Bankruptcy Basics

There are two kinds of bankruptcy:  liquidation and reorganization.  Chapter 7 governs the liquidation of all debtors.  Chapters 9, 11, 12, and 13 provide for reorganization of different types of debtors – municipalities, companies, farmers, and individuals.
  
Liquidation is straightforward.  A trustee is appointed to investigate the debtor’s assets, liquidate nonexempt assets, and distribute the proceeds to creditors.
 
Reorganization is more complicated.  In a reorganization case, the debtor has the right to enter into transactions and operate its business in the ordinary course, without specific permission of the court, pending confirmation of a “plan” by which it exits bankruptcy.

Dealing with a debtor in a reorganization case has its risks.  Generally, if credit terms are extended to the debtor and the debtor defaults, the creditor then must file a proof of an administrative claim and wait to be paid.  Such claims are paid on a priority basis ahead of unsecured creditors. There are many examples of insolvent bankruptcy estates where post-petition creditors walked away disappointed.
 
Once a bankruptcy proceeding is commenced an “automatic stay” goes into effect, and with limited exceptions, no actions may be taken to collect debts or enforce liens against the debtor or the debtor’s property.  The stay is effective even if a creditor has not received notice of the stay, and creditors may be liable to the debtor for willful violations of the stay.
 
In certain circumstances, the stay can be lifted.  A common feature of bankruptcy procedure is a secured creditor’s motion for “relief from stay.”  With respect to specific collateral, if the debtor has no equity in that property, and if the property is “not necessary to any effective reorganization,” then a secured creditor may obtain relief from the stay and thus be allowed to foreclose his security interest or mortgage lien.

Fundamental to bankruptcy law is the notion that all creditors of the same class are to be treated equally.  At the end of the day, the pool of money available for distribution to unsecured creditors is to be divided ratably among them, with each receiving the same percentage of recovery on its claim.  Obviously, that scheme would be upended if the debtor could pay some of its unsecured creditors just before bankruptcy, leaving the others to share the diminished pot.
 
Accordingly, the Bankruptcy Code allows the debtor (or trustee) to “avoid” and recover “preferential” pre-bankruptcy payments that were made within 90 days before the case was filed.  There is no penalty for receiving a “preferential” payment, other than the possibility that you might have to give it back.  Thus, it is almost always best to take a payment and worry about preference liability later. There are important protections that may allow creditors to escape the preference net.  Generally, if a payment received by a creditor is a “contemporaneous exchange for new value,” or constitutes a payment of a debt “in the ordinary course of business” and is made “according to ordinary business terms,” then it cannot be avoided.  The underlying policy here is to protect creditors who continue to furnish new goods and services to the debtor, and who get their invoices paid on time, even though the debtor is in financial distress.
 
With some exceptions, a proof of claim must be filed in a bankruptcy case to preserve a creditor’s right to receive a distribution.  We usually recommend filing a proof of claim in all cases, even when not technically required.  Note, however, that upon filing a proof a claim, a claimant is deemed to have irrevocably submitted itself to the jurisdiction of the bankruptcy court for all matters related to the claim, including, for example, the debtor’s counterclaims or claims seeking recovery of preferential payments.
 
The debtor may assume, assume and assign, or reject leases and other executory contracts.  Assumption is conditioned on the cure of all defaults.  Rejection constitutes a breach of contract entitling the lessor to a pre-petition damage claim.  A lessor is generally entitled to rent while the bankruptcy is pending.  A contract provision prohibiting assignment without consent is generally unenforceable, except when “otherwise applicable nonbankruptcy law” prohibits assignment without the counterparty’s consent. Thus, “personal services” contracts cannot be assigned without consent.  Some courts have held that franchise agreements cannot be assigned without consent of the franchisor.  Moreover, some courts, including those in the 9th Circuit (which includes the West Coast), hold that where a contract cannot be assigned to a third party under the foregoing principles, it cannot even be assumed by the debtor as part of a reorganization.  That gives a franchisor virtual “veto power” over its franchisee’s reorganization.

In bankruptcy reorganizations, the debtor exits bankruptcy pursuant to a “plan.”  In effect, the plan is a binding contract between the debtor and its creditors for repayment of the debts included in the Plan. The plan allows the debtor to restructure its debts, reducing the debt principal and paying it over time. Creditors are classified in order of priority, with secured creditors separately classified according to their collateral.  Claims are paid in order of priority and must receive payments with a present value at least as much as they would receive in a Chapter 7 liquidation.  Claim priorities are set by the bankruptcy code.  Claims for expenses incurred during the bankruptcy, certain taxes, wages, employee benefits, and others have priority over general unsecured claims.

The goal of most bankruptcies is the discharge of all or part of pre-bankruptcy debts.  Individuals may obtain a discharge under any chapter.  Corporations and partnerships can receive a discharge only in Chapter 11 and 12 – not 7.  Discharge does not affect liens and security interests.  Only a secured creditor’s right to recover a deficiency judgment against the debtor is discharged.

Certain debts of the debtor may not be dischargeable.  These include most taxes, alimony and child support, educational loans, and debts incurred through actual fraud, false financial statements, embezzlement, willful and malicious injury, or conversion– except that some debts for intentional torts may be discharged by individuals in Chapter 13.