Bankruptcy Primer for Creditors

• EXECUTIVE SUMMARY AND CONCLUSIONS
  • Prior to Bankruptcy
  • After Your Customer Files Bankruptcy
    • What You Can Do Now to Collect Account Receivables
    • Extending New Credit to the Debtor
    • Evaluating Risk of Future Preference Claims
    • Defending Preference Claims
  • Policy Conclusions
• INTRODUCTION
  • The Importance of Security
  • Creditors v Creditors
  • Paradigm Shift
  • Public Policy
  • Bankruptcy Timeline and Terms
  • Types of Bankruptcy
    • Chapter 7
    • Chapter 11 Reorganization
    • Chapter 13 Plan
    • Involuntary Bankruptcy
  • Foreign Bankruptcies and Creditors
  • Consumer and Individual Bankruptcies
    • Means Testing
    • Credit Counseling
    • Discharge Every Eight Years
    • Homestead Exemptions
• THE BANKRUPTCY FILING
  • Notice of Bankruptcy
  • Automatic Stay
  • Proof of Claim
  • Schedules
  • No Notice of Bankruptcy
• THE BANKRUPTCY PROCESS
  • Getting on the Mail List
  • The Meeting of Creditors
  • Objection to Discharge
    • Discharge of a Specific Debt
    • Discharge of the Debtor
  • Objection to Exemptions
  • The Creditors’ Committee
  • The Trustee
• DOING BUSINESS WITH THE DEBTOR IN BANKRUPTCY
  • Can You Be Forced to Do Business with the Debtor?
  • Do You Want to Do Business with the Debtor?
  • Administrative Expense Priority
  • Assumption or Rejection of Executory Contracts
  • Critical Vendors
• MOTIONS
  • Motion for Relief from the Stay
    • Foreclosing on Property or Repossessing Equipment
    • Complaint to Enforce Mechanic’s Lien
    • Termination of a Lease
    • Setoff Rights
  • Deadline to Assume or Reject
  • Payment of Administrative Expenses
• ADVERSARY PROCEEDINGS
  • Adversary Proceedings or Complaints
  • Reclamation Rights
• PREFERENCES
  • Introduction
    • The Objective
    • The Preference Mechanism
    • The Perception Problem
    • The Policy Problem
    • The Information Problem
    • The Timing Problem
  • The Trustee’s Burden of Proof
    • Secured Creditors
    • Assumption of Contract
    • Trust Fund Statutes and Agreements
    • Earmarking
  • Defenses to a Preference Action
    • Ordinary Course of Business
    • Contemporaneous Exchange for New Value
      • COD Sales
      • Release of Mechanic’s Lien or Bond Rights
      • Triangulation
    • Subsequent Advance Rule
    • Equitable Liens
• Appendix 32 — Bankruptcy Checklist
• Appendix 33 — Notice of Bankruptcy
• Appendix 34 — Bankruptcy Proof of Claim
• Appendix 35 — Request for Service of Notices

EXECUTIVE SUMMARY AND CONCLUSIONS

This outline is intended to introduce construction contractors, suppliers and other commercial creditors to some of the issues and concepts in bankruptcy law. This is not a comprehensive explanation of bankruptcy and will not deal at all with many issues. We have generalized and simplified many legal concepts, so that the explanations are short, uncluttered and easily understandable. Every set of facts and circumstances raise different legal issues. You should consult this firm or another attorney in dealing with any specific problem.

Prior to Bankruptcy

If you deal with bankruptcy cases regularly, you will come to the conclusion that a creditor avoids bankruptcy preference problems by using the same techniques good credit managers already use to avoid collection problems. Good preference defenses are just an extra-added bonus for good credit management. The creditor that consistently forced the debtor to stay on terms will have a smaller receivable to lose in bankruptcy and also will not have preference problems. By definition, all of these payments were in the ordinary course of business.

Similarly, the creditor that always preserved and enforced mechanic’s lien and bond rights are more likely to collect after bankruptcy and will have better defenses against preference actions for moneys received before bankruptcy. Mechanic’s lien and bond rights are the single greatest mechanisms for construction suppliers to avoid bankruptcy problems. It is an opportunity to be a secured creditor, often with priority over all other secured creditors in the bankruptcy. If you still had mechanic’s lien and bond rights at the time of pre bankruptcy payments, you will also have much better defenses to any preference action.

If a creditor is concerned with insolvency, they can refuse to deliver on any project that does not have good payment bond or mechanic’s lien rights. Payment bond rights are probably the best and most efficient mechanism to enforce payment. Mechanic’s lien rights can vary in strength and can be expensive to enforce. The creditor must research the payment bond and mechanic’s lien rights on any particular project before beginning deliveries.

Creditors requiring some type of consensual security will have the same dual benefits in a subsequent bankruptcy. With a security interest in accounts receivable or liens on equipment, there is a much lower chance of default. The debtor is more likely to stay within terms. The prepetition unpaid receivable will be lower in the event of bankruptcy. Any payments received shortly before bankruptcy will not be preferences, because there was an enforceable security interest against the debtor.

By the same token, if a creditor has a personal guarantee, the debtor is more likely to stay on terms. The unpaid receivable will be lower. The payments received are more likely to be “in the ordinary course of business,” because the invoices will not be as old. This creditor will also have a better chance of collecting an unpaid receivable after bankruptcy. The creditor is still free to sue the guarantor, unless the guarantor is also in bankruptcy.

Requiring C.O.D. shipments may be the surest way to avoid bankruptcy issues. You do not need to worry about collecting payment for materials, if you are collecting on delivery. These payments cannot be preferences. Even if the debtor gives you a bad check, you can probably object to a discharge from this debt because of fraud.

Joint check agreements and trust fund agreements are helpful mechanisms to collect receivables before and after bankruptcies. These mechanisms will also provide protections against preference claims.

If a creditor is genuinely concerned with insolvency, it is generally better to get payments from anyone other than the debtor.1 Joint check agreements can be a good mechanism for this purpose.2 Owners or bonding companies can agree to make direct payments to a creditor. This is the single best protection against preference problems. Even if a creditor has perfectly good mechanic’s lien or bond rights, a bankruptcy estate is likely to bring a preference claim if a payment is made directly from the debtor to the creditor during the preference period. If a creditor has made a bond claim or mechanic’s lien claim, it is preferable to demand payment directly from the bonding company or owner.

Reclamation rights can be helpful pre-bankruptcy tools. A creditor concerned with bankruptcy can make a reclamation demand. Reclamation rights would survive bankruptcy. Those reclamation rights can then be traded for cash or security. This would not be a preference, since it is a contemporaneous exchange for new value. Even if the creditor fails to provide the written reclamation demand in time, the creditor is still entitled to an “administrative expense claim” for any goods received by the debtor in the 20 days prior to the bankruptcy petition. Filing for an administrative expense claim provides the creditor a high priority in the bankruptcy that will normally result in payment.

It is helpful to get new financial statements regularly, especially if there is concern over a bankruptcy. First, this will help the creditor investigate the risk of bankruptcy and determine whether they wish to continue doing business. If a debtor refuses to supply any financial information, this should only add to a creditor’s concern.

If the debtor does supply incorrect financial information, this may constitute a written misrepresentation concerning solvency. This misrepresentation can extend the creditor’s reclamation rights more than ten (10) days and may be grounds to avoid discharge in bankruptcy from this particular debt.

After Your Customer Files Bankruptcy

Once a customer files bankruptcy, quick action can help collect a receivable and avoid preference problems. A bankruptcy checklist is attached as Appendix 32.

What You Can Do Now to Collect Account Receivables

On the outstanding account receivable, the most important thing to do now is establish security rights. This usually means mechanic’s lien and payment bond claims. You are still free to make payment bond claims (as long as the bonding company is not in bankruptcy). This is true in all states.

In most states, the mechanic’s lien is not a preference and does not violate the automatic stay. This means you are free to file mechanic’s liens wherever you may have rights. In fact, you must still file your mechanic’s liens within the normal deadlines, which could be as soon as 90 days after your last deliveries. This is true in Virginia and the District of Columbia. In Maryland and some other states, however, the mechanic’s lien is not “inchoate.” You are stayed from proceeding against the property of the debtor in a mechanic’s lien action.

In Maryland and many other states, it may be possible to establish rights under a “Trust Fund Statute” even after a bankruptcy. You may also have a trust fund agreement with your debtor that brings you to the same result. You may be able to collect a receivable directly from an owner or general contractor. You may even be able to establish priority over money held by the bankruptcy estate.

Reclamation rights can also trump a bankruptcy, as discussed below.

You have less risk accepting payments from someone other that the bankrupt debtor, both before and after a bankruptcy filing. Encourage bonding companies, property owners and general contractors to make payment directly to you. A joint check is also better than a direct payment from the debtor, although after bankruptcy the debtor’s endorsement of the check may technically require bankruptcy court approval.

After bankruptcy, the debtor can “assume” contracts that are profitable and “reject” unprofitable contracts. Creditors on rejected contracts become general unsecured creditors. The debtor must “cure all default” on assumed contracts. If you have a contract to supply all of the materials at a favorable price on a profitable job, the debtor may wish to assume the contract to complete the job. You would have to continue supplying the job, but the debtor would need to cure all default and pay your prepetition invoices also. The debtor may also wish to assume a profitable contract with a general contractor or owner. That contract may require the debtor to make sure all subcontractors and suppliers are paid on the project. Curing all default on that contract may require the debtor to pay invoices on that job.

If nothing else, you should be sure to file your proof of claim in the bankruptcy. This will insure that you share in any future distributions to general unsecured creditors. The notice of bankruptcy you receive will give you instructions regarding proofs of claim. File a proof of claim early, even if no deadline has been set. This helps insure that you will not miss a deadline, if the court later sets one.

You can also check on the bankruptcy court website whether there is a deadline for proofs of claim. This bankruptcy court sponsored website includes much basic information regarding a case. You can also subscribe to a service known as “Pacer,” which allows you to access almost all papers filed in the case for a small fee. You can file a “Rule 2002” Request for Service of Papers, requesting hard copies of all papers filed in the case. You or your attorney can also request a CM/ECF (Case Management/Electronic Case Filings) ID and Password. You can then electronically file and monitor all papers filed in that bankruptcy case.

CM/ECF allows you 24 hour access to case file documents, to file electronically, automatically receive e-mail notice of all case activity and to download and print all documents filed in the case directly from the court’s system. You will receive notice of future events in the bankruptcy, including any deadline for proofs of claim. In a large bankruptcy, this also means a large volume of paper and electronic files that you do not care about. The safest course, however, is to have someone keep track of motions and other events in the bankruptcy, either on Pacer or through a Rule 2002 Request for Service. Even if you include your e-mail address on your Rule 2002 Request for Service, you will not receive e-mail notification of case filings unless you also have a CM/ECF ID and Password. For more information on signing up with CM/ECF, go to: http://pacer.psc.uscourts.gov/cmecf/index.html.

Extending New Credit to the Debtor

The only truly safe way to do business with a debtor in bankruptcy is to require cash in advance. Otherwise, any creditor at least runs the risk of administrative costs and problems going to bankruptcy court to enforce payment. However, there are also risks of non-collection.

You will have a high administrative expense priority for postpetition sales, but there may be no money available for distribution no matter how high your priority. Another secured lender may have “super-priority” over all available cash flow. An administrative expense claim can also be denied if the expense was not “actual and necessary” for the preservation of the estate.

A creditor with an ongoing contract may be forced to continue doing business with the debtor. It is very risky, however, to continue performance and extend credit unless and until the contract is assumed. Otherwise, the creditor can have the same problems with an administrative expense claim just discussed. A creditor is better off requiring assumption of the contract, before continuing performance. This will also result in “cure” and payment of all prepetition debt. If the debtor is unwilling or unable to assume the contract immediately, the creditor should insist on cash in advance, a letter of credit, or other adequate assurance before continuing performance.

Evaluating Risk of Future Preference Claims

You are at risk for a preference claim for all payments you received in the 90 days prior to the bankruptcy. Unfortunately, the bankruptcy trustee does not need to bring a preference claim against you for two years. The “statute of limitations” for a preference claim is two years after the bankruptcy petition.

The bankruptcy trustee will get payment records from the debtor during the course of the bankruptcy. The trustee will probably make a preference claim on all payments made by the debtor in the 90 days prior to the bankruptcy, that were on invoices that were more than sixty days old. The critical date is the day the debtor’s check clears their bank, not the date you receive or deposit the check. The trustee generally will not spend much time evaluating whether each payment is a preference, they will simply make demand on all creditors that received checks during the preference period and leave it to the creditor to show why it is not a preference. In a large bankruptcy, this can mean that hundreds of demand letters will go out in the second year of the bankruptcy.

First, collect and protect information now, as soon as the debtor files bankruptcy. It will be harder to locate invoices and find salesmen two years from now. Collect a summary of all checks received from the debtor in the hundred days prior to the bankruptcy. A check received one hundred days before the bankruptcy probably did not clear the debtor’s bank until less than 90 days before the bankruptcy.

Then look at the invoices paid with each of the checks received. How old were each of the invoices at the time that the debtor’s check cleared their bank? The trustee generally will not pursue any payments on invoices that were less than sixty days old, because those payments were in the “ordinary course of business.”

Now pretend that you never received the payment and evaluate your ability to collect on these invoices. Again, this mostly boils down to security rights in the form of bond claims, mechanic’s lien rights, personal guarantees, etc. Generally, you will have a defense to a preference claim if you could have enforced your rights to payment after the bankruptcy, even if the debtor had not sent you the check before the bankruptcy.

Look at each invoice and determine whether you have lien, bond or other security rights. This is going to be much easier to do now than two years from now. Your own documents and outside witnesses are easier to find now. Where is this project? Who is the owner? Who is the general contractor? Were you still in lien rights at the time you received the payment? Was there a payment bond on the project and were you within time to make a payment bond claim at the time you received payment? If you were a secured creditor, generally the payment was not a preference.

You may actually need to file your lien or bond claims for money you have received. You may want to force the debtor and bankruptcy trustee to litigate the preference case now, while you still have lien or bond rights to protect you. It is often advantageous to bring the debtor, the bankruptcy trustee, the project owner, general contractor and the bonding company into the bankruptcy court early. Litigate the preference and your bond claim simultaneously with all parties in one courtroom. These parties may be helpful now in proving you had security and forcing the debtor to resolve a preference claim, but this help may not be available two years from now.

It is always important to be careful with lien and bond claim waivers, to make sure your security rights are not waived if a preference claim is brought against you later. This is discussed in other chapters of this book.3 After bankruptcy you should deal the same with your (1) uncollected receivable and (2) all money received during the preference period. “Spread” the invoices to figure out where all the material went and whether you have security rights for uncollected receivable and for payments received shortly before the bankruptcy filing.

Defending Preference Claims

You will eventually receive a letter asserting that you received payments during the 90-day preference period prior to the Bankruptcy filing. This letter will demand you to pay this amount back to the bankruptcy court. At this point you should consider hiring an attorney, depending on the dollar amount or the issues involved. You or your attorney should write further information on the payments they allege are preferences. They can at least give you a copy of a computer printout showing the check numbers and dates.

This type of case can often be settled for about 50 cents on the dollar, especially in the early stages or before a suit is filed. If your defenses are better, you have a better chance of getting a good settlement. Unfortunately, you have to decide now whether you would rather just try to settle this claim for about 50 cents on the dollar or spend significant administrative time analyzing the accounts for defenses and later incur legal fees in defense.

You should confirm whether your company received this “Preference” amount during the 90 days prior to the bankruptcy. You should evaluate the strength of you defenses. You will then know more about the case than the lawyer on the other side. If you have no real defenses to the preference claim, you want to work hard on settling the case for less than the full amount of the debt. If you have some arguable defenses, you may be able to settle for a small percentage.

There are a few truly solid preference defenses. If you are sure you have a solid defense and the bankruptcy estate refuses to dismiss the case, your attorney can consider a motion for summary judgment to get the case thrown out of court.

Policy Conclusions

When a customer files bankruptcy, a creditor has a basic policy decision, whether to “participate in the bankruptcy process.” Bankruptcy is a battle between innocent creditors. The bankruptcy process is an attempt to maximize the distribution to general unsecured creditors.

If a creditor tries to establish mechanic’s lien rights, payment bond rights, trust fund or equitable lien rights, reclamation rights or some other priority, this will lower the amount available to general unsecured creditors. It may maximize this particular creditor’s recovery, but it will lower the recovery to their brethren. This activity will also result in increased legal fees. The creditor will expend higher legal fees trying to establish priority. The debtor, the trustee, and the unsecured creditors committee will fight the creditor, to preserve money available for distribution. This further depletes the estate, whether the creditor succeeds in establishing priority or not.

If there is a genuine chance of a good distribution to general unsecured creditors, all creditors have a common interest in lowering the heat level, participating peacefully in the bankruptcy process and maximizing the distribution for all general unsecured creditors. For this reason it is important to evaluate the initial schedule of assets and liabilities and watch the activities of other creditors to evaluate the chances of a good distribution.

If there is little chance of a good distribution for general unsecured creditors, then each creditor has a stronger incentive to try and establish priority rights. The creditor’s worst case is that it will waste time and money on legal fees. If there is no chance of a distribution from bankruptcy, this is not a risk, only an expense.

Unfortunately, the experience for most unsecured creditors is that they never see any distribution from a bankruptcy or very small distributions. Accordingly, most creditors are cynical of the bankruptcy process and will always do their best to establish their own priority over other creditors. This becomes a self-fulfilling prophecy. All creditors are pushing their own self-interest, expending legal fees in the process. The debtor, the trustee, the bankruptcy court, and the unsecured creditors committee are all expending time and money fighting these creditors. This process further reduces the likelihood of any distribution.

INTRODUCTION

The Importance of Security

Why are one-year adjustable mortgage rates 6%, while some credit cards charge 18% interest per annum? Each dollar costs the bank the same amount. How can it be cheaper to lend one dollar than the other? Security is the most important difference. Security increases the bank’s chances of preventing default and collecting its money within terms. In the event of default, the bank increases its chances of collecting faster and at lower cost.

Why does security decrease the risk of non-collection? When you purchased your last home or automobile, the bank required you to sign at least two pieces of paper. One was your promissory note. This was your “contract” with the bank in which you agreed to make certain monthly payments. This is your “personal promise to pay.” This allows the bank to sue you personally in the event of default.

The other paper you signed was a mortgage, deed of trust or other “security agreement.” Your security agreement provides the bank rights against the “security property.” In the event of default, the bank can foreclose upon the security property, whether it is a house, automobile or other property.

If the debtor is solvent, security is not as important. The lender will be able to go against the debtor on the “contract.” The lender will be able to obtain a personal judgment against the debtor and will then be able to attach all assets owned by the debtor. This is discussed in other chapters of this book.4

If the debtor is insolvent or disappears, security becomes critical. The contract or promise to pay will be worthless if the debtor cannot be found or is insolvent. The lender with only a contract or personal promise to pay is a “general unsecured creditor.” All of the general unsecured creditors go in one “big pot.” All of the assets of the debtor that are not encumbered by a security interest also go in the same big pot. The general unsecured creditors share pro rata in the available assets, according to the amounts of their claims.

It does not matter which creditor filed their proof of claim first or who was the first to jump in the big pot. A bankruptcy estate is similar to a probate estate when someone dies. It is no coincidence that they are both referred to as an “estate.” The objective is to “liquidate” the assets of the estate that are not encumbered by a security interest and then distribute the proceeds to creditors, pro rata, to the extent possible.

Any of you that have experience as a general unsecured creditor in a bankruptcy know that this usually means you will be paid nothing or a very small percentage of your claim. By definition, if a debtor is in bankruptcy, it has very few unencumbered assets to go in the big pot for distribution to general unsecured creditors. Almost all of the debtor’s assets are encumbered by liens to some lender, and the debtor’s liabilities generally exceed its assets.

In the event of bankruptcy, the “secured creditor’s” rights in the “security property” are generally not affected by the bankruptcy. The debtor has, in effect, disappeared and the lender’s contract rights against the debtor are now worthless. However, the secured creditor, while perhaps delayed5 from foreclosing against the property, will eventually collect as long as there is sufficient equity in the property.

Secured creditors generally have the option of simply “riding out” the bankruptcy. The debtor may eventually obtain a “discharge” from the debt as a matter of personal liability. A discharge from personal liability, however, will not eliminate the lien or security interest of the lender in the security property. After the debtor has obtained a discharge and the bankruptcy is closed, the “automatic stay” is also terminated and the secured lender is free to foreclose upon the security property.6

Secured lenders are often not satisfied to wait this long and can also request the bankruptcy court for “relief from the stay.”7 If the debtor has no equity in the security property and the property is not necessary to a reorganization of the debtor, the bankruptcy court will probably grant the secured lender relief from the stay. The secured lender will now be free to foreclose.

Security can be either “consensual” or “judicial.” Consensual security is provided with the consent of the debtor and is available to all types of lenders. Customers can agree to provide blanket consensual security applicable to all projects, such as personal guarantees, letters of credit or security interests in accounts receivable and equipment. These devices would be helpful to suppliers in any business, including construction materials, food service, or equipment dealers.

Most of the companies you are doing business with have a large credit line for the operation of their business. The bank that provides this credit line probably required a blanket security interest on all of the accounts receivable of the debtor, all of the debtor’s contract rights, inventory, and equipment.8 If the company purchased trucks, vehicles, or heavy equipment, the seller of the equipment or a bank financing the acquisition again probably required a security interest. If the company owns real estate, there is probably a mortgage to a bank. All of these encumbered assets will not go in the big pot to be shared by general unsecured creditors, until the secured creditor has been paid in full. The bottom line in bankruptcy is that secured creditors get some or all of their money while unsecured creditors get very little or nothing.

Construction contractors and suppliers that have mechanic’s lien or payment bond rights are generally in the same position as a secured lender. Mechanic’s lien rights in most states are a security interest that will survive bankruptcy and result in secured creditor status. In states, such as Maryland, that do not have “inchoate” mechanic’s lien rights, contractors and suppliers may be general unsecured creditors. Some states have higher priority on mechanics liens than others. This is something that a contractor needs to understand in each state in which they are doing business. Mechanic’s lien rights vary from state to state and are discussed in greater detail in other chapters of this book.9 Rights under payment bond or guarantees will also generally be unaffected by bankruptcy. Unless the bonding company or guarantor is a debtor in bankruptcy, the creditor is still free to enforce rights under payment bonds or rights under guarantees.10

“General unsecured creditors,” however, will share only in assets that are not already encumbered as security property for a secured lender. Typically, there are not many unencumbered assets. If there were, there would probably not have been a bankruptcy.

Creditors v. Creditors

Bankruptcy is often not a battle between the debtor and a creditor. It is a battle between creditors. Secured and unsecured creditors are certainly adverse. If a bank can prove it properly filed a UCC financing statement on accounts receivable11, those assets are pulled out of the big pot and there is less for unsecured creditors to share. If a construction material supplier can establish mechanic’s lien rights, this will give them “priority” in that particular receivable. That material supplier will be paid in full, leaving less for the unsecured creditors. If the material suppliers had failed to perfect mechanic’s lien rights, however, this supplier would be another general, unsecured creditor. This receivable would be snatched up by another mechanic’s lien claimant or would go into the big pot to be shared with other unsecured creditors. The debtor doesn’t care which creditor gets this asset. The debtor will not get any of the assets.

Similarly, unsecured creditors are adverse to other unsecured creditors. The more unsecured creditors in the big pot, the less there will be to go around. If you are the only unsecured creditor that files a “Proof of Claim,” you may get all available funds.12 All secured and unsecured creditors are entitled to be paid. Fairness and justice would dictate that all of them get their money. Bankruptcy, however, is a battle between “innocents.” The “bad guy” is gone. All that is left are “good guys” that never bargained for problems with the debtor. The bankruptcy process tries to provide order and fairness for the innocents battling over the limited assets.

Paradigm Shift

Creditors and their lawyers spend a lot of time trying to collect money. Especially when debtors are in default of their payment obligations, an adversarial relationship develops between creditor and debtor. The debtor is trying to keep from paying money at all or any sooner than they have to. The creditor is trying to get as much money as they can as fast as they can.

The creditor’s frame of mind is to “win” this contest against the debtor. It is only fair that the debtor pay. The debtor agreed to pay in a solemn promise or contract. The creditor has delivered all labor and materials promised to the debtor. The debtor should perform its promises as well. This is only fair. The creditor is only looking for justice.

The creditor tends to take this same frame of mind into the bankruptcy forum. The creditor is still, of course, only trying to collect money rightfully due, and has still lost the value of all labor and materials supplied. The bankruptcy rules seem to thwart this basic justice, making it complicated and difficult for a creditor to collect debts justly due and owing. Why is this? Why do bankruptcy law and the bankruptcy court favor the debtor and make it so difficult for a creditor to obtain justice? The debtor often continues in business. The officers and directors of the debtor are often still seen running the company and driving the same valuable automobiles.

We could debate endlessly whether or not the bankruptcy process is fair or proper. I will not attempt to solve that problem. In order to understand how the bankruptcy works, however, the creditor must understand the philosophic foundation of this system. There is no doubt that many debtors abuse the bankruptcy process or that the system could use reforms. On the other hand, there must be good reasons a bankruptcy system has survived over one hundred years in most civilized countries. The United States Congress passed the current Bankruptcy Code into law after seeking the advice of many experienced lawyers, judges, and academics. Federal courts enforce the Bankruptcy Code as the law of the land and an important public policy objective. What are all these people thinking? This is not a conspiracy of insolvent debtors to avoid justice. Penniless individuals and insolvent companies have not succeeded in thwarting justice and the wishes of the successful and healthy businesses in this country.

The creditors of the world must step outside of their normal frame of mind in order to understand the bankruptcy system. There are important public policy considerations that make a Bankruptcy Code important to society as a whole. More importantly, however, bankruptcy is not a contest between the creditor and the debtor. Rather, the Bankruptcy Code is an attempt to generate fairness between a large number of participants, including all creditors, all employees of the debtor, the public at large, and the debtor itself.

In his influential book, The Seven Habits of Highly Effective People, Dr. Stephen Covey explains the importance of an ability to make a paradigm shift in order to be successful. There are as many points of view as there are people in this world. We can never succeed unless we can understand other points of view. Creditors will never succeed in the bankruptcy process until they understand the objectives of the Bankruptcy Code.

Public Policy

In Medieval times, the Government did put debtors in prison. This would seem fair to many creditors. The moneyed aristocracy made the rules. If you did not keep your agreements and pay your debt, creditors could make sure you were really sorry.

While creditors did obtain some satisfaction through this system, there were some obvious problems. Debtors could not earn any money to repay debts while they were in jail. Even worse, the Government was financing their room and board. On a larger philosophic level, society needed a system that encouraged risk taking and entrepreneurship. Why would anyone take a risk in starting a new business venture if failure meant spending the rest of your life in jail? We do not need potentially productive members of society sitting in jail at government expense. We need them out working at their jobs and caring for their families. Why would anyone get up and go to work everyday if all of what they earned for the rest of their lives would go to creditors? Not only was the debtor-prison system inhumane and costly, it decreased production and suppressed economic activity.

We as a society eventually decided that we needed a system that allowed individuals to obtain a clean bill of health, emerging debt free and encouraged to go back to work. Debtors would have to give up all assets they had. Those assets would be distributed fairly between creditors, but all debt would otherwise be “discharged” and eliminated.

Have you ever wondered why every civilized country in the world has limited liability entities? Creditors often perceive great unfairness when a corporation disappears with one swipe of a pen, but the former corporate president can still be seen driving her Cadillac in the neighborhood. Some of the first limited liability entities in history were the Dutch and English trading companies in the Age of Exploration. Why would entrepreneurs risk borrowing money to build ships and explore the world for new trading partners and natural resources when the result could so easily be financial failure, debtor’s prison and a lifetime of repaying creditors?

Modern society needs entrepreneurs to create new businesses, new products and new jobs. This isn’t going to happen if entrepreneurs face a lifetime of ruination. When dealing with a corporation, limited partnership, LLC, or other limited liability entities, you as a creditor simply have to understand that you will only be paid if the business succeeds. If creditors are not satisfied with this arrangement, they must decide to deal only with sole proprietorships or to always require personal guarantees. This would certainly limit the creditor’s opportunities to do business.

When businesses fail, society often has a strong interest in finding a way to let the business continue. Historic problems with the steel, coal, and railroad industries are good examples. Bethlehem Steel has “failed.” They are no longer paying their debts as they become due. Liabilities exceed assets and the company has a negative net worth. Are we better off if Bethlehem Steel disappears from the face of the earth? Tens of thousands of people will be out of work. The nation would lose a major source of steel, an important component of national industrial production. Recovery by creditors will also be limited.

If an insolvent company is “liquidated,” when liabilities exceed assets, secured creditors will probably lose money while unsecured creditors are left with nothing. If the company has a workable, basic business plan, however, continuing the business will mean the generation of profits to pay unsecured creditors, jobs for employees, a tax base for the government, and a steel supply for industry.

Indeed, the shareholders often change in a “reorganized” corporation. When liabilities exceed assets, there is no “equity” for the shareholders (equity owners). Employees may become partial owners in exchange for lost pensions or the agreement to continue working. Unsecured creditors may receive stock instead of cash repayment of loans. Secured creditors sometimes become the “owners” of companies by agreeing not to foreclose on machinery and other assets.

This becomes all the more confusing because the former shareholders and managers of the failed business may continue as players. This can create the perception that the business continues unchanged while general unsecured creditors remain unpaid. The former shareholders and managers, however, may be mere employees in the reorganized company. The business may have failed only because of uncontrollable market conditions and the former managers may still be the best managers to work for the new employee or creditor owners. The former shareholder owners of the company must contribute cash or other “new value” to the reorganized venture in exchange for stock in the new reorganized company. They may also receive stock over time based on the success of the venture or services provided over time.

In general terms, the secured and/or unsecured creditors of the failed business become the owners and can make whatever deal they deem advisable with the former owners of the failed business. Generally the old equity owners must lose their interest in the company unless they contribute genuine new value or the creditors are paid in full. This is known as the “absolute priority” rule.

Bankruptcy Timeline and Terms

The bankruptcy timeline can generally be depicted as follows:

 

 

The bankruptcy process normally begins when the debtor files a “bankruptcy petition.” All transactions that occurred with the debtor before that time are now called “prepetition.” All transactions after that are called “postpetition.” It often becomes important whether a debt is prepetition or postpetition. It is the prepetition unsecured debt that goes into the big pot and shares in any eventual distribution to any general unsecured creditors. A debt for labor or materials supplied after the date of bankruptcy is postpetition debt, which is of higher priority and more likely to be paid.13

Immediately upon the filing of a Voluntary Petition in Bankruptcy, an “Order for Relief” is entered. In an Involuntary Petition, the court will enter an “Order for Relief” after the debtor is given an opportunity to oppose the petition.

Once the order for relief is entered, the bankruptcy process begins and the “automatic stay” is in place. The automatic stay ends the “race to the courthouse.” All creditors are forbidden from taking aggressive action against the debtor or otherwise improving their position. General unsecured creditors will not be able to secure the amount owed to them, by judgment or otherwise. The debtor is no longer permitted to simply pay any creditor they wish.14 This automatic stay is one of the most important policy objectives of the Bankruptcy Code. All creditors are forced to simply stop aggressive behavior and participate in an orderly bankruptcy process.

This policy objective is so important that the Bankruptcy Code effectively pretends that the bankruptcy petition was filed 90 days earlier. The 90 days prior to the bankruptcy petition is called the “preference period.” Not only are creditors prohibited from improving their position after the bankruptcy petition, Bankruptcy Code also “undoes” or eliminates many things that improved a creditor’s position in the 90 days prior to the bankruptcy period.15 Any payments made by the debtor during the preference period may have to be repaid by creditors. If a creditor obtained a security interest in property of the debtor during the preference period, this lien can be removed.

The policy behind the automatic stay and preference period is to encourage creditors to work with a debtor, rather than force them into bankruptcy. A creditor is less likely to be aggressive with a debtor if the creditor knows that a bankruptcy petition within 90 days can mean that the creditor wasted legal fees for a judgment, garnishment, security interest or other aggressive attempts to collect.

Mechanic’s lien rights are an important exception to this rule. In a state with an “inchoate” mechanic’s lien, the contractor or supplier has mechanic’s lien rights from the moment they supplied labor or materials. Accordingly, perfecting mechanic’s lien rights is not a preference in such states. This is discussed in greater detail in other chapters of this book.16

Accordingly, advanced planning is very important in establishing security rights. If a creditor is depending on consensual security, the creditor must make sure to get this at least 90 days before a bankruptcy filing. The only way to be safe is to require some type of security before supplying labor and materials.

By the same token, it is important to determine whether payment bond rights exist and to evaluate your mechanic’s lien rights before supplying labor and materials. If you are doing business in a state with strong inchoate mechanic’s lien rights, you do not need to be as concerned with consensual security. If your mechanic’s lien rights will be limited or lost in bankruptcy, however, it becomes more important to require security early.

Types of Bankruptcy

Chapter 7

This is a liquidation. All of the unencumbered assets of the debtor are thrown into the big pot. All of the general unsecured creditors are also thrown into the big pot and share pro rata in whatever assets are available (share pro rata in the proceeds of the liquidation). Secured creditors have their rights in their collateral and will be paid in full if there is enough equity in the security property.

An individual person can file a Chapter 7 and obtain a “discharge.” The individual emerges from bankruptcy with no debts, and only those assets exempt under the code17. An individual will obviously continue to exist. The debtor is still responsible for postpetition debts and cannot get another discharge in bankruptcy for 6 years.18 This individual may not have been a good business risk and may have been poor at handling credit, but many creditors will want to do business with an individual after bankruptcy. Creditors can often charge premium rates and need not worry about another bankruptcy for 6 years.

A corporation or other limited liability entity can also file a Chapter 7, but this is less common. A corporation cannot receive a discharge in Chapter 7. The corporation is simply out of business. If a corporation is insolvent, it is not normally worth it to pay legal fees or filing fees for a bankruptcy. The business is simply abandoned. Creditors are free to obtain judgment, but will be unable to collect.

Sometimes corporations will file Chapter 7 in order to wind down the business in an orderly manner. There may be a few profitable projects or contracts that the debtor wishes to complete. The bankruptcy and automatic stay will keep creditors from harassing the debtor while this occurs. Indeed, the automatic stay may be the only reason a corporation files a Chapter 7 bankruptcy. Legal fees and administrative time may both be lower if general unsecured creditors are forced to stop aggressive action. The profits collected while the business is wound down may all go to a secured creditor with a security interest in all accounts receivable and the personal guarantee of officers and directors.

Creditors are not normally faced with the decision whether to do business with the debtor postpetition in a Chapter 7, but creditors should be especially cautious of a corporate debtor requesting credit in a Chapter 7. By definition, the business will disappear. The creditor does have “administrative expense priority” for the postpetition debt, but there may be no assets, cash flow, or debtor from which to collect.19

Chapter 11 Reorganization

This is usually only for corporations and other limited liability entities. The corporation can eventually develop a “plan of reorganization” and can continue in business. Secured creditors will normally retain their collateral rights. Unsecured creditors will have their right to a pro rata distribution of the unencumbered assets and may get a portion of future profits or a shareholder interest in the reorganized entity.

In general terms, the debtor can continue “business as usual” after the Chapter 11 petition. Normally, the management of the debtor remains in control of the business as a “debtor in possession.”20 The debtor in possession is authorized to operate the business and incur unsecured debt in the ordinary course of business.21 This postpetition unsecured debt will have administrative expense priority.22 There is no need for the debtor to get bankruptcy court approval to incur trade debt or pay such postpetition trade creditors in the ordinary course of business.23

A Chapter 11 debtor can convert the case to a Chapter 7 liquidation at any time. Creditors sometimes request the bankruptcy court to convert the Chapter 11 to a Chapter 7 liquidation, if creditors feel that a continuation of the business will just deplete assets and there is little chance of a successful reorganization.

There is such a thing as a Chapter 11 liquidation. This is similar to a Chapter 7 liquidation. All of the assets of the corporation will be sold and the debtor will go out of business. Chapter 11 liquidations are preferred sometimes, however, in order to wind down the business of the corporation in the most profitable manner.

Normally, the objective of a Chapter 11 reorganization is to continue in business. Eventually, a “plan of reorganization” is adopted. Most plans of reorganization call for secured creditors to retain their collateral rights. If there is sufficient value in the collateral, the secured creditor will eventually be paid most or all of what they are owed. Federal, state and local governments are usually also paid in full for tax liabilities. General unsecured creditors will receive some percentage of their debt, to be paid over time as the reorganized business generates profits. The plan will typically call for the shareholders or equity holders in the business to lose some or all of their ownership interests. There is usually some change in the ownership of the entity in the plan of reorganization. Secured creditors, unsecured creditors, or employees may become the owners of some or all of the reorganized entity.

Only the debtor is allowed to propose a plan of reorganization for the first 18 months after the bankruptcy petition.24 This deadline cannot be further extended by the court.24 This deadline cannot be further extended by the court.25 If the debtor’s plan has not been filed or accepted within deadlines, the trustee, creditors committee, an individual creditor, or another party in interest may file a reorganization plan.26

Under a plan, all creditors are separated into “classes,” such as secured, unsecured, equity owners, governmental taxes, etc.27 All creditors in each class must be treated the same under the plan. Creditors that will receive less than payment in full are “impaired.” Creditors that will not lose any rights are “unimpaired.”28

All creditors will eventually receive a “disclosure statement” describing the plan and the debtor’s financial circumstances. All impaired creditors with allowed claims will have an opportunity to vote on the plan.29 Unimpaired creditors are conclusively presumed to have accepted the plan, since they will be paid in full.30

Each impaired class of creditors must accept the plan or the court must determine that a “cram down” is appropriate.31 A class of creditors has accepted the plan if more than one half (1/2) of the creditors have voted in favor and two thirds (2/3) of the amount of the claims in the class have voted in favor of the plan.32 If one class of creditors has not approved the plan, the court can still approve the plan by “cram down,” if all creditors in the class will receive at least as much as they would have under a Chapter 7 liquidation.33 In any event, however, at least one impaired class of creditors must accept the plan.34 This requirement sometimes causes debtors to artfully create classes of creditors, in order to make sure that one impaired class approves the plan. Once these and other requirement are met, the court can “confirm” the plan.

Once the plan of reorganization is confirmed, the corporation does obtain a discharge from general unsecured debt that arose before plan confirmation, whether or not a proof of claim was filed.35 All property of the bankruptcy estate becomes vested back in the debtor. That property is free and clear of all claims of creditors or shareholders in the former company.

In a Chapter 11 reorganization case, the code states that “debts were discharged upon confirmation of a plan.” Bankruptcies are sometimes dismissed, however, if the debtor does not make agreed payments under a plan. Chapter 11 bankruptcy is sometimes filed by wealthy individuals with complex business affairs. In an individual Chapter 11, debts are not discharged until all payments are made under a reorganization plan.36

There is a Chapter 11 reorganization process for “small business debtors,” with debts of less than Two Million Dollars. Some procedural rules are relaxed. For example, the debtor can dispense with a “disclosure statement” to all creditors, if the plan of reorganization itself provides adequate information for creditors to vote on the plan.37 This may help small businesses get out of bankruptcy faster and successfully reorganize. Other rules regarding the automatic stay are applicable only to small business cases.

In a small business reorganization, the debtor has an exclusive right to file a plan of reorganization for only 100 days after the petition. This can be extended by the Court, but extensions become more difficult more than 300 days after the petition.38 This will make it easier for creditors to have a case dismissed or converted to a Chapter 7, if no plan of reorganization has been approved within these deadlines.

Chapter 13 Plan

This is like a Chapter 11 Reorganization for individuals. The individual develops a plan that usually involves putting all “disposable income” in the big pot to be shared by all general unsecured creditors. Secured creditors have their collateral rights and will be paid in full if there is sufficient equity in the collateral. The individual gets to keep a large portion of their income during the Five-Year Plan for living expenses and general unsecured creditors normally receive only a small percentage of their claim. Only individuals with “regular income,” basically salaried individuals, can file Chapter 13.

Individuals normally elect to file a Chapter 7, because they can receive an immediate discharge, start a new day free of any debt, and are able to keep all of their future income. Some people file a Chapter 13 out of a sincere desire to repay creditors to the best of their ability. Others utilize Chapter 13 in order to schedule out a non-dischargeable tax claim. Often, individuals file a Chapter 13 in order to obtain a discharge from debts that may be non-dischargeable in a Chapter 7. This is usually some type of fraud claim.

Involuntary Bankruptcy

It is possible for three creditors to put an individual or corporation into an involuntary bankruptcy.39 The three creditors must have claims that are not contingent and not the subject of a bona-fide dispute.40 The bankruptcy court will enter an order for relief and start the bankruptcy process if the debtor is generally not paying its debts as they become due.41

The debtor can continue to operate the business, but creditors can ask the court to appoint a trustee to take control of the business.

The involuntary bankruptcy petition could be Chapter 7 or Chapter 11. In either case, however, the debtor or creditors can later ask to have the case converted to another chapter.42

Creditors may want to file an involuntary petition because the debtor is quickly losing money and creditors will be better off if all assets are immediately liquidated. Creditors may also want to file an involuntary bankruptcy if they think there is fraud in the company, gross mismanagement or if management is paying select creditors at the expense of others. Unpaid creditors may file an involuntary petition to establish the right and the timetable to require repayment of preferences.

For any individual creditor, an involuntary petition is often more valuable as a threat than action. Once the involuntary bankruptcy process begins, the creditor is not able to appropriate to itself the benefit of this action. All of the debtor’s creditors will be involved and all of the debtor’s assets must be equitably distributed pursuant to the Bankruptcy Code. All of the transaction costs and inefficiencies of any bankruptcy will exist and the eventual distribution to general unsecured creditors may be small. Petitioning creditors can recover the costs of filing a successful involuntary petition as an administrative expense. On the other hand, petitioning creditors may have to pay legal fees if they fail to prove that the debtor is legally bankrupt.43 Punitive damages are a possibility if the involuntary petition was filed in bad faith.

Foreign Bankruptcies and Creditors

The Bankruptcy Code generally adopts the Model Law on Cross-Border Insolvency from the United Nations Commission on International Trade Law. The objective is cooperation between courts of the United States and courts of other countries in cross-border insolvency cases; greater legal certainty for trade and investment; and fair and efficient administration of cross-border insolvencies.

The process starts with a foreign insolvency proceeding. A “foreign representative” may then request recognition of the foreign proceeding in a US Bankruptcy Court in a District where the debtor has its principal place of business or principal assets or where a judgment enforcement proceeding is pending.44 Once the foreign bankruptcy is recognized, the foreign representative can act for the debtor in the US Bankruptcy Court. The foreign representative has the automatic right to operate the debtor’s business as a “debtor in possession.”45 Several U.S. Bankruptcy Code provisions will apply, including the automatic stay provisions which will now apply to assets of the debtor in the United States.46 Creditors must be careful about violating the automatic stay as to foreign owned property in the United States.

Foreign creditors are now also entitled to non-discriminatory treatment in any US Bankruptcy with “the same rights regarding the commencement of, and participation in, a case under this title as domestic creditors.”47 They are entitled to the same notices given to creditors generally.47 They are entitled to the same notices given to creditors generally.48

CONSUMER AND INDIVIDUAL BANKRUPTCIES

Means Testing

Means Testing is designed to eliminate abuse by individual debtors by preventing individuals with high income from filing for a Chapter 7 discharge. The trustee or a creditor can request dismissal of a Chapter 7 case if the debtor’s income is above the median income in that geographic area and the debtor has “sufficient available net income.”49 There are complicated formulas to qualify a debtor, but a creditor can generally ask the court to dismiss a case if a debtor has available net income of at least $10,000 over a 5-year period for repayment of debts. If a debtor consents, the case can be converted to a Chapter 13, instead of dismissed, which has always required the debtor to repay a portion of debts over time.

These provisions may aide a commercial vendor that sells goods to an individual consumer or a creditor seeking to enforce a personal guarantee of a commercial account.

Credit Counseling

Individual debtors are also required to take mandatory credit counseling and education in order to obtain a bankruptcy discharge.50 This makes it more difficult generally for debtors to file bankruptcy and will hopefully avoid subsequent bankruptcies through education. A debtor must obtain credit counseling and perform a personal budget analysis from an approved non-profit budget and credit-counseling agency before filing a bankruptcy petition. In addition to pre-bankruptcy credit counseling, debtors must also complete a course on personal financial management in order to receive a discharge in Chapter 7 or Chapter 13. 51

Discharge every Eight (8) Years

There must be eight (8) years between discharges under Chapter 7 or Chapter 11.52 In Chapter 13, no discharge is available to a debtor that received a discharge in a Chapter 7, 11 or 12 Bankruptcy filed within 4 years prior to the current Chapter 13. A Chapter 13 debtor also cannot receive a discharge in a new Chapter 13 case filed within 2 years prior to the new Chapter 13 petition.53

Homestead Exemptions

Homestead Exemptions protect certain types of property of an individual debtor from creditors. Homestead Exemptions, created by state law, have generally been respected by the bankruptcy code. These exemptions vary from state to state. Florida, Iowa, Kansas, South Dakota, and Texas have unlimited Homestead Exemptions for a debtor’s personal residence. This has resulted in much abuse as debtors sliding into insolvency in any state would liquidate all available assets, move to a state with an unlimited homestead exemption and buy a mortgage free mansion. Once residence is established, the debtor would then file bankruptcy, discharge all debt, and still have an unlimited asset in the personal residence.

There are complicated provisions restricting abusive use of Homestead Exemptions. Homestead Exemptions are restricted, regardless of state law, to $125,000 if the debtor bought their residence less than 40 months before the bankruptcy filing.54 The Debtor also loses their exemption as to any property disposed of in the 10 years prior to the bankruptcy petition with the intent to hinder, delay or defraud a creditor.55 Assets protected from creditors in individual retirement accounts are also now generally limited to One Million Dollars.56

THE BANKRUPTCY FILING

Notice of Bankruptcy

When a debtor files bankruptcy, you should receive a “Notice of Bankruptcy” if you are a creditor. The Notice of Bankruptcy is sent by the bankruptcy court clerk to all creditors listed by the debtor in their bankruptcy petition. An example is shown at Appendix 33. The notice will state the name and address of the debtor that has filed bankruptcy and provide the name and address of the bankruptcy court. The notice will also identify the name and address of the debtor’s attorney, name and address of the bankruptcy trustee, and tell you whether the bankruptcy is a Chapter 7, Chapter 11, or some other type of bankruptcy.

Automatic Stay

The notice of bankruptcy will inform you:

Creditors may not take certain actions:

The filing of the bankruptcy case automatically stays certain collections and other actions against the debtor and the debtor’s property. If you attempt to collect a debt or take other action in violation of the Bankruptcy Code, you may be penalized.

This is the “automatic stay.” When a debtor files bankruptcy, creditors are automatically prohibited from taking action against the debtor or the debtor’s property. The bankruptcy case may later be dismissed if the debtor fails to comply with their bankruptcy obligations. Creditors may bring a motion to “lift the stay” or dismiss the bankruptcy on various grounds.57 Until the stay is lifted or the bankruptcy is dismissed, however, creditors are generally prohibited from harassing the debtor in any manner or taking affirmative steps to collect a debt.

Violating the automatic stay can result in severe penalties.58 Creditors are not permitted to call or write the debtor in an attempt to collect, may not file suit, and may not take any further action in any pending lawsuit. Creditors are also prohibited from taking any action against the debtor’s property, may not foreclose on any security interest, may not file a mortgage or judgment lien, may not repossess a vehicle, may not evict a tenant from real estate, and may not take rented equipment.

The automatic stay is an important part of Bankruptcy Code policy. This ends the “race to the courthouse.” Bankruptcy is intended to be an orderly process to liquidate or reorganize the debtor and this is impossible if creditors are allowed to aggressively pursue the debtor. Fairness between creditors is also an important objective and the debtor’s limited assets should not go to the creditor that is the most aggressive or the creditor that can afford the most attorneys’ fees. The automatic stay is often the very objective of a bankruptcy filing, if a creditor is about to foreclose on property or has just filed some other legal action. Debtors sometimes file bankruptcy just to temporarily stop some foreclosure action and will thereafter allow their case to be dismissed.

An important exception to the automatic stay is the right to file a mechanic’s lien in states with inchoate mechanic’s lien rights.59 In states with inchoate mechanic’s lien rights, contractors or suppliers had lien rights from the moment they supplied labor and materials to a property. Accordingly, filing a mechanic’s lien is not a preference and is not an affirmative action against the debtor or the debtor’s property. The mechanic’s lien only provides public notice of the lien that the creditor always had. Filing a lawsuit to enforce mechanic’s lien rights, however, is normally a violation of the automatic stay and requires a motion for relief of the stay.60

Secured creditors are stayed from moving against their collateral. Secured creditors retain their security rights in the collateral, but may not foreclose or repossess without filing a “motion for relief from the automatic stay” to obtain bankruptcy court permission.61

It is important to note that creditors are stayed only from taking action against the debtor in bankruptcy or against the property of the debtor in bankruptcy. Creditors often have rights against more than one debtor. If you have a contract with a husband and wife, and only the husband files bankruptcy, you may still take action against the wife. If a corporation files bankruptcy, but you have a personal guaranty from an officer, you may move against that personal guarantor. You may still enforce a payment bond claim, unless the bonding company happens to be in bankruptcy.

There are some limits on the automatic stay for “serial filers,” that is debtors that repeatedly file bankruptcy petitions. Most of these provisions concern consumer bankruptcies, but some are also applicable to commercial debtors. 62

Proof of Claim

The notice of bankruptcy will also provide a deadline for filing proofs of claim or instruct you not to file a proof of claim unless you receive further notice. It is very important to file your proof of claim before the deadline, because you have probably waived your claim otherwise.

A proof of claim is essentially a lawsuit against the debtor. Creditors are stayed from filing a lawsuit in other courts, but are permitted to make their claim against the debtor in the form of a bankruptcy proof of claim filed in the bankruptcy court. Creditors may also include any pre-petition and post-petition contract-based claims for attorney’s fees in their proof of claim.63

A proof of claim form is shown at Appendix 34. If a proof of claim is “allowed” the creditor is entitled to its pro rata share of any distribution from the bankruptcy estate (the big pot). Creditors have an important advantage in that their filed proof of claim is deemed accepted, unless the debtor, trustee or another creditor objects.64 The debtor has the burden of introducing evidence to disprove your claim. 65

Debtors usually do not have an incentive to object to any one particular claim, because all the debtor’s assets will normally be split amongst creditors. The debtor will not end up with any assets and usually doesn’t care how assets are distributed. Bankruptcy is often not a contest between the creditor and the debtor, but rather a contest between creditors. Another creditor or the trustee may file an objection to a proof of claim.66

On the proof of claim form at Appendix 34, creditors are asked whether they have ever received notices in this bankruptcy. As discussed below, creditors will receive bankruptcy notices only if the creditor was listed as a creditor in the bankruptcy petition schedule of liabilities. If you have never received bankruptcy notices, it is important to check this box on the proof of claim form in order to have your name added to the “matrix” mailing list for future notices. Similarly, the proof of claim form invites the creditor to list a new or different address for notices. A debtor will often list a creditor’s address the same as the address used to send payments. For large corporate creditors, this may be a lock box address or main headquarters address. If future notices are sent to this address, it may take awhile for these notices to be forwarded to the credit manager or other person making decisions for the creditor. Future notices could include a notice that the bankruptcy had been dismissed, an objection to a creditor’s proof of claim, or other important activities in the bankruptcy court. These deadlines are often very short and it is important to get notices to decision makers promptly.

Box One of the proof of claim form asks for the “basis of claim.” For construction contractors and suppliers, this will normally be either “goods sold” or “services provided” or both. The creditor is permitted to check more than one box.

Box Four of the proof of claim asks for the “amount of claim.” This should be the total amount of the debt to this creditor as of the day of the bankruptcy petition, including principal, interest and service charges. Creditors should identify the “date debt was incurred” in Box Two and must separately account for the interest portion of the claim.

In determining the amount of claim for the purposes of Box Four, creditors should keep in mind that all debt for labor and materials provided pre-petition should be included. This amount includes charges for labor and materials provided pre-petition that were not invoiced until post-petition.

The creditor should identify any “security” for the debt in Box Five of the proof of claim. This asks whether the creditor has security in the property of the debtor. For example, the debtor could have provided the creditor with security interest or UCC financing statement in an account receivable, equipment or real estate. This could also be a mechanic’s lien interest in the debtor’s property. This would be true if you were supplying labor or materials directly to the owner of the real estate and that owner filed bankruptcy.

If your debtor was not the owner of the real estate (your debtor was a contractor or subcontractor), however, your mechanic’s lien rights are not a security interest in the real property of the debtor. It may still be advisable to file a proof of claim as a secured creditor in this instance, however. Your mechanic’s lien rights in an owner’s property do give you priority over the receivable owed by the owner to your debtor. Your mechanic’s lien interest is in the real estate of the owner (and not the debtor), but this gives you an interest in the receivable owed by the owner to the debtor. This receivable is property of the debtor.67 It is not clear whether you are required to file a proof of claim as a secured creditor in this situation.

The status of trust fund rights is also questionable on a proof of claim. These rights can exist as a result of state trust fund statutes or as a result of a trust fund agreement. This is discussed in other chapters of this book.68 A trust fund claimant is probably not a “secured creditor” because they are not claiming a security interest in property of the debtor. This money is simply not property of the bankrupt debtor. The trust fund was always the property of the creditor, and the debtor was only a trustee. It is probably advisable to make note of a trust fund claim in Box Five on a proof of claim, however. An “equitable lien” claimant, however, is more likely an actual secured creditor in bankruptcy.69

Any secured creditor, trust fund or equitable lien claimant should engage counsel to file a proof of claim. It is tempting to view a proof of claim as simple and unimportant. If a creditor is owed a small amount of money and is satisfied with general unsecured creditor status, credit managers and other laypersons can usually file proofs of claim on their own. It is unlikely there will be a distribution in most bankruptcies anyway. A creditor that hopes to be paid in full should take care in a proof of claim, in order to avoid taking inconsistent positions. Counsel should generally file a proof of claim in any case involving a large amount of money, any type of secured claim, a trust fund or equitable lien claim, an administrative expense claim, or any claim to full payment because of assumption of a contract.

Box Six of the proof of claim inquires whether the creditor has “unsecured priority” status. This would almost never be applicable to a construction contractor or supplier and generally involves employees of the debtor or governmental units.

The bottom of the proof of claim form instructs the creditor to attach documents relevant to the proof of claim, including contracts, invoices, or evidence of a security interest. It is important to attach documents. This is an easy way to show evidence or further detail of your claim. Remember, the proof of claim is deemed accepted if the debtor does not object. This essentially gets all these documents “into evidence” in proving your claim. If you have a pending lawsuit against the debtor, it may be convenient to attach a copy of the lawsuit with exhibits. This is an easy way to provide detail on your claim.

The bottom of the proof of claim form also provides instructions if you want a “File Stamped Copy” of your proof of claim. This is always advisable, so that you have evidence in your file of the date of filing and contents of your proof of claim.

A creditor should make sure that all of its claims are included in the proof of claim, including all principal, interest and attorney’s fees. Proof of claim can later be amended or supplemented, however. Make sure you file something before the deadline expires, even if you are missing some information or documents. You may be able to add this additional information later.

Schedules

Soon after filing bankruptcy, the debtor is required to file a schedule of assets and liabilities, a schedule of current income and current expenditures, and a statement of the debtor’s financial affairs.70 These are collectively referred to as “schedules.” The debtor must file schedules along with its voluntary petition, unless the immediacy of the filing does not allow. In the event that debtor or debtor’s counsel must file the petition in a short amount of time, a list of the names and addresses of all the debtors’ creditors can be filed along with the voluntary petition. Such a filing is known as a “bare bones petition.” The filing of complete schedules within 15 days of filing the petition must follow a bare bones petition.71 Similarly in an involuntary case, the debtor must file its schedules within 15 days after the entry of the order for relief.72

Any creditor will want to review these schedules before attending the meeting of creditors, in order to better question the debtor at the meeting. On larger and more complicated bankruptcies, the debtor will often get an extension of time to file these schedules. Bankruptcies are sometimes dismissed if the debtor never files schedules.73

The schedules are essentially a complete financial statement of the debtor. The debtor is required to list all of its assets, secured creditors, unsecured creditors, income in the current year and past years.

The debtor is also supposed to list all creditors, the amount of the debt and whether the debt is “unliquidated,” “contingent” or “disputed.”74 The debtor lists secured creditors on a separate schedule. In a Chapter 11, if a creditor is listed and the debt is not scheduled as unliquidated, contingent or disputed, then the creditor is deemed to have an allowed claim in the amount listed, even if this creditor fails to file a proof of claim. If a creditor wishes to claim a higher dollar amount, wishes to claim secured status, or if the debt is listed as unliquidated, contingent or disputed, then the creditor must file a proof of claim. It is advisable for all creditors to file a proof of claim, however, especially if the court has issued a “Notice of Need to File Proof of Claim,” also known as a “bar date” order. In any event, all creditors must file a proof of claim in a Chapter 7 bankruptcy.

Reviewing the schedules is a good opportunity for a creditor to review the debtor’s complete financial picture. This will help decide whether the debtor has any chance of reorganizing successfully, whether there is any chance of a distribution for general unsecured creditors, or whether there will be sufficient cash flow to pay administrative claims for creditors doing business with the debtor postpetition.75 This information can be helpful to a creditor later, if the bankruptcy is dismissed for any reason. A creditor may wish to obtain a copy of the schedules for this reason.

If there is a chance of a good distribution, a creditor is more comfortable working within the bankruptcy process and not trying to assert equitable lien or administrative expense status. This will reduce legal fees for the creditor and the debtor, increasing the chances of a good distribution. If there is no chance of a distribution to general unsecured creditors, however, the creditor’s only chance for payment will be to establish mechanic’s lien, trust fund, equitable lien, administrative expense, or other priority status.

No Notice of Bankruptcy

What if you did not receive notice of the bankruptcy? This may be because the debtor used a bad address for you, or because of problems with the mail. It may also mean that the debtor did not list you as a creditor on the debtor’s schedule of assets and liabilities.

If you are not listed as a creditor on the debtor’s schedule of assets and liabilities, it will be necessary to file a proof of claim in the bankruptcy to share in any distribution to general unsecured creditors. A secured creditor, however, will not generally lose any rights in security property, even if they fail to file a proof of claim.76

A creditor that receives no notice of the bankruptcy will technically be unaffected by the bankruptcy. As a practical matter, however, this will rarely be helpful.

If a corporate debtor is liquidating in bankruptcy, the distribution to creditors in the bankruptcy will be the only chance to collect anything. After the bankruptcy, the corporate debtor will have no assets and will simply be out of business. In a Chapter 11 Reorganization, a creditor not on the schedules and not filing a proof of claim will not be included in the plan.77

If an individual files a Chapter 7 bankruptcy, an unlisted creditor that did not receive notice of the bankruptcy may technically be able to sue the debtor for the full amount of the debt after all other debts have been discharged and the bankruptcy is closed. If this was a “no assets” bankruptcy that resulted in no distribution, however, courts have allowed the debtor to reopen the bankruptcy later to add the unlisted creditor and obtain a discharge from that debt.78

The bottom line is that it is generally better for creditors to participate in the bankruptcy process and file a proof of claim, even if they were not originally listed as a creditor and did not receive notice of the bankruptcy.

THE BANKRUPTCY PROCESS

Getting on the Mail List

If you received notice of the bankruptcy, then you were listed as a creditor on the schedule of assets and liabilities. As a listed creditor, you are also entitled to notice of meeting of the creditors, notice of dismissal of the bankruptcy or notice of discharge.79 You will not, however, receive notice of many other proceedings in the bankruptcy, unless you file a Rule 2002 request for service of papers. This is shown at Appendix 35.

Once you file a request for service, you will receive copies of everything that occurs in the bankruptcy. This is both good news and bad news. You will be aware of everything in the bankruptcy that may help you or may hurt you. You will have an opportunity to object to anything you think may hurt your ability to collect.

Receiving notice of all proceedings, however, means that you will receive many notices, motions, objections, and other proceedings. Someone has to sift through all of this to determine whether any of it impacts you. This will mean legal fees if you have an attorney file a Notice of Appearance by Counsel and Request for Service of the Papers for you.

This will also mean a large volume of paper, which must be stored somewhere. Fortunately, most bankruptcy courts use electronic filing. This saves a lot of space and speeds the process, but someone still must review all notices to make sure your interests are protected.

Remember that bankruptcy is essentially the same as lawsuits filed at the same time by everyone doing business with the debtor. Everyone that has done business with the debtor is filing a proof of claim, filing motions to foreclose on security property or filing motions for payment of administrative expenses. The debtor must file a motion to hire a lawyer, pay any creditor, or to settle any claim. All of this means many notices and motions to review.

If you are satisfied to be a general unsecured creditor and do not expect a distribution, you probably do not want to file a Rule 2002 request for papers. Simply file your proof of claim and close your file. You will receive notice if there is any objection to your proof of claim.80 If you are owed a large sum of money, however, you will need to get counsel to keep track of the bankruptcy. You want to object if the debtor is engaging in diseconomic behavior, if secured or unsecured creditors are overreaching and generally to maximize the eventual distribution to general unsecured creditors. You will also want to watch whether the debtor assumes a contract with you or any upstream contractors on a project to which you supplied labor and materials.81 If you are claiming mechanic’s lien, trust fund or equitable lien rights, you must respond if any secured creditor is claiming an interest in the same funds.82

It is a common problem that creditors never receive notice of bankruptcy or that subsequent notices during the bankruptcy process are sent to a bad address. A creditor can send two communications to the debtor containing a current account number and creditor address for correspondence. If two such notices are sent to the debtor in the first 90 days of the bankruptcy, then the debtors are required to send further notices to the creditor at that address and include the account number.83

It is also possible for any creditor to file a notice of address with any bankruptcy court that then has to be used by any bankruptcy court in any chapter 7 or 13 bankruptcy.84 Most creditors should consider filing such a notice with their local bankruptcy court for all of their accounts to make sure that bankruptcy notices go to the proper credit managers of the creditor.

A monetary penalty for violation of the automatic stay cannot be charged against a creditor for actions taken before the creditor receives notice of the bankruptcy.

The Meeting of Creditors

The notice of bankruptcy you received probably also gave a date, time and location for the “meeting of creditors.” See Appendix 33 . What is this meeting of creditors? Do you need to go? Do you need to have an attorney attend for you? Generally, no decisions will be made at the meeting of creditors that will prejudice you. It is an opportunity, however, to ask the debtor questions and collect information.

The meeting of creditors normally takes place at the US Trustee’s office. There may be many meetings scheduled for many different bankruptcies at the same time. The debtor must attend. The U.S. Trustee will be present.

Any creditor has the opportunity to ask the debtor about assets and liabilities, transactions, or any possible fraudulent activity. A creditor can ask the trustee to compel the production of documents and other information.

The trustee operates something like a justice of the peace. The trustee will protect the debtor if necessary, but will also make sure that the debtor complies with all rules. It is the trustee’s job to protect the bankruptcy estate assets in order to maximize the distribution to the pool of general unsecured creditors. In other words, it may not matter whether you as an individual creditor have been hurt, but rather whether the pool of creditors as a group has been hurt.

The trustee will help creditors both at and after a meeting of creditors, but there must be a “complainant” or someone bringing problems to the trustee’s attention. If you are aware of assets that the debtor did not list on schedules, the trustee will almost certainly require the debtor to produce documents about these assets. If you think a debtor has committed a fraud, the trustee will probably also compel the debtor to produce information. The trustee could, for example, require the debtor to produce copies of tax returns or bank account statements.

Normally, there are limits to the time a trustee will expend in any one case. A Chapter 7 trustee is normally a private attorney paid a nominal flat fee and a percentage of money brought into an estate. Accordingly, it is normally difficult for a trustee to justify spending much time on the case. In a Chapter 11, the U.S. trustee is usually involved. They may not be so concerned about profitability, but are still trying to handle a large volume of cases.

You have the opportunity to ask the debtor questions about their business or financial matters. Meetings are usually recorded and transcripts can be ordered, but you will want to check on this in advance if it is important.

Whether you should go to a creditor’s meeting, or have counsel attend, depends on your interest in the bankruptcy. If you are a relatively small, general unsecured creditor, there is no reason you have to attend. Nothing can happen at the meeting that will impact your rights. On the other hand, if you are a larger creditor, this is a good opportunity to collect information. This is particularly important if you believe the debtor committed a fraud upon you or you have another objection to discharge. Your objection to discharge must be filed within 60 days after the meeting of creditors, so this may be your only opportunity to collect information.85

Objection to Discharge

A creditor generally must file any objection to a discharge from debts within 60 days after the meeting of creditors, although you should also check the notice of bankruptcy carefully for a different deadline for objection. See Appendix 33. There are generally two types of objections to discharge.

Discharge of a Specific Debt

A §523 objection generally involves fraud on one particular creditor, resulting in no discharge on that particular debt. This type of objection has great advantages for a creditor. The debtor will be discharged from all other debts. This one creditor can pursue the debtor after the bankruptcy is concluded. This creditor will have a better chance of collecting in full.

An individual debtor is not discharged from any debt for money, property, services, or credit obtained by:

a. False pretenses, a false representation or actual fraud (other than a statement concerning the debtor’s financial condition), or

b. The use of a statement in writing concerning the debtor’s financial condition that is materially false, that the debtor made with intent to deceive, and on which the creditor reasonably relied.86

Generally a debt is nondischargeable if the debtor obtained money though fraudulent statements, whether the statements were verbal or written. There is a special rule, however, for statement concerning “financial condition.” A debtor can make false verbal statements concerning its financial condition and still receive a discharge, but not false written statements.87 This is a reason for creditors to require written financial statements or credit applications regularly. A debtor can obtain a discharge if he falsely stated verbally that he is solvent and has plenty of money to pay the debt. The debtor could not obtain a discharge if he stated that he was licensed and bonded, if this is not true.

A creditor will have the same problems with a §523 objection that exist in any fraud case. The creditor must prove that the debtor intended to deceive, must prove that the creditor actually relied on the deception, and must prove that the fraud actually caused damage. Mere promises to pay, however stupid, are not fraudulent. The debtor did not intend to deceive. False statements made after materials are shipped are not fraud, because the creditor did not rely on these statements to extend credit. False statements made to someone else will rarely be fraud, because the creditor could not have relied on these statements. Proving that the debtor is bad generally, and made many false statements will not prove fraud unless the creditor can prove the debtor made a specific statement in order to deceive this specific creditor and that the creditor actually relied on that statement in extending credit. As discussed below, however, proving that a debtor is bad generally may be a §727 objection, resulting in denial of any discharge from all debts.

Section 523 objections also exist to deny a discharge for alimony, child support, student loan repayments, injuries caused when driving while intoxicated, certain taxes, or other governmental claims. These sorts of objections normally do not exist in a commercial context and are not the subject of this outline.

Discharge of the Debtor

A §727 objection means that the debtor is “generally bad,” should not be allowed to use the bankruptcy process at all and should not receive a discharge at all.

Section 727 Objections to discharge occur only in individual Chapter 7 cases and liquidating Chapter 11 bankruptcies. A corporation reorganizing under Chapter 11 cannot be denied a discharge under §727, rather, in a corporate Chapter 11 all debts of the corporation arising before the date of confirmation are discharged upon confirmation of the plan of reorganization.88 Thus, the Court can deny a corporate debtor under Chapter 11 a discharge by refusing to confirm a plan of reorganization that is not offered in good faith. Corporations cannot obtain a discharge in Chapter 7, so there is no need to object. Individuals can obtain a discharge in Chapter 13 from debts that would not be dischargeable in Chapter 7. Individuals in a Chapter 13 are required to make payments under a three-year plan that may be extended for cause for up to five years.89

Any creditor or the U.S. Trustee can file a §727 objection if the debtor:

1. Has received a bankruptcy discharge in the last six years
2. Has transferred, removed, destroyed, mutilated or concealed property in the last year
3. Has concealed, destroyed, mutilated, falsified, or failed to keep books, documents, records, or papers concerning financial conditions or business transactions
4. Has dealt improperly with the court, including making a false oath on an account, presenting a false claim or withholding books, documents or other records relating to the debtor’s property or financial affairs, or failed to obey orders of the court

If the court denies the debtor a discharge under §727, the debtor cannot obtain a discharge at all from any debt. Once the bankruptcy has been dismissed, all creditors will be able to pursue the debtor for collection. The problem is that an objecting creditor cannot appropriate all benefit to itself. All creditors will be able to pursue the debtor. The debtor’s liabilities probably exceed their assets, or the debtor would not have filed bankruptcy to start with. Any individual creditor will have difficulty collecting. Also, the types of debtors that engage in bad behavior resulting in discharge denial are usually willing to engage in more bad behavior and make it even harder to collect. Still, a creditor may want to pursue a §727 objection to gain some satisfaction or to help police abuse of the bankruptcy process.

Objection to Exemptions

Similarly, a creditor must object within 30 days after the conclusion of the meeting of creditors to any exemption the debtor has claimed on any property. Exemptions involve only individual debtors and generally do not concern commercial creditors such as construction material suppliers. Exemptions could be an issue, however, when dealing with a sole proprietorship or when attempting to collect on a personal guarantee.

This outline will not deal in any depth with exemptions. Generally, however, an individual debtor can “exempt” certain property from the bankruptcy estate. Exempt property is not available for distribution to creditors.

The debtor may exempt property that is exempt under federal or state or local law, if the debtor was domiciled in the state or locality for 180 days immediately preceding the bankruptcy petition. Some states, such as Florida, allow the exemption of the debtor’s principal residence, no matter what the value. This results in some abuse, with some debtors moving to Florida, putting all of their available assets into the acquisition of a valuable personal residence, waiting 180 days and then filing bankruptcy.90

In any state a debtor can exempt certain property from the reach of the bankruptcy trustee and its creditors. The Bankruptcy code has set up standard Federal exemptions as shown below. In addition, state legislatures have the opportunity to opt out of the Federal exemption scheme in favor of their own.91 This has caused most states, including Virginia, to opt out of the Federal exemption scheme, while some have chosen to adopt the Federal exemptions. Still others allow debtors to choose from the state or Federal exemption scheme. As a result, great diversity exists in the assets a debtor can protect in different states.

In any state, a debtor can exempt property held as tenants by the entirety or joint tenants, if the property would have been exempt from the debts of the debtor under state law.

In states following the Federal exemption scheme the debtor may also exempt:

1. Up to $16,150.00 in a residence
2. Up to $2,575.00 in a motor vehicle
3. Up to $8,625.00 in household furnishings, household goods, wearing apparel and other items for personal or household use
4. Up to $1,075.00 in jewelry
5. Up to $1,625.00 in professional books or tools used in the debtor’s trade
6. Life insurance contracts
7. Social Security benefits, unemployment benefits, veteran’s benefits, disability benefits, alimony or support payments “to the extent reasonable necessary”, and certain pension, profit sharing, annuity or other plans
8. Payments received because of certain life insurance contracts, personal injury awards, or wrongful death awards92

The Creditors’ Committee

Very early in many Chapter 11 bankruptcies, a “creditors’ committee” will be chosen. It is the committee’s job to watch out for the best interests of the bankruptcy estate and the pool of unsecured creditors generally. The committee tries to maximize the eventual distribution to general unsecured creditors by keeping an eye on the debtor, the operation of the debtor’s business and assets, making sure secured creditors do not over reach or claim too many assets, watching the bankruptcy process generally and making sure the debtor does not waste assets. The committee will also prosecute preference actions against other creditors, try to collect the debtor’s receivables and other assets, collect on loans to principals or other “insider” transactions.

The committee’s work is extremely important and someone must do it. It is, however, very much like being president of your local homeowner’s association. While it is very important and you will benefit as a homeowner, it involves a lot of thankless work that will benefit a large group of people.

If you are one of the largest general unsecured creditors, it is very important to participate. The committee will have more influence than any one creditor over the conduct of the debtor and the bankruptcy process. The committee will normally hire an attorney to represent all of the general unsecured creditors. This is an expense of the bankruptcy estate. The bankruptcy estate essentially hires an attorney at its expense to protect your interest. If you are one of the largest unsecured creditors and expect a large percentage of any distribution you should participate on the creditors’ committee.

Creditors’ committees are not always appointed. In Chapter 11 cases a creditor’s committee can be formed soon after the bankruptcy petition and order for relief.93 A Chapter 11 Creditors’ Committee ordinarily consists of willing participants that hold the largest claims against the Debtor.94

In a Chapter 7 liquidation, creditors may elect a creditors’ committee at the Section 341 Meeting of Creditors. Normally, there is no creditor’s committee in a Chapter 7, however. A Chapter 7 Committee may be not have fewer than three and not more than 11 creditors.95

The Chapter 11 Creditors’ committee is chosen by the U.S. Trustee’s office. The debtor must file a list of its twenty largest unsecured creditors with the bankruptcy petition. The U.S. Trustee will mail or fax acceptances to some or all of the twenty largest unsecured creditors, asking whether they are willing to participate. These acceptances should be returned promptly if you wish to be on the creditors’ committee.

You must be a general unsecured creditor in order to be on the committee. A creditor claiming a security interest in property, trust fund or equitable lien rights, or mechanic’s lien rights probably will not qualify. Secured creditors have a conflict of interest with the creditors’ committee.

The United States Trustee has the sole power to appoint members of the creditors’ committee in Chapter 11 reorganization. This would normally happen very quickly, because the U.S. Trustee wants a creditors committee in place to help manage the bankruptcy. Creditors’ committee members are normally limited to the largest general unsecured creditors.

The court does have the power to change the membership of the creditors’ committee on request, if the court determines that the change is necessary to ensure adequate representation of creditors.96

The court can also add a creditor that is a small business concern, if the creditor’s claim is “disproportionately large” in comparison to the annual gross revenue of that creditor. This allows a small creditor to get on the creditor’s committee if the bankruptcy will have a large financial impact on that creditor.

Creditors’ committees have responsibility to provide information to creditors not on the committee. Committee must provide access to information and must solicit and receive comments from general unsecured creditors not on the committee.

The Trustee

The United States Trustee is a full time employee of the United States Government. The U.S. Trustee has an important role in every bankruptcy, making sure that all cases are administered fairly and efficiently. The U.S. Trustee may raise any issue in any bankruptcy case.97

In a Chapter 7 bankruptcy, a case specific “Chapter 7 Trustee” will also be appointed. A Chapter 7 Trustee or a Chapter 11 Trustee is normally an experienced private attorney appointed to a trustee panel by the bankruptcy court. The U.S. Trustee will appoint the Chapter 7 Trustee from the panel, but will still oversee the activities of the Chapter 7 Trustee. If no other case specific trustee is appointed, the U.S. Trustee is allowed to fulfill all trustee duties, but this is unusual.98

In a Chapter 11 reorganization, by definition, the debtor’s objective is to continue in business. There are obvious efficiencies in allowing the debtor to continue to run his or her own business. Normally, a Chapter 11 debtor continues to possess and operate the business as a “debtor in possession.” A debtor in possession has all the rights and duties of the trustee.99 At any time, however, the U.S. Trustee, a creditor, or any other party in interest can request the appointment of a Chapter 11 Trustee to take over control of the business from the debtor in possession.100 The bankruptcy court shall order the appointment of a Chapter 11 Trustee for cause, including fraud, dishonesty, incompetence, or gross mismanagement, or if the appointment of a trustee is in the interest of creditors, shareholders and other interests of the estate.101 The court could also leave the debtor in possession in place, but appoint an Examiner to investigate the past or present management of the estate.

The trustee in any case is the representative of the estate.102 This is similar to the role of the executor under a last will and testament when someone passes away. The executor under a will is the person that died for all purposes until the estate is closed. The executor collects all money due to the decedent, tries to pay all creditors to the extent possible, and distributes anything left over the beneficiaries. Similarly, the bankruptcy trustee has the capacity to sue and be sued on behalf of the bankruptcy estate.103 The trustee can run the business of the bankrupt debtor103 The trustee can run the business of the bankrupt debtor104 and hire attorneys, accounts, appraisers, and other professionals to assist.105

A trustee is almost always appointed in Chapter 7 liquidation. Promptly after a bankruptcy filing, the United States Trustee will appoint an interim trustee.106 A permanent Chapter 7 Trustee can be elected by the creditors at the §341 meeting of creditors, but this procedure is rarely employed.107 Normally, the interim trustee becomes the permanent Chapter 7 Trustee, assuming there is no conflict of interest and no election takes place at the meeting of creditors.108

The bankruptcy court can authorize the Chapter 7 Trustee to operate the business of the debtor for a limited period if this is in the best interest of the estate and consistent with the orderly liquidation of the estate.109 In any event, the Chapter 7 Trustee is required to:

1. Collect and liquidate all property of the estate
2. Close the estate expeditiously
3. Be accountable for all property received
4. Investigate the financial affairs of the debtor
5. If a purpose would be served, examine creditor proofs of claim and object to improper claims
6. If advisable, oppose the discharge of the debtor
7. Furnish information about the estate to any creditor or other party in interest
8. File periodic reports on the operation of the debtor’s business, if the trustee is operating the business, including a statement of receipts and disbursements
9. Make a final report and file a final account of the administration of the estate110

The duties of the Chapter 11 Trustee (or debtor in possession) are to:

1. Be accountable for all property received
2. If a purpose would be served, examine creditor proofs of claim and object to improper claims
3. Furnish information about the estate to any creditor or other party in interest
4. File periodic reports on the operation of the debtors business, including a statement of receipts and disbursements
5. Make a final report and file a final account of the administration of the estate
6. File any required tax returns
7. As soon as practicable file a reorganization plan, report why a plan will not be filed, or recommend conversion of the case to a Chapter 7 or a dismissal
8. After confirmation of a plan, file reports as necessary

Either the Chapter 11 Trustee or the debtor in possession has all of the duties above. If a trustee replaces the debtor in possession, that Chapter 11 Trustee also must:

1. File a list of creditors, a schedule of assets and liabilities, a schedule of current income and expenditures and a statement of the debtor’s financial affairs, (if the debtor has not already done so)
2. Investigate the acts, conduct, assets, liabilities, and financial condition of the debtor; the operation’s of the debtor and the desirability of the continuance of such business, and then file a report on any such investigation111

The trustee or debtor in possession is authorized to operate the business of the bankrupt and may enter into transactions in the ordinary course of business without any court hearing.112 This includes the right to incur and pay postpetition debts in the ordinary course of business without prior approval of the bankruptcy court.113

DOING BUSINESS WITH THE DEBTOR IN BANKRUPTCY

Can You Be Forced to Do Business with the Debtor?

You cannot be forced to enter into a new contract with a debtor in bankruptcy. If you have completed all existing contracts with the debtor, you are free to simply decide you do not want to do any further business with the debtor.

If you are a true open account supplier, you are also free to discontinue doing business. If you have no set contract, proposal, or quote with a specific quantity or duration, the debtor is not obligated to buy material from you. The debtor is free to call any of your competitors for material on any given day. You also had no obligation to supply material on any given day. Each time the debtor telephoned or appeared at your office, this constituted a new separate contract for the purchase of materials. If you are such an open account supplier, you are free to decide at any time that you do not wish to enter into any new contracts with the debtor or supply any additional materials, whether or not the debtor is in bankruptcy.114

On the other hand, you could have a set contract with the debtor to supply a certain amount of materials over a certain period of time. Perhaps you sent a proposal to the debtor to supply all of the material necessary for a certain construction project. Similarly, you may have agreed to supply all the material the debtor needed for this entire year at set prices. If the debtor accepted this proposal or quote, you are no longer an open account supplier. Whether the debtor is in bankruptcy or not, you have an obligation to supply the materials described in your contract until the contract has expired. This is an “executory contract,” discussed further below.115

An equipment supplier can also be on an open account basis and free to demand the return of equipment at any time. The same equipment vendor, however, might have entered into a one-month or one-year lease on the equipment. The equipment vendor in this case cannot demand return of the equipment, unless the d