While wishing our clients and friends a happy new year, we begin this new calendar year with a refresher on some bankruptcy basics.
Insolvency may generally be defined in two ways: (A) the inability to pay debts as they become due; and (B) a financial condition in which liabilities exceed assets.
Under either definition, an individual or entity may seek relief designed to provide a “fresh start.” When considering such relief, many immediately think of the remedies available under the United States Bankruptcy Code, a federal statute. However, additional remedies exist under state law and through informal, non-judicial means.
As we finish one year and start another, we know our clients are looking at situations requiring the attention of insolvency professionals who look to appropriate remedies and frequently look to federal law, but that is not the only source of guidance.
We have addressed insolvency remedies in previous client alerts: “Using Insolvency Tools While Facing Economic Challenges”; “Important Business Bankruptcy Law Amendments for Small Business”.
What follows is a skeletal overview of the principal options that individuals and entities—including businesses and municipalities—may consider when facing insolvency.
Under federal law, the Bankruptcy Code provides several chapters addressing reorganization and liquidation. Chapter 7 governs liquidation and is available to both individuals and businesses. In a Chapter 7 bankruptcy case, a trustee is appointed to liquidate the debtor’s estate and is responsible for searching for, and monetizing, any assets of the estate for the repayment of creditors.
Chapter 11 primarily addresses reorganization and is likewise available to individuals and businesses. In recent decades, Chapter 11 has also been widely used to effectuate liquidations, particularly through asset sales.
In a traditional Chapter 11 reorganization, a debtor formulates a plan setting forth how the debtor will emerge from bankruptcy, addressing how it will keep the business alive and repay creditors over time. Creditors whose rights are affected may vote on the plan, and the plan may be confirmed by the Court. However, many chapter 11 cases utilize section 363 for a sale of assets rather than a true we are organization of the business.
Likewise, under Chapter 13, an individual debtor with regular income, may propose a repayment plan to make installments to creditors over three to five years. A Chapter 13 debtor’s unsecured debts must be less than $526,700 and secured debts must be less than $1,580,125 as of the date of the filing for bankruptcy relief in order to be eligible. 11 U.S.C. § 109(e).
Other chapters address more specialized forms of insolvency, including Chapter 9 for municipalities, Subchapter V of Chapter 11 for small businesses, and Chapter 12 for family farmers and family fishing operations. These chapters are specific for certain types of debtors and specific criteria must be met prior to being afforded its relief.
Critical to deciding which form one might choose to address insolvency issues is that Federal bankruptcy law also provides tools that may not be available under state law or informal arrangements. These include, among others, the automatic stay, the ability to avoid and recover preferential transfers, and the rejection of executory contracts.
The automatic stay provides for a pause in any action or proceeding against the debtor or the commencement of any action or proceeding against the debtor after the bankruptcy filing. See 11 U.S.C. § 362. Therefore, the automatic stay gives the debtor relief from any collection efforts or lawsuits allowing it to deal with its insolvency issues.
The ability to avoid or recover preferential transfers allows the debtor, or the trustee in a case in which a trustee is appointed, to pursue transfers which were made to favored creditors or those TRANSFERS that are fraudulent prior to the bankruptcy filing. We recently discussed this topic in our prior client alert “Avoidable Transfers in Bankruptcy Law: Extending a Deadline Can Be Justified”.
Additionally, a debtor, or a trustee, may reject an executory contract of the debtor. See 11 U.S.C. 365. An executory contract is one where both parties to the contract still have significant obligations to perform. Examples of an executory contract are real estate leases or car leases. By rejecting the contract, it constitutes as a breach of the contract and eliminates any future obligation of the debtor. Although rejecting the contract eliminates any future obligation of the debtor, the other party to the contract gains an unsecured claim for damages from the breach.
Under state law, other remedies exist, including assignments for the benefit of creditors and state court receiverships. The basic concepts are parallel to those in federal law.
An assignment for the benefit of creditors (“ABC”) is a process similar to Chapter 7 relief, where a third-party, i.e. an assignee, is responsible for liquidating or distributing the assets of the distressed entity to pay off debts to creditors.
Similarly, state court receiverships involve appointing a court-appointed receiver who takes control of the assets of the distressed entity and preserves and protects them. However, unlike Chapter 7, these remedies provide the ability to select who will perform the “trustee” role, which is considered an advantage of these state court options. It should be noted that these processes are subject to applicable state law and vary by state.
Out-of-court options, not subject to statutory restraints, are also available to those facing insolvency. Such options are voluntary, out-of-court workouts, or liquidations. These remedies often include forbearance agreements between creditors and debtors, whereby a creditor will forgo its legal remedies upon a default for a certain period of time while the debtor promises to perform specific obligations pursuant to agreed-upon terms, such as continuing to make monthly interest payments.
We have used trust mortgages over the years to successfully resolve insolvency issues efficiently with lower cost, and faster returns. the trust mortgage works if all creditors agree. it parallels the provisions of the bankruptcy code and it’s key to success is transparency. we will write more about this process in a separate client alert in the future.
As discussed, there are various federal and state court remedies, along with non-judicial remedies, when facing insolvency. Deciding which remedy is best situated for you is fact specific and should be made with the guidance of counsel.
Please note this is a general overview of developments in the law and does not constitute legal advice. Nothing herein creates an attorney-client relationship between the sender and the recipient. If you have any questions regarding the provisions discussed above, or any other aspect of bankruptcy law, please contact Michael H. Traison, Esq. (mtraison@cullenllp.com) at 312.860.4230 or Kelly McNamee, Esq. (kmcnamee@cullenllp.com) at 516.296.9166.