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Bankruptcy – A Teaching Note

A federal statute called the Bankruptcy Code has been established to alter the legal rights and remedies of debtors and creditors when a debtor’s affair have deteriorated to the point that the normal rules no longer work effectively. The bankruptcy law frees the debtor from law suits, absolves the debtor of past due obligations and gives the debtor a fresh start. The Code allows an opportunity for businesses to restructure and possibly enhance the value for its creditors and possibly maintain employment that would otherwise be lost. Reorganization under the Code may provide the opportunity for an enterprise to get a fresh start and allow creditors to possibly benefit from the enhanced value of a going enterprise rather than accepting a pro rata share of a closed business.

Bankruptcy is not the only remedy to financial woes. Debtors may stall creditors until financial conditions improve or may, with the consent of creditors, restructure loans as an alternative to expensive bankruptcy proceedings.

Bankruptcy starts when someone, debtor or creditor, decides to use the bankruptcy law and the courts to resolve a deteriorating financial situation.

Bankruptcy gets its authority from the U. S. Constitution which empowers Congress “to establish . . . uniform laws on the subject of bankruptcies throughout the United States”. The first such law, the Bankruptcy Act of 1898, stood until the Bankruptcy Reform Act of 1978 was passed by the Congress repealing the original law. Several amendments to the Code have since been made. The bankruptcy act has eight substantive chapters:

Chapter 1 gives general definitions and provisions.

Chapter 3 deals with case administration

Chapter 5 deals with creditors, the debtor, and the estate

Chapter 7 deals with liquidation

Chapter 9 deals with the modification of debts of a municipality

Chapter 11 deals with reorganization (businesses, individuals and railroads)

Chapter 12 deals with adjustments of debts of a family farm or with regular annual income

Chapter 13 deals with adjustment of debts of an individual with regular income

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A debtor can file for bankruptcy but the debtor must pay the filing fee which can amount to $800 to $1000. If the debtor cannot pay the filing fee, the debtor cannot file bankruptcy. Creditors can start bankruptcy by:

Three or more creditors whose aggregate claims amount to more than $10,775 over the value of any assets securing those claims; or

One or more such creditors if there are less than 12 claim holders;

Fewer than all the general partners in a limited partnership; or

A foreign representative of the estate in a foreign proceeding concerning such person

A creditor need not prove that the debtor has insufficient assets to pay the debt. Failure to pay debts on time is sufficient for creditors to seek involuntary bankruptcy. However, creditors must prove that the debtor has not paid debts on time or the creditor may risk the assessment of damages if the creditor files in bad faith.

The most common bankruptcy proceeding are under Chapter 7 (liquidation), Chapter 11 (reorganization) and Chapter 13 (adjustment of an individual’s debts). While proceedings can move swiftly, it is not uncommon for bankruptcy to take many months or years to conclude. The expense can be very significant.

In Chapter 7 bankruptcy a trustee is appointed to do the following:

Reduce the debtor’s property to cash and close up the proceeding as soon as possible

Account for all of the property received

Investigate the financial affairs of the debtor and examine all claims for validity

Provide information about the estate to any interested party, furnish reports on the debtor’s business if it is authorized to be operated, and file a final report of the disposition of the estate with the court

Chapter 11 bankruptcy will be chosen by debtors and creditors if they believe that the business has more value as a going concern than if it were liquidated. The objective of this form of bankruptcy is to develop a plan that determines what each creditor will be paid and in what form the business will continue. In Chapter 11 bankruptcy, the debtor keeps possession of the assets and may operate the business unless it can be shown that the debtor is guilty of fraud, dishonesty, incompetence, or gross mismanagement or if it can be shown that such an arrangement is not in the best interests of the creditors (in which case the court appoints a trustee – not usually done). Whether the debtor in possession is running the business or a trustee is appointed, the duties are that of a trustee. The business can be run in the ordinary course without prior court approval. There are time limits for the debtor in possession to file a plan of reorganization and obtain approval of creditors. After the expiration of this time limit, creditors can file reorganization plans. The plan or reorganization designates classes of creditors (such as secured and unsecured) and tells how each is to be treated. The plan can also call for liquidation under Chapter 11 (but usually Chapter 7 is used for liquidation). A vote of creditors usually approves the plan, but the bankruptcy court can approve a plan notwithstanding the vote of the creditors if certain factors favor approval of the plan. Once the court approves the plan, the debtor is discharged from any past debts except as provided in the plan.

Chapter 13 bankruptcy has several major advantages for the debtor:

Once the case is filed, the debtor’s property and future income are under the court’s jurisdiction. The debtor is protected from litigation and collection efforts.

Unlike Chapter 7, the trustee does not take possession of the debtor’s property. The debtor can increase the value of the estate while in Chapter 13.

Chapter 13 can help preserve the debtor’s credit rating since this chapter contemplates some effort to repay old debts.

Only the debtor can file a plan and no competing proposals are allowed.

The court will discharge the debtor only after all payments under the plan are completed. Chapter 13 filings are only available to individuals with regular income and those who are liable for unsecured debt under $250,000 and secured debt under $900,000. Recent amendments to the Bankruptcy Code have been made with a view to correcting perceived abuses of Chapter 7 bankruptcy filings. These amendments include a provision for “means testing” to show that the debtor is not eligible for Chapter 13. If the debtor is eligible for Chapter 13, they must file under that chapter instead of Chapter 7 and the end result would be that the debtor would pay something to creditors over a 2 to 5 year period.

In bankruptcy situations, debtors may have more power to negotiate than might be expected:

There is an incentive for creditors to reach a speedy solution that could give earlier payments of debts;

Different classes of creditors may have different interests, such as, speedy settlement for a lower amount than owed, or full payment even if it takes a long time;

The automatic stay which delays the creditor’s ability to collect;

The debtor’s exclusive right to file a plan;

The debtor’s threat to cease operations that could impair the value of the assets;

The cost of litigation or extended bankruptcy proceedings;

The potential for future business if the debtor can continue and become healthy

The debtor’s knowledge of the business and its prospects for the future.

Creditors also have some leverage in negotiations with debtors:

The debtor’s exclusive right to file a plan expires after a set time and the creditors may file a plan at that time;

Some creditors may have personal guarantees to secure their debts;

Creditors may develop alternatives to the debtor’s plan that will favor their position;

The creditors may uncover fraudulent practices or preferences in recent payments giving the creditors increased leverage

Please answer.

The question :

1. What is the purpose of federal bankruptcy laws?

2. What are the two chapters of the bankruptcy code which pertain to corporations and under what circumstances are they used?

3. If a company is in financial trouble what are their alternatives to filing for bankruptcy?