Eight Most Common Bankruptcy Questions

Bankruptcy can seem daunting and overwhelming. Often, our clients come to us with many of the same questions. Our team of experienced insolvency attorneys have assisted numerous companies, both large and small, as debtors or creditors. Once you have basic understanding of bankruptcy and its alternatives, it is important to discuss the unique factors of your case. Planning ahead and understanding all of your options is critical to your long-term success and may provide more opportunities than you previously considered. Here are answers to eight commonly asked questions.

Does bankruptcy provide immediate financial relief?

Yes, bankruptcy provides a debtor with breathing room. When a bankruptcy case is commenced, an Automatic Stay goes into effect immediately. All pending lawsuits, foreclosures and other actions against the debtor are immediately stayed, which means that creditors are not allowed to send a demand letter or take any action to collect against the debtor. (There are some limited exceptions.) The Automatic Stay does not apply to actions against guarantors or other parties to litigation. Creditors can ask the bankruptcy court for permission to proceed, which may be granted if certain criteria are met. Creditors that violate the Automatic Stay may be sanctioned. Creditors’ positions are determined as of the date a case is filed. If a creditor is properly secured as of the filing, and there is collateral that secures the debt, the creditor will be treated as secured during the bankruptcy case. Once the bankruptcy case is filed, it is too late to record any liens (except for some narrow exceptions), because that would be a violation of the Stay.

What if I need to shut down my business and have someone else liquidate it?

Chapter 7 provides for orderly liquidation. If the debtor files a Chapter 7 bankruptcy case, a trustee will automatically be appointed, the business is shut down, and its assets liquidated. After the case is filed, only the trustee has authority to act on behalf of the debtor. It is the trustee’s job to liquidate assets, and file lawsuits to pursue claims if appropriate to bring money into the estate for the creditors. It can take years before a chapter 7 is completed and there is a distribution to creditors. Trustees are paid a percentage of the funds that they distribute to creditors, so they are motivated to find assets. Creditors are invited to a meeting of creditors (341 Meeting) that takes place in 4-6 weeks after the commencement of the case to ask questions about assets, or provide other information.

What if I want to control the liquidation of my company or sell it as a going concern?

In a Chapter 11, debtors can liquidate their own assets or reorganize. If a debtor files a Chapter 11 bankruptcy case, the debtor will retain control of its assets (unless a trustee is appointed for cause), and will attempt to develop a plan to either reorganize or liquidate. The court oversees the bankruptcy process, and creditors receive notice of the debtor’s actions. Bankruptcy may be used to sell assets of an operating company to a purchaser who wants to buy assets without the fear of creditors’ claims following the assets. Some buyers require the seller to file a bankruptcy, so that they can be sure that the assets are free of creditors’ claims. For debtors who want to reorganize, bankruptcy allows the debtor to reduce debts and pay creditors over a period of time, so that they can continue in business. Debtors try to pay as little as they can over time, subject to statutory limitations. Creditors hope to receive as much as possible, and often believe that the debtor can pay more. For some creditors, having the debtor survive is a factor. There is a new type of Chapter 11, commonly known as a Subchapter V for debtors that have debts (secured and unsecured) of less than $7.5 million, that is meant to be less costly and quicker to proceed through bankruptcy. There are advantages and disadvantages under this chapter.

What rights do creditors have in a bankruptcy?

Once a debtor files bankruptcy, creditors can have wide access to all of the debtor’s financial information and other matters that relate to the debtor’s operations, if it impacts payments to creditors. Creditors are given opportunities to object to various transactions if appropriate. Creditors can monitor Chapter 11 cases. In most cases with assets, a committee of unsecured creditors (Creditors’ Committee) will be appointed, and that committee will oversee the debtor’s case. All creditors are invited to the 341 Meeting in a Chapter 11. Debtors are required to file monthly operating reports, and from time to time report to the court on the status of the case. Creditors can also review the filings, ask for copies of pleadings and tax returns or contact counsel for the debtor or the Creditors’ Committee. Creditors can also ask to depose the debtor (called a 2004 Examination) and third parties (who have knowledge of the debtor’s financial affairs ) to look for assets. There is a big role for creditors in a Chapter 11, and the Court gives consideration to creditors’ reasonable concerns and tries to balance those with the debtor’s statutory rights. A creditor should carefully analyze when it is appropriate to intervene in a bankruptcy, and what steps it needs to take to protect its interests. Pre-bankruptcy planning can be just as important for the creditor as it is for a debtor, if the creditor is concerned about a filing.

Will bankruptcy allow a debtor to exit a long-term lease?

Yes, bankruptcy may limit lease liability. Bankruptcy also allows debtors to limit damages when getting out of leases. The bankruptcy code limits the amount owed on leases that are rejected to one year or 15% of the rent for the remaining term, not to exceed three years (Capped Damages). Landlords still have a duty to mitigate damages, but can maximize their claims by filing claims for funds owed for the pre-petition period, the Capped Damages, and rent owed for the period after the bankruptcy is filed (Administrative Claim). All creditors that provide services to the debtor post-bankruptcy are entitled to administrative claims, which have priority over unsecured creditors Terminating a lease in bankruptcy often allows debtor’s to reorganize in a way that they would not be able to do outside of bankruptcy.

As a creditor should I be concerned that a debtor or trustee will try to claw back payments that I received?

Creditors who receive payments within 90 days (1 year for insiders) of the commencement of the bankruptcy case are at risk for having those funds clawed back as Preferences if they are payments on antecedent debts, made while the debtor was insolvent, and allow the creditor to receive more than the creditor would have received in a chapter 7, subject to defenses. Bankruptcy affords the debtor powerful tools to recover pre-petition payments to a creditor. Defenses are factually intensive. Payments made or liens recorded pursuant to workouts, and forbearance agreements made within the 90 day period risk avoidance by a trustee if certain defenses are lost, based upon the structure of the agreements. Payments should be deposited as soon as possible to avoid delay if a creditor thinks that a debtor may file a bankruptcy since the 90 days is measured based on when the check clears the debtor’s bank account.

Can a corporate bankruptcy ever result in personal liability?

Fraudulent transfers may be pursued in bankruptcy. Transfers for less than equivalent value or made with the intent to hinder, delay, or defraud a creditor can be avoidable as Fraudulent Conveyances, and may give rise to personal liability where there was none before. In addition, officers and directors owe Fiduciary Duties to creditors when a company is insolvent, and care must be taken not to run afoul of those duties. Transfers which violate those duties could result in personal liability. While the avoidance of a fraudulent conveyance and breach of fiduciary duty action could result in personal liability outside of bankruptcy, the appointment of a trustee or creditors’ committee, and the disclosure of financial records increases the ability of a trustee or committee to pursue such actions.

Are there alternatives to bankruptcy?

A debtor can try to do a workout with one or all creditors. Multi-party workouts can be effective, but all parties should know what they would get in a bankruptcy in comparison to a workout, and creditors need to feel confident that the debtor is truthful and reliable. Full disclosure is critical.

In addition, under some state laws, such as California, a debtor can opt to do an Assignment for the Benefit of Creditors. When there is an Assignment for the Benefit of Creditors, a third party is selected to be the assignee. That assignee will liquidate the debtor’s assets. The assignee can sell an ongoing business in much less time than a sale in a Chapter 11 , or the assignee can liquidate the assets in an another format, such as an auction. Since businesses usually don’t operate in a Chapter 7, an Assignment for the Benefit of Creditors can be preferable if there are insufficient funds to do a Chapter 11 and the debtor wants to sell its operations as an ongoing business. Because there is no court supervision (in California), an assignment can save time and expenses. Like a bankruptcy, creditors share pro rata in the distribution of assets. An Assignment for the Benefit of Creditors is a useful tool if the debtor does not need the hammer of the automatic stay, but it has limitations. Buyers may try to control whether an assignment can be used, or if they want the protection of a bankruptcy court order. If a company does not have the cash to operate in a chapter 11, an Assignment for the Benefit of Creditors may be its only choice.

Should you have specific questions on how this pertains to your company, please reach out to our Bankruptcy Practice Group.