account upon settlement of class action ≠ executory K because payment was not contingent upon class members’ performing their obligations (only had to sign release of claim to get $). Energy Enterprises
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B. Assumption: Formal process by which the trustee takes advantage of favorable K and lives up to the obligation thereunder, subject to ct. approval. §365(a). 1. §507(a)(1) Cost of Performance = administrative expense. 2. §365(b) Cure of Defaults/Adequate Assurances: if trustee assumes K in default; he must cure defaults or provide adequate assurance of cure (including compensation for injury) and provide adequate assurance of future performance. a. If trustee assigns, he must give adequate assurance performance regardless of whether K is in default. 3. §365(c)(1) Limitation of Assumption of Non-Assignable Ks: Trustee may not assume or assign any executory K or unexpired lease, whether or not such K or lease prohibits or restricts assignment, if: (A) applicable law excuses a party from accepting performance from or rendering performance to an entity other than the debtor; and (B) the other party does not consent. Plain Meaning / Hypothetical Test: Perlman v. Catapult (9th Cir): although creditors and equity holders approved a pre-packaged Ch. 11, a third-party to a patent license refused consent. DIP may not assume an executory K over the nondebtor’s objection if applicable law would bar assignment to a hypothetical third party, even where DIP has no intention of assigning the K. Actual Test: Institut Pasteur (1st Cir): statute bars assumption by DIP only where the reorganization results in the nondebtor actually having to accept performance from a third party. Reorganization where debtor become subsidiary of licensor’s direct competitor did not require licensor’s consent because not an actual assignment of the license. 4. §365(d) Time to Assume: Chapter 7 = 60 days to assume or it is deemed rejected. Chapter 11 = may assume or reject any time before confirmation of plan (but court may order a shorter period of time to decide). 5. §365(f)(1) Assignment: trustee may assign a K notwithstanding a provision in the K that prohibits assignment or one in applicable law (except as provided in §365(c)— third party has to consent twice: to both assumption & assignment). a. §365(k) No Liability After Assignment: Only assignee is liable for breach of assigned K (even though assignor would remain liable under state law). 6. §541(c) Ipso Facto Clauses: trustee may assume K notwithstanding a nonassignment provision or ipso facto clause that terminates K due to debtor’s financial condition or status in bankr.
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C. Rejection: trustee may choose to breach the K, and the other party becomes a claimant for the amount of the damages. §365(g): 1. Estate no longer under any obligation to perform; 2. Estate is no longer entitled to receive benefits of the K; 3. Rejection is a breach of the K creating an unsecured pre-petition claim for the nondebtor party; and 4. The “claim” (and nothing else) is dischargeable in the bankr. proceeding. a. Rejection of K does affect creditor’s perfected security interest. LSC v. First Tennessee b. Rejection of K voids covenant-not-to-compete clause. In re Register c. Third-party rights to license IP, lease real estate, purchase real estate ≠ void due to debtor’s rejection. §365(n), (h), (i). VIII. Avoiding Powers A. Trustee’s Strong-Arm Powers 1. Asserting Rights of Hypothetical Lien Creditors and Purchasers a. §544(a): Trustee, upon filing, has the rights and powers of—and may avoid transfers or obligations voidable by (whether or not such a person exists, i.e., hypothetical): 1) Creditor that obtains a judicial lien on all of the debtor’s property. 2) Creditor that obtains an execution against the debtor that is returned unsatisfied. 3) Bona fide purchaser of real property that obtains the status of a bona fide purchaser and has perfected. • • Unperfected, secured creditors become general, unsecured creditors. Trustee may recover property that the debtor has transferred if transferee has not perfected its interest (including subsequent transferees until one takes the property for value without knowledge that the original transfer was voidable). Trustee may not avoid a subordination agreement between creditors (allowed under §510(a) if state law allows). Kors v. Howard Bank §551: Avoided transfers and void liens are preserved for benefit of the estate. §546(b)(1): §544(a) does not upset the right of purchase-money lenders to file PMSI within 20 days under UCC §9-317(e)—even after the automatic stay, as allowed by §362(b)(3).
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2. Asserting Rights of Actual Creditors a. §544(b)(1): Trustee may avoid (unwind): 1) Any transfer of a debtor’s interest in property (or obligation incurred) 2) That is voidable under applicable law by an unsecured creditor. Usually applies to: a) Fraudulent conveyances outside of §548’s 1-year limitation. b) Recovery under “bulk sale” statute (when debtor sells all of its inventory outside of normal course of business without notifying creditors) c) Illegal dividends or stock repurchases. • • • • There must be an actual unsecured creditor at filing who could assert the claim (regardless of the amount of the individual creditor’s claim). Charitable contributions are excepted (as described in §548(a)(2)). Recovery of the entire original transfer goes to the estate. Trustee lacks standing to bring an action to “pierce the corporate veil” on behalf of creditors (proceeds would not go to the estate), Ozark Equipment, or sue indenture trustee on behalf of debt-holders, Caplin v. Marine Midland.
b. Uniform Fraudulent Conveyance Act (State Law—use state S.O.L.) 1) UFCA §2 “Insolvency”: present fair salable value of assets < amount needed to pay existing debts as they become absolute and matured (“Bankruptcy”/“Balance Sheet” definition) 2) UFCA §4 Conveyances by Insolvent: Every conveyance (regardless of intent) made (or obligation incurred) is fraudulent as to creditors, if: a) Without fair consideration; and b) By a person who is or will be rendered insolvent by the conveyance. 3) UFCA §5 Persons in Business: Every conveyance (regardless of intent) by persons engaged in business is fraudulent as to present and future creditors, if: a) Without fair consideration; and b) Property remaining after conveyance is unreasonably small capital. 4) UCFA §6 Beyond Ability to Pay: Every conveyance made (or obligation incurred) is fraudulent as to both present and future creditors, if: a) Without fair consideration; and b) With intent (or belief) to incur debts beyond ability to pay as they mature. 5) UFCA §7 Intent to Defraud: Every conveyance made (or obligation incurred) with actual intent to hinder, delay, or defraud present or future creditors is fraudulent as to both present and future creditors. • • Recipient returns the property and gets back (or has a claim for) what he paid. “Fair consideration” = good faith exchange of a fair equivalent. Moody
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B. Statutory Liens 1. §101(53) “Statutory Lien”: lien arising solely by force of a statute on specified circumstances or conditions. 2. §545(1) Springing Liens: Trustee may avoid fixing of statutory lien that is triggered by filing bankruptcy, debtor’s insolvency or financial condition, or related events. 3. §545(2) Hypothetical Bona Fide Purchaser: Trustee may avoid fixing of a statutory lien to the extent that it is not perfected or enforceable at the time of filing against a bona fide purchaser (whether or not such purchaser exists). • • • Statute does not assume that hypothetical bona fide purchaser perfected. Trustee does not obtain “hypothetical possession.” In re Walter Some courts allow trustee to avoid lien if any bona fide purchaser could.
C. Fraudulent Conveyances 1. §101(32) “Insolvency”: sum of entity’s debts > all of entity’s property at FMV 2. §548(a)(1): Trustee may avoid any transfer of a debtor’s interest in property (or obligation incurred) made or incurred on or within 1 year of filing, if: a. §548(a)(1)(A) Intentional Fraud: debtor made such transfer (or incurred such oblig) with actual intent to hinder, delay, or defraud present/future creditors; or b. §548(a)(1)(B) Constructive Fraud: debtor received less than reasonably equivalent value in exchange for such transfer or obligation, and: 1) Was insolvent on the date of such transfer (or obligation) or became insolvent as a result of such transfer (or obligation). §548(a)(1)(B)(ii)(I); or 2) Was engaged in business (or about to engage in business) for which property remaining was an unreasonably small capital. §548(a)(1)(B)(ii)(II); or 3) Intended to incur (or believed that he would incur) debts that would be beyond debtor’s ability to pay as such debts matured. §548(a)(1)(B)(ii)(III). • • • • • Charitable contributions are excepted. §548(a)(2). An actual creditor who could invoke fraudulent conveyance law is not necessary. Value assets on a going concern basis. Moody “Reasonably equivalent value” ≠ FMV; price received from noncollusive, real estate mortgage sale conducted according to state law satisfies. BFP v. RTC “Unreasonably small capital”: Financial condition short of equitable insolvency; must be reasonable foreseeable; look at whether the parties’ projections were objectively reasonable based on the company’s actual performance. Moody
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D. Voidable Preferences 1. Scope of Preference Law a. §547(b): Trustee may avoid any transfer of a debtor’s interest in property (including granting a security interest) (all 5 elements are required): To or for the benefit of a creditor; On account of an antecedent debt; Made while the debtor was insolvent; Made: a) On or within 90 days before filing; or b) 1 year if transferee was an “insider” (§101(31)) at time of transfer; and 5) Enables such creditor to receive more than he would under Ch. 7 if the transfer had not been made. b. §547(f): Debtor is assumed to be insolvent on or during the 90 days before filing. c. §547(e)(2)(A): Perfecting a security interest on or within 10 days after a loan is made is not considered a transfer on account of an antecedent debt. d. If debtor pays off loan, which an insider guaranteed, and files > 90 days but < 1 yr later, trustee may recover from the insider but not the transferee. §550(c). e. Letters of Credit: 1) Debtor has an antecedent debt to creditor. 2) Bank has K obligation to pay creditor when presented with conforming docs. 3) When bank pays creditor, debtor has a K obligation to pay bank. Trustee may recover from either creditor or bank (even if bank takes a security interest for the amount of the transfer): a) Even though bank pays creditor, it debtor must transfer cash (or a security interest) on account of an antecedent debt for creditor’s benefit. b) When debtor pays bank, it makes a transfer on account of an antecedent debt for the benefit of creditor. Bergner v. Bank One 2. Earmarking Doctrine a. “Earmarked Loan”: new lender directly pays an antecedent debt, or debtor is obligated to use the proceeds of a new loan to repay an antecedent debt. b. Earmarking Doctrine: payment of an antecedent debt is not a preference if it is replaced with a new loan with equal priority. In re Heitkamp 1) 2) 3) 4)
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3. Safe Harbors: Trustee may not avoid these transfers: a. §547(c)(1) Contemporaneous Exchange for New Value: Transfer to the extent that it was intended by debtor and creditor to be (and in fact was substantially) a contemporaneous exchange for new value given to the debtor. b. §547(c)(2) Payment of Debt in the Ordinary Course of Business: 1) Debt was incurred in the ordinary course of debtor and transferee’s business; 2) Payment made in the ordinary course of debtor and transferee’s business; and 3) Payment made according to ordinary business terms. • • • Payments on long-term debt, as well as short-term debt, may qualify for this exception if all elements are satisfied. Union Bank v. Wolas Is a loan incurred in the ordinary course of business if incurred only once in the company’s life? Maybe so, unless terms or conditions are suspect. Is an on-time payment made in the ordinary course of business if the debtor has stopped paying everyone else?
c. §547(c)(3) Transfer of PMSI: 1) Transfer creates a security interest in property acquired by the debtor; 2) Security interest secures new value that was: a) Given at or after signing a security agreement describing property; b) Given by or on behalf of the secured party; c) Given to enable the debtor to acquire such property; and d) In fact used by debtor to acquire such property; and 3) Security interest is perfected ≤ 20 days after taking possession of property. d. §547(c)(4) Payment to Creditor Who Makes a New Loan for Same Amount: 1) Transfer to or for benefit of creditor; and 2) After transfer, same creditor gave new value to debtor 3) Only applies to the extent that the new value is not: a) Secured by an otherwise unavoidable security interest, and b) Proceeds of a loan that itself has been repaid with an otherwise unavoidable transfer to creditor. e. §547(c)(6) Fixing a Statutory Lien: Transfer to fix a statutory lien not avoidable under §545.
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E. Adequate Protection 1. §362(d)(1): allows the court to lift the automatic stay for cause, including lack of adequate protection. a. §361 “Adequate Protection”: requires the debtor to protect the secured creditor from any loss of the collateral’s value; decline in value may be compensated by: 1) Cash payment(s) 2) Additional or increased security interest 3) Other relief giving creditor the indubitable equivalent of its property interest 2. Post-Filing Interest on Collateral Not Declining in Value: a. Under-Secured Creditors: Under-secured creditors are not entitled to compensation under §362(d)(1) for the delay caused by the automatic stay in foreclosing on their property. Timbers of Inwood b. §506(b) Over-Secured Creditors: to the extent a claim is secured by property with value greater than the claim, the claimant is allowed interest on the claim, plus reasonable fees, costs, and charges provided for under the agreement from which the claim arose. c. §726(a)(5) Unsecured Creditors/Solvent Debtor: if debtor is solvent, postpetition interest is allowed on unsecured claims (under-secured claimant could convert his claim to an unsecured claim to receive the interest). 3. §522(b) Post-Filing Attachment of Proceeds/Income from Collateral: post-filing attachment of a security interest is generally allowed in the proceeds, product, offspring, profits, and rents of or from collateral subject to an unavoidable security interest, if the underlying agreement so provides and was properly perfected.
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F. Setoffs 1. “Setoff” Right: legal right of a creditor to cancel debt it owes to the debtor by reducing the amount that the debtor owes it (when creditor both owes money to—and is owed money from—the debtor). a. §506(a): A claim is “secured” to the extent subject to a setoff right. b. Exercise of a setoff right is a “transfer.” See §101(54). 2. §553(a) Setoff Generally Respected: Subject to the automatic stay, creditor may offset a mutual pre-filing debt that the creditor owes to the debtor against the creditor’s claim against the debtor, except to the extent that: a. §553(a)(1): creditor’s claim is disallowed; b. §553(a)(2) Trafficking in Claims: the claim was transferred (by an entity other than debtor) to the creditor: 1) After commencement of the case; or 2) After 90 days before filing and while debtor was insolvent. (One who owes money to the estate may not purchase an unsecured claim at a discount from a third party and effectively convert it into a secured claim.) 3. §553(c): Debtor is assumed to be insolvent on or during the 90 days before filing. 4. §553(b) Pre-Bankruptcy Exercising of Setoff Rights: a. §553(b)(2) “Insufficiency”: amount, if any, by which a claim against the debtor exceeds a mutual debt owed by the holder of such claim to the debtor. b. §553(b)(1): if a creditor offsets a mutual debt owed to the debtor against a claim against the debtor on or within 90 days before filing: 1) Trustee may recover from such creditor the amount so offset, 2) To the extent that any insufficiency on the date of such setoff is less than the insufficiency on the later of: a) 90 days before the date of filing; and b) The first date during the 90 days immediately preceding filing on which there is an insufficiency.
Example: Point A Unsecured claim (debtor owes creditor) $100 Mutual debt (creditor owes debtor) (50) Insufficiency $50 Decrease in insufficiency between point A and date of setoff Trustee may recover $20 from creditor under §533(b). Date of Setoff $130 (100) $30 $20 Point A = 90 days before filing (if an insufficiency existed then); otherwise, it is the first date within the 90 days on which an insufficiency arose.
Braniff Airways: if creditor receives a payment (rather than exercising its setoff right), the payment is not a voidable preference, if the creditor could have exercised a setoff right on that date without triggering §533(b).
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IX. Chapter 11 Reorganization A. §1121 Who May File a Plan: 1. §1121(b): Only debtor may file a plan until 120 days after date of order of relief. 2. §1121(c): Anyone other than the debtor may file a plan only if: a. Trustee has been appointed; b. Debtor has not filed a plan by 120 days after order for relief; or c. Debtor has not filed plan that has been accepted, before 180 days after date of the order for relief, by each class of impaired claims or interests. 3. §1121(d): For cause, court may increase or decrease 120-day and 180-day periods. B. §1122 Classification of Claims and Interests 1. §1121(a) Substantially Similar: (except for the de minimis claims class) a plan may place a claim or interest in a particular class only if such claim or interest is substantially similar to the other claims or interest in the class. a. Similar claims (considering nature and rank) need not be put in the same class if their holders have different outside interests. In re U.S. Truck b. Similar claims may be put in the same class even if their holders have different outside interests. In re Martin’s Point 2. §1121(b) De Minimis Claims Class: for administrative convenience, a plan may designate a separate class of claims consisting only of every unsecured claim that is less than an amount that the court approves of as reasonable and necessary. C. §1123 Contents of the Plan Designate classes of claims and classes of interests. §1123(a)(1). Specify classes that are not impaired. §1123(a)(2). Specify treatment of impaired classes. §1123(a)(3). Provide for equal treatment within each class, unless a specific holder agrees otherwise. §1123(a)(4). 5. Provide adequate means for the plan’s implementation, such as curing or waiving any default. §1123(a)(5)(G). 1. 2. 3. 4.
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D. §1124 Impairment of Claims or Interests 1. A class is impaired under the plan, unless with respect to each claim or interest of such class, the plan: a. Leaves unaltered the legal, equitable, and K rights; or b. Notwithstanding any K provision or applicable law that allows the holder to get accelerated payment upon default: 1) Cures any default (other than a default caused by bankruptcy, insolvency, or financial condition of debtor); 2) Reinstates the maturity; 3) Compensates the holder for any damages incurred as a result of reasonable reliance on the K; and 4) Does not otherwise alter the legal, equitable, or K rights. Cure and compensation payments may not be made in deferred cash payments after the effective date of the plan (cure must be made by the effective date of the plan). In re Jones E. §1126 Acceptance of the Plan: a holder of a claim may accept or reject the plan. Adequate disclosure of information is required. 1. §1126(c): a class of claims has accepted the plan if the creditors in the class have accepted the plan: a. At least 2/3 in face amount; and b. More than 1/2 in number of allowed claims. 2. §1126(f) Unimpaired Classes: a class that is not impaired under the plan (and each holder of a claim or interest of such class) is conclusively presumed to have accepted the plan [no solicitation of votes needed].
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F. §1129 Confirmation of the Plan 1. §1129(a) Voluntary Confirmation of the Plan: the court shall confirm the plan only if all the requirements of §1129(a) are met. a. §1129(a)(7) Best Interests of Creditors Test: with respect to each impaired class, each holder of a claim or interest: 1) Has accepted the plan; or 2) Will receive under the plan property of a value (at the effective date of the plan) not less than the amount that such holder would receive if the debtor were liquidated under Ch. 7. b. §1129(a)(8) Acceptance by Each Class: With respect to each class of claims or interests: 1) Such class has accepted the plan; or 2) Such class is not impaired under the plan. c. §1129(a)(10) Acceptance by At Least One Impaired Class: If a class of claims is impaired under the plan, at least one class of claims that is impaired under the plan has accepted the plan (not including acceptances by any insider). d. §1129(a)(11) Feasibility: Confirmation of the plan is not likely to be followed by liquidation or need for further financial reorganization. • Court should consider: (1) adequacy of the capital structure; (2) earning power of the business; (3) economic conditions; and (4) ability of management. In re Merrimack Valley Oil Court must consider whether the interest rate required on deferred cash obligations in order to comply with the “fair and equitable” cram-down requirement in §1129(b)(2)(A)(i)(II) makes the plan unfeasible. In re Landmark at Park Plaza
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2. §1129(b) Cram-Down a. §1129(b)(1): If all applicable requirements of §1129(a) are satisfied except §1129(a)(8), the court shall confirm the plan, if: 1) Plan does not discriminate unfairly; and 2) Plan is “fair and equitable” with respect to each impaired class that has not accepted the plan. b. §1129(b)(2) Fair and Equitable: the condition that the plan be “fair and equitable” with respect to a class, includes the following requirements: 1) §1129(b)(2)(A) Secured Creditors (2 requirements): a) §1129(b)(2)(A)(i)(I): secured creditors retain liens securing their claims to the extent of the allowed amount of such claims; and b) §1129(b)(2)(A)(i)(II): receive deferred cash payments totaling the face amount of such claims, with a present value (at the effective date of the plan) of at least the value of such holder’s interest in the estate’s interest in such property. (1) If under secured creditor makes §1111(b) election to treat entire claim as secured, he will receive total cash payments = total face amount of his claim, but PV of the payments = value of the underlying collateral.
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2) §1129(b)(2)(B) Unsecured Creditors (Alternative Tests): a) §1129(b)(2)(B)(i) Property (Need Not Be Cash) = Total Amount (Not PV) of Claim: plan must provide that each holder of a class of unsecured claims receives or retains property of a value (as of the effective date of the plan) equal to the allowed amount of such claim; or b) §1129(b)(2)(B)(ii) Absolute Priority Rule: holder of any claim or interest that is junior to the class of unsecured claims will not receive or retain under the plan on account of such junior claim or interest any property. (1) New-Value Exception: Equity holders may participate in a cramdown plan, even if superior unsecured claims receive property less than the total amount of their claims, if the equity holders participation is based on a contribution in money or money’s worth, reasonably equivalent in view of all the circumstances to the participation of the stockholder. Case v. L.A. Lumber (a) Contributions of labor, experience, and expertise are too intangible, inalienable, and unenforceable to amount to “money or money’s worth” Norwest Bank v. Ahlers (b) Whether a “new-value exception” continues to exist is not decided, but in any event a plan that vests equity in the reorganized business in the hands of old equity holders without extending an opportunity to anyone else either to compete for that equity or to propose a competing plan violates §1129(b)(2)(B)(ii). 203 North LaSalle St (c) If equity holders argue that the new equity is not worth much (hence, they should not be required to put in much new capital), this works against their feasibility argument. c. §1129(b)(2)(C) Equity Interests (2 Alternatives): 1) §1129(b)(2)(C)(i) Preserves Preferred Stock Superiority: interest holder must receive property with a value (as of effective date of the plan) = liquidation preference of such interest, the redemption price of the interest, or the value of the interest; or 2) §1129(b)(2)(C)(ii): interest holder that is junior to the interests of the class will not receive or retain any property under the plan on account of such junior interest. G. §1111(b) Election: secured creditor may elect to have its entire claim treated as secured regardless of the collateral’s value (otherwise, the claim is bifurcated between secured and unsecured).
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