More and more individuals and corporations are filing for relief under the U.S. Bankruptcy Code- or so the media reports indicate. Lenders and suppliers of goods and services on credit may not be aware of their rights in bankruptcy proceedings. This brief summary of bankruptcy and its definitions should help you take a more active role with legal counsel to best establish and collect your claim in a bankruptcy estate.
Types of Bankruptcy Relief
The U.S. Bankruptcy Code became effective October 1, 1979. Within it are various "chapters" under which firms or individuals may file. For example, those applying for liquidation, commonly thought of as "bankruptcy," file under Chapter 7. In contrast, individuals with a regular income and noncontingent, liquidated debt of less than $250,000 and secured debt of less than $750,000 rule under a Chapter 13 debt adjustment. Family farmers, defined as those engaged in farming with more than 80% of their income derived from farming operations, may file under Chapter 12 for a reorganization. Chapter 11, perhaps the category with the most notoriety, is for large, complex corporate debt restructuring.
Any creditor, secured or otherwise, faced with a customer filing under any of these bankruptcy chapters is immediately confronted with a number of decisions. The issues vary widely on a case-by-case basis and are dictated not only by the type of collateral held but certainly the chapter under which the debtor has filed.
The following factors should be addressed in a bankruptcy proceeding.
Automatic Stay
Filing for relief under any chapter of the bankruptcy code immediately initiates an automatic stay being issued by the bankruptcy court prohibiting virtually any action by a creditor against the bankruptcy debtor, its property or estate. In other words, foreclosures, garnishments, levies and litigation all grind to an immediate halt upon the filing of the bankruptcy and issuance of the automatic stay. The automatic stay remains in effect until the creditor has taken affirmative action to have the stay lifted or until the case is closed, dismissed or a discharge granted.
It is almost never in the best interest of a secured creditor to wait for the case to be closed. Rather, immediate action to regain control of its collateral is the lender's best course.
Cash Collateral
A secured creditor involved in a Chapter 11 proceeding may be faced with the question of the debtor continuing to use "cash collateral" to finance ongoing operations. Cash collateral includes the use of cash, deposits, instruments or even proceeds, rents, products or offspring of property subject to a security interest.
The debtor may not use cash collateral to fund the Chapter 11 proceedings without the written consent of the secured creditor (preferably approved by the court) or order of the bankruptcy court that the secured creditor is adequately protected. A secured creditor in such a position must be vigilant to insure that the debtor's use of the cash collateral does not impair or deteriorate its loan to collateral ratio.
Adequate Protection
Adequate protection is a concept that implies the secured creditor's position will not worsen during bankruptcy proceedings. A secured creditor may prohibited from relief under the automatic stay and an ultimate seizure or foreclosure so long as it collateral position is adequately protected.
Types of adequate protection commonly offered to a secured creditor include an equity cushion of value over the loan amount, a replacement lien, or periodic payments, the amount of which is either the subject of negotiation or the decision of the bankruptcy court. Once again, a secured creditor must guard to insure that throughout the bankruptcy proceeding it receives or retains sufficient funds or collateral so that its collateral position does not deteriorate.
Trustees Avoiding Powers
The bankruptcy code is premised on the concept that creditors of the same class should be treated equally. To employ this premise, a trustee in bankruptcy is granted certain powers, including:
- Preferences- The trustee is allowed to set aside and recover certain preferential transfers, including payments or conveyances by the debtor within 90 days prior to the filing for bankruptcy, which is made on behalf or to the benefit of the creditor. This transfer must enable the creditor to receive more than the other creditors in its class. The look-back period for insiders, such as relatives or business partners, is extended to one year. There are a number of defenses and exceptions to the trustee's action for voidance of preferences. Suffice it to say, all creditors in receiving prepetition transfers from a debtor should be aware of this potential litigation.
- Fradulent Transfers - A trustee may attack any prepetition transfer made within one year of bankruptcy if the debtor received less than reasonably equivalent value or otherwise intended to defraud creditors. Return of collateral and even foreclosures, have been held to be fradulent transfers subject to avoidance by the trustee if the debtor was not provided with reasonably equivalent value. The premise of this power is to insure a debtor does not transfer property to the detriment of creditors just prior to bankruptcy. However, secured creditors must be mindful actions that may be injurious to junior or unsecured creditors will be subject to the scrutiny of the trustee in bankruptcy.
Abandonment
Property may be removed from the estate and from the trustee's administration if it is abandoned. Property is normally abandoned if it is subject to a valid and perfected security interest or otherwise exempt property of the debtor and provides no equity for the trustee. Even property subject to administration by the trustee that is of inconsequential value may be abandoned. Secured creditors should be aware they may petition the court to force an abandonment by the trustee.
Sales Free and Clear of Liens
The trustee in bankruptcy may, under certain circumstances, sell secured property of the estate free and clear of liens. This will normally take place only if equity is generated over and above the secured lien and for the benefit of the unsecured creditors.
An important right of the secured creditor is that the trustee may only take such action upon notice and opportunity for hearing and objection by the lienholder. No sale of collateral may take place unless the secured creditor consents or is adequately protected.
Any secured creditor faced with a trustee's notice to sell its collateral free andclear of liens must be very careful to insure its right in the collateral and the sale proceeds remain in place including interest accruing at the contract rate together with all costs of collection and attorney fees.
Conclusion
Bankruptcy is becoming a fact of life in American business. All creditors and businesses from time to time will be faced with the prospect of a customer filing for relief under the U.S. Bankruptcy Code.
The law seems to indicate that the creditor who most zealously protects its rights in the bankruptcy proceeding will be rewarded for its efforts. It is not sufficient to simply assume collateral will remain in place regardless of the bankruptcy proceeding. Secured creditors interested in minimizing their losses must take action when faced with a bankruptcy to actively participate in the liquidation or reorganization process.
This article was written by Kevin Checkett & originally was published by Baird, Kurtz and Dobson, certified public accountants, for its financial institution newsletter, "Financial Alert."
