Bankruptcy – Morrison 2008

  • Introduction
  • Bankruptcy Policy – Designed to cure failings of contract law
  • Judgment Proof Debtor Problem – Contract law assumes everyone can pay damages
  • Encourages excessive and duplicative monitoring by several creditors, and
  • Encourages hiding of assets, both of which are wasteful
  • Creditor Collective Action Problem – Contract law assumes that debts are independent of one another, and that debtors can collect a debt w/o affecting the collection of debt by other creditors
  • Creditors have incentive to collect their debts first to get a bigger chunk than other creditors, and
  • Have incentive to force a firm to liquidate e/t firm may be worth more as a going concern
  • Butner principle – bankruptcy law respects rights of creditors outside of bankruptcy unless a specific bankruptcy provision or policy requires a different rule
  • Problem: judges sometimes use bankruptcy powers to try and solve problems that are not bankruptcy problems
  • Alternatives to bankruptcy
  • Contract around/default rule – not allowed
  • Contract w/ 3rd party lender – not feasible
  • Borrow from single creditor – more costly to borrow
  • Introduction to the Code
  • Individuals
  • Chapter 7: liquidation /fresh start
  • Rationale: individual debtors have careers and may be more productive in the future if allowed to start over
  • Problem: vulnerable to the abuses of forum shopping, debtors can relocate assets to states with bankruptcy exemptions
  • Chapter 13: future income instead of liquidation
  • Rationale: attempts to solve forum shopping problems of c7
  • 2005 act makes it costly to determine whether debtor belongs in c7 or c13
  • Themes: harsher penalties for bankruptcy deters people from taking on debt initially, and does nothing to facilitate collection for creditors
  • Bankruptcy is in essence a compelled social insurance to cure the cognitive failure that occurs when people take on debt they cannot payback
  • Corporations
  • Chapter 7: liquidation
  • Chapter 11: reorganization
  • Appropriate only for firms in financial, noteconomic distress
  • Financial distress: wipe away debt, firm can still profit; problems exist in the firm only because of its current capital structure
  • Economic distress: even if debt is wiped away, firm cannot profit; competition or the market has run firm out of business
  • Equity holders: cannot demand payment until all creditors have been paid
  • Characteristics of Debt
  • Tradability: all debt is tradable, firms can buy debt & collect themselves
  • Secured debt: require promise to repay & right to property interest in collateral if debtor does not pay
  • Unsecured debt: lends based only on a promise to repay by debtor
  • Cost/Benefits of Secured debt
  • Benefits
  • Cheaper b/c creditor has priority in bankruptcy
  • Solves collective action problem
  • Promotes specific monitoring
  • Monitoring benefits spillover to unsecured creditors and the firm
  • Costs
  • Collateral may depreciate or otherwise disappear
  • More secured debt means higher cost of unsecured debt
  • Unfairness to tort victims, secured creditors get priority
  • May deter monitoring in some situations if creditors think they’re guaranteed payment
  • Commencement of the Case
  • Eligibility
  • In General
  • Distressed business (financial, not economic)
  • Collective action problem
  • Non-bankruptcy law is inadequate
  • §109 – who may be a debtor
  • §109(a) – general qualifications; persons under §101(41)
  • “Individual” defined under state law
  • “Partnership” defined under state law
  • “Corporation” defined in §101(9)
  • Non-business trusts generally not given bankruptcy protection
  • §109(b-f) – qualifications for the individual Chapters (Chapters 7-13)
  • §109(b) – Chapter 7, basic “liquidation”
  • Anyone except railroads, insurance companies, and banks/banking/savings institutions.
  • Voluntary or involuntary
  • §109(c) – Chapter 9, insolvent municipalities
  • §109(d) – Chapter 11, “reorganization” chapter
  • Anyone under Chapter 7 + railroads
  • Voluntary or involuntary
  • But, NOT stockbroker or commodity broker.
  • Chapter 7 has special rules for these people already.
  • §109(e) – Chapter 13, individual reorganization
  • Available ONLY to “an individual with regular income”
  • Voluntary
  • §109(f) – Chapter 12, “family farms” with regular annual income
  • Voluntary
  • §109(g) – a.k.a. “GET A MOVE ON!” NOT allowed to be a debtor if individual or family farmer has been a debtor in a case pending under Title 11 at any time in the preceding 180 days if
  • Case dismissed for debtor’s willful failure to abide by court orders.
  • The debtor requested and obtained the voluntary dismissal of the case following the filing of a request for relief from the automatic stay provided by section 362 of this title.
  • Filing the Petition
  • §301 – Voluntary
  • Debtor files for BR, and filing the petition leads to order for relief (without any BR hearing).
  • Date of filing = date of order
  • §302 – spousal filing
  • §303 – Involuntary (i.e. ONLY Chapter 7 or 11)
  • Who files?
  • Person
  • File petition w/BR court
  • Three or more entities file
  • Their claims are not
  • Contingent as to liability
  • Subject of a bona fide dispute
  • An indenture trustee representing such a holder
  • Fewer than 12 such entities that hold such claims.
  • Debtor’s business continues to operate
  • May order interim trustee to take possession of the property and to operate any business of the debtor.
  • Trial, and court orders relief ONLY IF debtor is generally not paying such debtor’s debts as such debts become due
  • Problems
  • It is harder to force a firm into involuntary bankruptcy b/c of the benefits of putting off employment layoffs as long as possible and possible opportunism by creditors who are also competitors
  • It may be too hard to push firms into bankruptcy; allows managers to continue taking on debt to stall the inevitable eventually making the firm worth less than if it had been liquidated earlier
  • Dismissal
  • BR Code’s Weak Ex Ante Filters
  • Theme: dismissal is important b/c ex ante filters in the code are weak, firms which theoretically don’t qualify for bankruptcy can get in; creates inefficiencies
  • Problem: evidence shows that ppl generally underfile for BR b/c of the stigma associated w/ it and the destruction of business value when in BR
  • BR Code’s Strong Ex Post Filters
  • §305(a) –dismissal when interests of creditors and debtors would be better served by dismissal
  • In re Colonial Ford: debtor cannot file c11 in contravention of a previously established “workout” b/w debtor and all creditors
  • Rationale: no collective action problem here b/c creditors had all agreed; contracting around the code in a “workout” situationex postto financial distress is an exception to the general prohibition on contracting around the BR code
  • §707(a) – dismissal for “cause” including “unreasonable delay” and “nonpayment of fees”
  • §707(b) Abuse – court may dismiss for abuse if
  • Debtor can pay
  • Filed in bad faith, or
  • In totality of the circumstances demonstrates abuse
  • Under 2005 act, any party involved can dismiss or convert if debtor makes greater than the median income & require means test
  • If debtor fails means test, abuse is presumed & debtor must rebut
  • §1112(b) – dismissal for “cause” such as “unreasonable likelihood of rehabilitation”
  • Rationale: helps filter out firms w/ no collective action problem, suffering economic distress, or w/ adequate state law alternatives
  • In re Kingston Square Associates: orchestration of creditors to force a firm into involuntary bankruptcy in order to surmount a bankruptcy remote provision does not amount to “collusion” under §1112(b) b/c orchestration was for purpose of benefiting value of estate & not in bad faith
  • Rationale: holding is the counterpart to Colonial Ford b/c it prohibits ex ante contracting around bankruptcy through bankruptcy remote provisions
  • In re Integrated Telecom Express: bankruptcy petition filed by financially healthy debtor who expects to gain nothing from c11 filing but the benefit of capping landlord damages was filed in bad faith and dismissed under §1112(b)
  • Rationale: allowing the firm to steer value away from landlord divert value from creditors to equity holders which is not allowed under the absolute priority rule
  • Bankruptcy Waivers
  • Waivers to BR are generally unenforceable
  • Rationale: could lead to liquidation of viable firm & benefits only current lenders, not future lenders
  • Specifically unenforceable: explicit waivers in lending agreements & waivers in workout agreements that anticipate a firm’s survival
  • Potentially enforceable: waivers in workout agreements that anticipate liquidation provided all parties agree
  • The Automatic Stay
  • §362 –“presumptive” injunction that arises by operation of law immediately upon the commencement of the BR case prohibiting commencement of actions for prepetition claims or enforcing liens; automatic b/c act of filing petition brings it into effect
  • Rationale: ensures property of the debtor is not dissipated while claims are sorted out; allows rights of creditors to be determined in a single forum
  • Stay can be lifted
  • §362(a)(1, 2, 6, 7, 8) – Prohibits all activity against the debtor relating to the collection of claims that arose before the commencement of the BR case.
  • §362(a)(5) – Prohibits any steps to create, perfect, or enforce a lien against property of the debtor to secure a prepetition claim.
  • §362(a)(2, 3, 4) – Stay on all postpetition activity to remove property from the estate or to establish or enforce an interest in it.
  • §362(b) – Exceptions to the automatic stay include
  • Does NOT operate as a stay on criminal action or proceeding against debtor.
  • Does NOT operate as a stay on an action or proceeding by a governmental unit … to enforce such governmental unit’s … police and regulatory power, including the enforcement of a judgment other than a money judgment, obtained in an action or proceeding by the governmental unit to enforce such governmental unit’s or organization’s police or regulatory power
  • Pecuniary Test
  • Seeking to enforce $ judgment.
  • For the $  NOT protected by this exemption
  • For the public interest  okay under this exemption.
  • §362(c) – Duration of the stays
  • Property of the estate: until such property is no longer property of the estate.
  • Everything else is stayed until the earliest of:
  • Time the case is closed
  • Time the case is dismissed
  • §362(d) – Relief from stay (after party applies for relief from stay)
  • For “cause” – lack of adequate protection
  • Debtor has no interest in property
  • Property not necessary for effective reorganization
  • Limits on the Automatic Stay
  • Stay n/a to third-parties or codefendants, creditors can collect on promises made by third parties contingent on the payment of the debtor
  • Equity Holders
  • Official Bondholders Comm. v. Chase Bank: automatic stay §362(a)(3) in reorganization did not prohibit secured creditors from foreclosing on stock to initiate a shareholder vote absent a showing of “clear abuse”
  • Rationale: equity holders can exercise their traditional corporate governance rights short of abuse in reorganization
  • “Clear Abuse” requires a showing that vote risks rehabilitation is for purposes of increasing bargaining power, or is for purpose of diverting value away from unsecured creditors
  • Contractual Rights
  • In re Cahokia Downs: automatic stay under 362(a)(3) prohibits insurance company from cancelling policy despite it being terminable at will when such cancellation is done for purpose of avoiding payment to other creditors
  • Rationale: circumstances made it appear that insurance co was attempting to divert value of policy away from other creditors b/c no increased risk of fire postpetition compared to prepetition
  • In re MJ & K Co: automatic stay could be lifted to permit law school to take possession of bookstore property when such property was under contract that was terminable at will and termination was in good faith
  • Rationale: special weight given to the nature of the law school’s business which required law school to take immediate possession of the premises
  • Takeaway: distinction b/w these cases is that insurer in Cahokia looks like someone collecting a debt (BR reason), whereas law school in MJ & K appears to be trying to get stay lifted for better service (non-BR reason)
  • Gov’t Interests
  • In re FCC: FCC re-auction of PCS license after debtor default and files c11 was exempted from the automatic stay b/c it was an exercise of regulatory authority
  • Rationale: “timely payment” was required by the FCC as a regulatory condition, and thus the re-auction of the license was regulatory, not fiscal
  • US v Nicolet: action by EPA against polluter-debtor seeking damage judgment not subject to stay under 362(b)(5) b/c such an action was an exercise of regulatory power AND EPA was only seeking to fix damages at trial, not to collect a “money judgment
  • Rationale: gov’t was acting on behalf of general welfare enforcing regulatory laws, not on behalf of its own pecuniary interests
  • Claims
  • Policy Problems
  • Cloud over bankruptcy: when a firm reorganizes b/f a large debt is due in the future, possibility for opportunism by reorganization creditors to cheat future claimant out of this debt
  • Excessive voice problem: when a claimant w/ small probability of success at trial, but very large claims, holdup bankruptcy to extort a payment
  • Minimizing administrative cost: reducing the number of participants in the bankruptcy process to make it faster
  • In General
  • Claim under §101(5) – right to payment, or right to equitable remedy for breach of performance if such breach gives rise to a right to payment
  • OH v Kovaks: state which seized assets of debtor to cleanup an industrial site had a claim under 101(5)(b) b/c the debtor’s action was a “breach” of a duty and the obligation to pay could not be fulfilled in any other way than the payment of money, and the claim was dischargeable under 727(b)
  • Rationale: “breach” in 101(5)(b) includes statutory breach as well as contractual breach, and obligation to pay the cleanup was a “right to payment”
  • Problem: this holding distorts the states incentives; makes them wait until debtor files BR to move for lifting of stay under 362(b), but does not let them act b/f BR is filed b/c they will not be paid in BR
  • When does claim arise?Three tests:
  • Accrued state law claim – claim arises when claimant has a state law claim at time of filing
  • Conduct test – when the conduct giving rise to liability occurs b/f petition filed
  • Piper test – individual’s future claim qualifies under 101(5)(b) if
  • Events occurring b/f confirmation create a relationship b/w claimant & debtors product; AND
  • Basis for liability is debtors prepetition conduct
  • Epstein v Official Comm. of Unsecured Creditors: future tort victims of airplane MFG do not have claims under 101(5)(b) b/c they do not have preconfirmation exposure to identifiable defective product & thus fail relationship prong of Piper test
  • §727(b) – allows discharge of debts arising b/f BR
  • Allowingand Estimating Claims
  • §501 – a creditor or an indenture trustee may file a proof of claim. An equity security holder may file a proof of interest
  • If a creditor does not timely file a proof of such creditor’s claim, an entity that is liable to such creditor with the debtor, or that has secured such creditor, may file a proof of such claim.
  • §502 – Claims/interests are deemed allowed unless a party in interest objects
  • Allowance recognizes creditor’s right to share in the assets of the estate. Assets are distributed to holders of allowed claims at the end of the BR process
  • Upon objection, there’s notice and a hearing to determine the amount of such claim in lawful currency of the United States as of the date of the filing of the petition, and shall allow such claim in such amount, except to the extent that –
  • Such claim is unenforceable for a reason other than that it’s contingent or unmatured.
  • Such claim is for unmatured interest.
  • Such claim is a lessor’s claim for property damages done by lessee and the claim exceeds an amount determined by rent percentages and the unpaid rent that’s left §502(6))
  • Bittner v Borne: BR did not err when it assessed creditor’s claim in successful litigation by reference to the merits
  • Rationale: if claims are valued instead by possible damages minus percentage of success then creditor would gain too much voice in the reorganization process
  • AH Robins Co: punitive damages disallowed under 105(a) equitable power
  • Rationale: this is no longer the view of the function of 105(a) powers, now seen more as a tool for enforcing other provisions of the code, not as a general equitable power
  • Secured Claims
  • In General: less worry of undue influence than unsecured debt; generally raises issues w/ collateral
  • Oversecured Creditors: value of collateral assets exceeds claim
  • Undersecured Creditors: value of claim exceeds value of collateral assets; portion of claim that exceeds collateral is shared w/ unsecured creditors (bifurcation)
  • §506 – valuing secured claims, determined in light of the purpose of the valuation and the proposed disposition or use of such property and in conjunction with any hearing on such disposition or use on a plan affecting such creditor’s interest
  • §506(a) – allowed secured claim = “a secured claim to the extent of the value of such creditor’s interest in the estate’s interest in such property”
  • §506(b) – if the property that secures the claim is more valuable than the secured claim, then secured creditor may receive interest on the difference in value
  • §506(c) – trustee (who is using the property secured by the claim) may recover from the property securing the interest the reasonable, necessary costs and expenses of preserving or disposing of the property to the extent that it benefits the secured claim holder
  • §506(d) – secured but DISallowed claim  lien is void unless
  • it was only disallowed under §502(b)(5) or (e) OR
  • it was only disallowed because entity failed to file proof of the claim under §501
  • Associates Commercial Corp v Rash: valuation of collateral during the invocation of 1325(a) cramdown is the replacement value, not foreclosure value
  • Rationale: “disposition or use” language of 506(a); replacement value allows secured creditors to get more than was bargained for and compensates for the inability to repossess collateral immediately
  • Cramdown – allows debtor to keep collateral, and creditor keeps lien on collateral, debtor promises to pay current value of collateral over period of loan
  • §1325(a)(5) – court confirms a “cramdown” plan re: allowed secured claim if
  • Secured creditor has agreed to the plan
  • The plan lets secured creditor keep the lien securing the claim AND
  • The value, as of the effective date of the plan, of property to be distributed under the plan on account of such claim is not less than the allowed amount of such claim;
  • Debtor surrenders the property to secured creditor
  • Property of the Bankruptcy Estate
  • 541(a) estate includes all “interests of the debtor in property” as of the commencement of the case
  • Chicago BOT v Johnson: all interests of the debtor enter BR subject to non-BR limitations unless BR policy requires otherwise
  • Rationale: creditor can’t take a greater interest in property