THE BANKRUPTCY CODE
The United States Bankruptcy Code is a federal body of law that governs the rights of debtors and creditors when an entity files a bankruptcy petition in this country. The Code is complicated and lengthy, but there are a few significant issues of which every corporate creditor should be aware. The purpose of this article is to highlight those basic, but important, points.
The entity in bankruptcy is called the “debtor.” Parties that are owed money by the debtor are called “creditors.” Creditors may be either secured creditors, meaning that they hold collateral for the debts owed them, or unsecured creditors, who do not have any collateral or security for their claims. Some other important possible parties in interest to a bankruptcy case are a creditors’ committee and a trustee. The entire bankruptcy process is administered by a bankruptcy court judge, with the input and oversight of the Office of the U.S. Trustee, which is a branch of the U.S. Department of Justice.
The two main types of corporate bankruptcy, as opposed to personal or individual bankruptcy, are Chapter 11 (reorganization) and Chapter 7 (liquidation). In addition, Chapter 15 governs the proceedings in the U.S. when a foreign entity with assets in the United States files a bankruptcy proceeding in a foreign country and an “ancillary” or cross-border bankruptcy case in the U.S. to protect its U.S. assets.
Under Chapter 11 of the Bankruptcy Code, a debtor-in-possession or a trustee attempts to reorganize a debtor company’s business. The reorganization is generally consummated through confirmation of a plan of reorganization or a sale of substantially all the debtor’s assets out of the ordinary course of business. Under Chapter 7, a trustee is appointed who sells or otherwise liquidates the debtor’s assets, with the assets or proceeds of sale distributed to creditors according to the priorities of distribution established in the Bankruptcy Code.
In addition, a creditor or a group of creditors may file an involuntary bankruptcy petition against a debtor, which forces the “alleged debtor” entity into bankruptcy. Generally, an involuntary bankruptcy petition can be filed by a group of eligible creditors when the debtor is not paying its debts as they become due.
The filing of a voluntary or involuntary bankruptcy petition under Chapter 7 or 11 creates what is called a bankruptcy “estate.” There is no bankruptcy estate as such when an entity files a Chapter 15 bankruptcy case. Further, the filing of a voluntary or involuntary bankruptcy petition under Chapter 7, 11 or 15 invokes a “stay” against certain creditor actions to collect debts that were incurred prior to the bankruptcy filing, called the “pre-petition” period, as opposed to after the bankruptcy filing, called the “post-petition” period. The automatic stay is one of the fundamental purposes of bankruptcy, because it gives the debtor breathing room to try to solve its financial problems and difficulties.
THE AUTOMATIC BANKRUPTCY STAY
When a company files for bankruptcy protection, there is an automatic, legal stay or prohibition against attempting to collect a debt that was incurred before that company (the debtor) filed for bankruptcy. Likewise, there is a stay against acts to sell or otherwise take possession of goods or collateral that are property of the debtor’s bankruptcy “estate.”[1]
RELIEF FROM THE AUTOMATIC BANKRUPTCY STAY
Section 362(d) of the Bankruptcy Code allows creditors and other interested parties to seek relief from the automatic stay in certain circumstances. This section of the Bankruptcy Code provides, in pertinent part, that “[o]n request of a party in interest and after notice and a hearing, the court shall grant relief from the stay provided under subsection (a) of this section, such as by terminating, annulling, modifying, or conditioning such stay—
- for cause, including the lack of adequate protection of an interest in property of such party in interest;
- with respect to a stay of an act against property under subsection (a) of this section, if—
- the debtor does not have an equity in such property; and
- such property is not necessary to an effective reorganization….”
PROPERTY OF THE ESTATE
As noted above, the commencement of a bankruptcy case creates an “estate.” Such estate is “comprised of all the following property, wherever located and by whomever held: (1) … all legal or equitable interests of the debtor in property as of the commencement of the case.” Bankruptcy Code Sec. 541(a).
Property of the estate is broadly defined and interpreted. Thus, it is usually prudent to assume that property in which the debtor has an interest is property of the debtor’s estate and seek stay relief.
CRITICAL VENDOR STATUS
When a company files for bankruptcy, it will often file a motion for authority to pay critical vendors. Without such a critical vendor order, the debtor is not allowed to pay its “pre-petition” creditors. In order to ensure uninterrupted flow of goods or services from its vendors, a debtor may obtain one or more critical vendor orders. Critical vendor status allows a debtor in bankruptcy to pay a vendor for pre-petition goods or services immediately after filing, despite the fact that it violates the absolute priority rule, whereby pre-petition claims are paid pursuant to a confirmed plan of reorganization.
CONTRACT REJECTION DAMAGE CLAIMS
Another issue that often arises in bankruptcy is rejection of contracts or leases by the debtor. Section 365(a) of the Bankruptcy Code states that “the trustee, subject to the court’s approval, may assume or reject any executory contract or unexpired lease of the debtor.” An executory contract is one that requires performance by both sides in the future.
Thus, under the Bankruptcy Code, a debtor in bankruptcy may be able to reject an executory contract or unexpired lease. The damages flowing from the rejection, which is considered a breach of the contract, are deemed a pre-petition, general, unsecured claim. Although the contract rejection actually occurs after the bankruptcy filing, or post-petition, the breach occasioned by the rejection is deemed to have occurred immediately prior to the filing, or pre-petition.
VENUE OF BANKRUPTCY CASES
Venue of bankruptcy cases (i.e., where the cases are heard) is governed by the Judiciary Act, 28 U.S.C. § 1408, which states in pertinent part that “a case under title 11 [the Bankruptcy Code] may be commenced in the district court for the district—
- in which the domicile, residence, principal place of business in the United States, or principal assets in the United States, of the person or entity that is the subject of such case have been located for the one hundred and eighty days immediately preceding such commencement, or for a longer portion of such one-hundred-and-eighty-day period than the domicile, residence, or principal place of business, in the United States, or principal assets in the United States, of such person were located in any other district; or
- in which there is pending a case under title 11 concerning such person’s affiliate, general partner, or partnership.”
Person is defined in the Bankruptcy Code to include a corporation. 11 U.S.C. § 101(41). As to a corporation, domicile is generally understood to mean state of incorporation. Thus, under subsection (1) of 28 U.S.C. § 1408, a corporate debtor may file a bankruptcy petition in the place where it is incorporated, where it has its principal place of business or its principal assets.
Under subsection (2) of 28 U.S.C. § 1408, a corporation may also file a bankruptcy petition in the district where an affiliate has filed for bankruptcy. Thus, a corporation that is not incorporated in a particular state, and does not have either its principal place of business or its principal assets in that state, may nonetheless file for bankruptcy in a state where one of its affiliates files for bankruptcy.
VENUE OF ADVERSARY PROCEEDINGS
As to adversary proceedings, which are lawsuits brought in the context of a bankruptcy case, such as a preference proceeding, venue is governed by 28 U.S.C. § 1409(a), which states in pertinent part that “a proceeding arising under title 11 [the Bankruptcy Code] or arising in or related to a case under title 11 may be commenced in the district court in which such case is pending.”
Thus, once a bankruptcy petition or case is filed in a particular district, a proceeding that could only be brought in the context of that bankruptcy case, such as a preference proceeding, can be brought in the same district where the underlying bankruptcy case is pending, with some limited exceptions regarding small value claims, etc.
VENUE OF CASES ANCILLARY TO FOREIGN PROCEEDINGS
As to a case ancillary to a foreign proceeding, “a case under chapter 15 of title 11 [the Bankruptcy Code] may be commenced in the district court of the United States for the district—
- in which the debtor has its principal place of business or principal assets in the United States;
- if the debtor does not have a place of business or assets in the United States, in which there is pending against the debtor an action or proceeding in a Federal or State court; or
- in a case other than those specified in paragraph (1) or (2), in which venue will be consistent with the interests of justice and the convenience of the parties, having regard to the relief sought by the foreign representative.”
28 U.S.C. § 1410.
Chapter 15 cases are usually brought to protect a foreign country company’s assets in the United States. In practice, a foreign country corporation may file a Chapter 15 ancillary proceeding in a United States federal district where it has minimal assets, such as a bank account, or in a district where it has paid a retainer to an attorney for the sole purpose of filing the Chapter 15 case or ancillary proceeding.
CHANGE OF VENUE IN BANKRUPTCY
“A district court may transfer a case or proceeding under title 11 to a district court for another district, in the interest of justice or for the convenience of the parties.” 28 U.S.C. § 1412. Thus, bankruptcy venue may be changed if a bankruptcy case is filed in a district where it does not really belong, because it would make it too hard for employees or small creditors to appear and be adequately represented and heard in the case.
PREFERENCE PROCEEDINGS
A debtor in bankruptcy or a trustee may seek to avoid or recover payments made by the debtor within 90 days before the debtor filed bankruptcy, if the debtor was insolvent at the time of the transfer, the payment was made on account of an antecedent debt, and the transfer allowed the creditor to receive more than it would receive in a Chapter 7 liquidation.
The manner by which a debtor or a trustee attempts to avoid or recover allegedly preferential payments is through an adversary proceeding, which is a lawsuit filed in the context of the underlying or main bankruptcy case.
Section 547(b) of the Bankruptcy Code states that “the trustee may avoid any transfer of an interest of the debtor in property—
- to or for the benefit of a creditor;
- for or on account of an antecedent debt owed by the debtor before such transfer was made;
- made while the debtor was insolvent;
- made–
- on or within 90 days before the date of the filing of the petition; or
- between ninety days and one year before the date of the filing of the petition, if such creditor at the time of such transfer was an insider; and
- that enables such creditor to receive more than such creditor would receive if–
- the case were a case under chapter 7 of this title;
- the transfer had not been made; and
- such creditor received payment of such debt to the extent provided by the provisions of this title.”
A creditor may defend a preference proceeding on the basis that the plaintiff, which could be the debtor, a trustee, or unsecured creditors’ committee, cannot prove the elements of the preference cause of action.
DEFENSES TO PREFERENCE PROCEEDINGS
One common defense to proof of the elements of the preference cause of action is that there was not an antecedent debt to begin with, because the vendor received payment of its charges before it delivered or provided the goods or performed the services for which it was paid. If there is a pre-payment or a cash on delivery (COD) payment, then there was arguably not an antecedent debt at all, and the transfer was not a preferential payment in the first instance.
A creditor may also defend a preference proceeding on the basis that the carrier was fully secured at the time of the preferential payment transfers by virtue of the fact that it has collateral. Thus, the plaintiff cannot make out one of the elements of the preference cause of action, that the creditor received more from the preferential transfers than it would receive in a liquidation.
Even if the plaintiff in the preference adversary proceeding can prove the elements of the preference cause of action, there are also several affirmative defenses to a preference proceeding, under Bankruptcy Code Section 547(c).
The three most important affirmative defenses are contemporaneous exchange for new value, subsequent new value, and ordinary course of business.
Contemporaneous exchange for new value defense
Contemporaneous exchange for new value means that the debtor and the creditor intended that the payment was in simultaneous exchange for provision of new goods or services, and the payment was substantially contemporaneous.
Subsequent new value defense
Subsequent new value means that, after the preferential payment, the creditor provided the debtor with new goods or services. The creditor is entitled to a new value credit for the price or value of the new goods or services provided.
A creditor might have a subsequent new value defense to a preference demand if it provided goods or services to the debtor subsequent to receipt of the preferential transfers but before the bankruptcy petition filing date. The goods or services that were provided after the transfers but before the petition date constitute subsequent new value, to which a preference defendant is entitled to a credit.
Ordinary course of business defense
Ordinary course of business means that the debt was incurred in the ordinary course of business of the debtor and the creditor, according to ordinary business terms between the debtor and the creditor, or according to ordinary business terms in the creditor’s industry.
Generally, the debt that was paid by a preferential transfer was incurred in the ordinary course of business of the debtor and the creditor. However, a creditor defendant in a preference proceeding may argue that the payment was made in the ordinary course of business between the debtor and the creditor, based on the number of days from invoice date to payment date, usual manner of payment by check or wire transfer, lack of extraordinary collection efforts, etc. Also, a creditor may argue that it has an ordinary course of business defense according to the ordinary business terms in the creditor’s industry, since the terms and manner of payment of charges are often similar across the relevant creditor’s industry.
Ordinary course of business is primarily a mathematical test that compares the average and range of “days to pay” in the preference period to the historical or pre-preference period. The closer or more similar the average or range of days to pay in the preference period compared to the pre-preference period, the stronger the ordinary course of business defense.
TRUSTEE STRONG ARM POWERS
Section 544(a) of the Bankruptcy Code states in pertinent part that “[t]he trustee shall have, as of the commencement of the case, and without regard to any knowledge of the trustee or of any creditor, the rights and powers of, or may avoid any transfer of property of the debtor or any obligation incurred by the debtor that is voidable by—(1) a creditor that extends credit to the debtor at the time of the commencement of the case….”
This provision is known as the trustee’s “strong arm” powers, whereby the trustee stands in the shoes of any pre-petition creditor to avoid fraudulent transfers by the debtor, etc.
Section 544(b) states in pertinent part that “the trustee may avoid any transfer of an interest of the debtor in property or any obligation incurred by the debtor that is voidable under applicable law by a creditor holding an unsecured claim that is allowable under section 502 of this title….”
This provision allows the trustee to use state lookback periods to avoid fraudulent transfers or conveyances, for example, in addition to the two year lookback period of Section 548 of the Bankruptcy Code, which allows the trustee to void fraudulent transfers under Bankruptcy law. In practice, many state lookback periods for fraudulent transfers are longer than the two year period of Section 548 of the Bankruptcy Code, such as four years under New Jersey law or six years under New York law.
CONCLUSION
If you are a creditor, it is good to know the basics of the bankruptcy process as it relates specifically to your company’s industry. Such knowledge can help you effectively collect a debt owed to your company, even from an insolvent debtor, without violating the automatic bankruptcy stay. You might even be able to help your company defend itself against attempted avoidance of a preference payment by a bankruptcy trustee or other preference plaintiff. For further information regarding bankruptcy issues, please contact Rick Steinberg, Esq. at rsteinberg@pricemeese.com or (201) 391-3737.
[1] Section 362(a) of the Bankruptcy Code states in pertinent part that “a petition filed under … this title … operates as a stay, applicable to all entities, of—
- the commencement or continuation, including the issuance or employment of process, of a judicial, administrative, or other action or proceeding against the debtor that was or could have been commenced before the commencement of the case under this title, or to recover a claim against the debtor that arose before the commencement of the case under this title;
- the enforcement, against the debtor or against property of the estate, of a judgment obtained before the commencement of the case under this title;
- any act to obtain possession of property of the estate or of property from the estate or to exercise control over property of the estate;
- any act to create, perfect, or enforce any lien against property of the estate;
- any act to create, perfect, or enforce against property of the debtor any lien to the extent that such lien secures a claim that arose before the commencement of the case under this title;
- any act to collect, assess, or recover a claim against the debtor that arose before the commencement of the case under this title;
- the setoff of any debt owing to the debtor that arose before the commencement of the case under this title against any claim against the debtor….”
