By Ian Corp
Even if you have not been involved in a bankruptcy proceeding, every lawyer should know about the effects that filing bankruptcy has. Although the decision affects the debtor’s rights and obligations, it can also impact the rights and obligations of others that are owed money from the debtor or have rights in the debtor’s property. To hedge risks and anticipate pitfalls, this article provides a few basic considerations that every lawyer should be aware of if your client or a counterparty is about to file bankruptcy.
Executory contracts
Under 11 U.S.C. § 365, any bilateral contracts that are not fully performed, such as a lease agreement, may be assumed or rejected after a debtor files bankruptcy. In Chapter 7 cases, the debtor has sixty days after filing the petition and in Chapter 11 cases, the debtor can assume or reject the contracts any time before confirmation of their plan of reorganization. An example: Assume that company A is the landlord of real property that is leased by company B. The companies have a lease agreement that ends in December 2024. But company B falls behind on rent and company A sends a notice of default under the lease agreement—the notice does not declare that the lease is terminated. Instead, it provides company B an opportunity to cure. Before the cure period expires, company B files for bankruptcy. Here, company B may move the bankruptcy court for relief to assume the lease agreement under 11 U.S.C. § 365. But if company A had terminated the lease before the bankruptcy petition was filed, then company B would be unable to assume the lease.
Preferential payments
When a company or individual files for bankruptcy, the debtor or the trustee that administers the bankruptcy estate for the benefit of the debtor’s creditors can recover any transfers of value made within the ninety days before bankruptcy was filed. For example, assume that company A resolves a dispute with company B on January 1 for $100,000.00. The next day, company A wires the funds to company B. Three weeks later, company A files for bankruptcy. Under 11 U.S.C. § 547, that $100,000.00 payment is considered a preferential payment because it was made when company A was insolvent and it is likely more than what company B would have received if company A underwent a Chapter 7 liquidation. If company B refuses to return the money, company A will likely file an adversary proceeding against it in the bankruptcy case. Among other defenses it might have, if company B can show that the payment was made in the ordinary course of its business with company A, unlikely here, then it could defeat company A’s claim.
Court approval now required
Once a company has filed for bankruptcy, everything outside the ordinary course of its business requires court approval. If there is any dispute about monies owed, or property that the debtor is looking to sell, under Fed. R. Bank. P. 9019 and 11 U.S.C. § 363, respectively, the court must approve any settlement or the sale before any consideration is exchanged.
Status and security of your claim
If a creditor lent money to the debtor and the creditor had a security agreement, the creditor should evaluate the priority, validity, and extent of its interest. First, the creditor should take all steps necessary to perfect its interest, like filing a UCC financing statement. This is critical. In bankruptcy, secured creditors have a much higher likelihood of recovery against unsecured creditors, who are unlikely to recover anything at all. Second, the creditor should evaluate if any other creditors already have liens on similar property. For example, if the debtor authorizes a blanket lien to a creditor before your client’s blanket lien encumbered the debtor’s assets, that prior security interest might impair your own. And if the debtor has since sold any assets subject to your lien, the proceeds of that sale are now encumbered by your lien. Tracing these funds is key to increase the likelihood of repayment. And third, the creditor should analyze its priority, or place in line to recover from the debtor, against other similarly situated creditors.
Effect of the automatic stay
A central concept of bankruptcy law, and a critical benefit to any debtor, is the automatic stay. Under 11 U.S.C. § 362, when a debtor files bankruptcy, any proceedings against the debtor must cease immediately and the status quo against the debtor must remain intact. This is a significant benefit to the debtor because it allows the debtor to negotiate with its creditors under the protection of bankruptcy law and the bankruptcy court. If any creditor desires to proceed against the debtor notwithstanding the automatic stay, the creditor has a few options. First, it can show that good cause exists to lift or modify the automatic stay. Second, the creditor can show that it is not adequately protected, which means, for example, that whatever collateral it has in the debtor’s property is insufficient to cover the debt owed, and that the collateral is unnecessary for the debtor’s reorganization. Or third, that the debtor is a single asset real estate entity.
Conclusion
Aside from the automatic stay, not all of these concepts apply when a debtor files bankruptcy. But each should be considered if your client or its counterparty is, or may become, insolvent.