This document provides an executive summary of key bankruptcy concepts for creditors in business insolvencies under Chapter 11. It discusses first day motions, the automatic stay, debtor in possession financing, critical vendor motions, administrative claims including the 20-day priority claim, reclamation rights, setoff/recoupment, and disclosure requirements. The summary focuses on outlining creditor remedies and priority status within Chapter 11 bankruptcy proceedings.

1. bankruptcylaw
a legal update from Shumaker, Loop & Kendrick November 2008
Business Bankruptcy: First Day Motions
Executive Summary • In almost every Chapter 11
proceeding, the debtor will file a number
of “first day” motions which are usually
scheduled for hearing a day or two after
Need to Know Bankruptcy Concepts the bankruptcy filing. Most of the “first
day” motions are procedural and
administrative, but there are also
The following is an executive summary substantive motions. Perhaps the most
of the “need to know” bankruptcy substantive first day motion is the
concepts as they impact creditors in debtor’s motion to approve debtor in
business insolvencies. possession or “DIP” financing.
Chapter 11 has been
increasingly used as a • The Bankruptcy Code provides that
Chapter 11 vs. Chapter 7 pre-petition liens on collateral do not
tool to liquidate business
• Chapter 11 is technically used for extend to property acquired by the
assets as a “going debtor post-petition. In addition, the
bankruptcy reorganizations, while
Chapter 7 applies to liquidations.
concern” hence the
, Bankruptcy Code provides that the
Chapter 11 and Chapter 7 can apply to frequent “liquidating 11”. debtor may not use as working capital
either business or individual the lender’s “cash collateral”, which is
bankruptcies. the cash generated by inventory sales
and accounts receivable collections,
• Chapter 11 has been increasingly used unless the lender consents or the
as a tool to liquidate business assets as Bankruptcy Court permits the debtor
to use cash collateral over the lender’s
a “going concern”, hence the frequent Automatic Stay objection.
“liquidating 11”. By contrast, in a
Chapter 7 liquidation, the appointed • To promote the bankruptcy concept
trustee is not permitted to operate the • For these reasons, it is common for
of providing “breathing room” to a debtor and its lender to reach a
business, except in rare circumstances. debtors, the Bankruptcy Code enjoins
Accordingly, any going concern value consensual post-petition financing
any action to collect pre-petition debts arrangement, called DIP financing.
can be achieved only through a owed to creditors. This would include
“liquidating” Chapter 11. commencing or continuing a lawsuit, • Very often the lender has superior
entering or enforcing a judgment, negotiating position and thus the DIP
• Many lenders, who assert liens on terminating contracts or taking any other
substantially all of a debtor’s assets, financing agreement appears one-sided.
action to enforce payment. Bankruptcy Courts almost always
often prefer a “liquidating” Chapter 11
because of the Bankruptcy Code’s approve DIP financing as necessary to
• There are limited occasions where the allow a debtor to continue operating,
unique provisions allowing debtors to Bankruptcy Code permits a creditor to
sell assets free and clear of liens (with although creditor objections can modify
obtain “relief from stay” to proceed. or eliminate objectionable provisions
liens attaching to proceeds), which
enable a debtor to deliver “clear” title of the DIP financing.
• Stay violations can result in claim
to prospective buyers. Many buyers elimination, penalties and sanctions
insist that their purchase of assets be including attorneys’ fees for the debtor’s
conducted through a Section 363 sale counsel.
in a liquidating Chapter 11.
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2. November 2008
• Clearly there are substantive rights of Doing Business With a • The practical solution to this problem
other creditor’s constituents that can be has been for vendors to require the pre-
compromised as a result of a DIP Chapter 11 Debtor petition purchase orders to be re-issued
financing, and creditors’ committees post-petition.
often file objections to DIP financing •Upon the filing of a Chapter 11 by a
proposals. customer, vendors must determine • Many debtors, particularly in larger
whether to sell to the debtor post- cases, file a “first day” motion seeking
• In light of the global credit crisis, petition. an order from the Bankruptcy Court
lenders’ willingness and perhaps ability granting administrative claim priority
to make DIP loans will undoubtedly be • To avoid the inherent risk of a for post-petition shipments on pre-
materially reduced. Chapter 11, vendors often sell on a cash petition orders, to avoid the re-issuance
before delivery or “CBD” basis. of purchase orders.
• As an alternative source of cash,
Debtors unable to obtain DIP financing • To remain competitive, vendors are • In the case of a pre-petition supply
may seek Bankruptcy Court permission sometimes compelled to extend credit contract which provides for credit terms,
to use the lender’s “cash collateral” over terms to Chapter 11 customers. In this debtors may assert that such contracts
the lender’s objections. event, creditors should carefully impose an obligation on the vendor to
evaluate the risk of non-payment in extend credit. While Bankruptcy Courts
• At one time, critical vendor motions Chapter 11. usually compel a vendor who is a party
were also included in the “first day” to a supply contract to ship goods,
motions. However, the current trend • The Bankruptcy Code treats credit Bankruptcy Courts have rarely forced a
is for courts to delay consideration of extended to a Chapter 11 debtor in the vendor to extend credit to a Chapter 11
any critical vendor motion until various ordinary course of business as an debtor.
parties, including the unsecured administrative expense priority claim.
creditors’ committee, have been given As indicated below regarding claim • Since a Chapter 11 filing effectively
an opportunity to evaluate the motion. priorities, administrative expense relieves the debtor of pre-petition debt,
claims enjoy a “high priority” and are the debtor’s post-petition cash flow may
generally paid, absent an actually be healthier than it was pre-
“administrative insolvency”. petition. However, creditors should
independently evaluate the risks of
• By contrast, extensions of credit that extending credit to a Chapter 11 debtor.
To remain competitive, are not in the ordinary course of A key component of this evaluation
vendors are sometimes business must first be approved by the should be the debtor’s DIP financing and
Bankruptcy Court, or they are not its impact on the debtor’s working capital
compelled to extend entitled to administrative expense requirements.
credit terms to Chapter priority treatment.
11 customers.
• At the time of the Chapter 11 filing,
it is common for vendors to have open
purchase orders from debtors that
arose prior to the Chapter 11 filing,
that provide for post-petition shipment
by the vendor.
• In a recent Bankruptcy Court ruling,
the Court denied the vendor
administrative expense priority status
for post-petition shipments on pre-
petition purchase orders since the
shipment arose from a pre-petition
contract.
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3. November 2008
Schedules of Assets and – Employee wage claims of not more • Absent an administrative insolvency,
than $10,950 for 2008. administrative claims are generally paid
Liabilities and Statement in full, as the Bankruptcy Code requires
of Financial Affairs – Certain employee benefit contribution that such claims be paid in full as a
claims as defined by the Bankruptcy condition precedent to confirmation of
• The Bankruptcy Code imposes a Code. any plan of reorganization.
requirement on every debtor to file
detailed Schedules of Assets and – Deposit claims of not more than • Moreover, while not a specific
Liabilities as well as a Statement of $2,425 for 2008 for deposits made by requirement of the Bankruptcy Code, a
Financial Affairs. The Schedules of individuals for the purchase of goods debtor is generally obligated to “pay as
Assets and Liabilities list the debtors or services for family or household use. it goes” while in Chapter 11, meaning it
assets and values and detail the names must be able to pay its ongoing
of secured and unsecured creditors, the – Certain government tax claims as administrative claims in the ordinary
amount of the indebtedness and defined by the Bankruptcy Code. course of business. A material build up
whether or not the indebtedness is in unpaid administrative claims indicates
disputed. The Schedules also contain – Allowed unsecured claims of a a potential inability to obtain plan
a list of equity holders and contracts to Federal Depository Institution confirmation, and thus, provides the
which the debtor is a party. The regarding capital requirements of an grounds for a conversion of the Chapter
Statement of Financial Affairs includes insured depository institution. 11 proceeding to a liquidation proceeding
the disclosure of the location of books under Chapter 7.
and records, and transfers made to – General unsecured claims.
insiders and non-insiders prior to the
bankruptcy filing. – Equity interests. Creditor Remedies
• Secured, administrative and priority
claims are generally paid in full while • 20 Day Administrative Claim
Claim Priorities unsecured claims are rarely paid in full
and in fact rarely receive any material – The 2005 Bankruptcy Code
• The Bankruptcy Code sets forth clear dividend. Equity interests are almost Amendments added Section 503(b)(9) to
priorities of payment or entitlement to always canceled at no value. the Bankruptcy Code which provides
payment by types of creditors or claims that sellers of goods are entitled to an
as follows: • There are many exceptions to the administrative priority claim for the
general rules. In the case of an value of goods delivered to a debtor
– Secured creditors, as a result of pre- “administrative insolvency”, the value within 20 days prior to the bankruptcy
petition consensual liens on assets and of the debtor’s assets are insufficient filing.
proceeds of assets. to pay the lender’s claims and also the
administrative claims. With increasing – The case law addressing Section
– Administrative claims, which are the frequency, and as a result of very high 509(b)(a) provides some predictability
costs associated with the administration loan to collateral value ratios, assets on how this remedy will benefit vendors.
of the post-petition bankruptcy estate. are insufficient to pay lenders in full
These would include purchases of much less claims “below the line”. – There are two essential components to
goods and services post-petition as well Often lenders will find it necessary to the 20 day administrative claim: 1)
as professional fees associated with the pay professional fees associated with getting the claim allowed as an
administration of the bankruptcy estate. negotiating and closing a sale of its administrative claim in the first instance;
collateral in connection with a and 2) getting the claim paid by the
– Claims arising during the “gap” Bankruptcy Code Section 363 sale. bankruptcy estate. Upon a motion by
period, which is the time period Lenders often resist paying other the creditor, most courts have allowed
between the filing of an involuntary administrative claims, creating lack of vendors an administrative claim for the
petition by three or more creditors and equality in treatment of similarly value of goods delivered within 20 days
the date on which an order for relief is situated claims. prior to the filing. As a result of the
entered by the Bankruptcy Court. general rule that unsecured claims
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4. November 2008
receive little or no distribution and – Prior to the 2005 Bankruptcy Code – Only a debtor can make the
administrative claims are generally paid Amendments, the Bankruptcy Code determination that a particular vendor
in full, converting any portion of an recognized the state law remedy of is critical and seek court approval of
unsecured claim to an administrative reclamation but also recognized that same. A creditor cannot independently
claim is a material achievement. permitting vendors to reclaim goods impose its critical vendor status on a
would be disruptive to a debtor’s debtor.
– Courts have been less willing to order attempted reorganization. Accord-
immediate payment of 20 day ingly, the Bankruptcy Code allowed a – Critical vendor payments have become
administrative claims, instead allowing bankruptcy judge to grant a lien or increasingly controversial and certain
them to be paid in connection with plan administrative claim to the seller in court rulings, including the Kmart
confirmation or in connection with the lieu of the actual return of goods. decision, have limited the critical vendor
sale of substantially all of the debtor’s remedy. Some jurisdictions refuse to
assets. As with any other administrative – The 2005 Bankruptcy Code Amend- entertain a critical vendor motion.
claim, if the Chapter 11 proceeding is ments eliminated the provision allow- However, Delaware and New York
administratively solvent, payment of ing a bankruptcy judge to grant a lien continue to be jurisdictions where critical
the 20 day administrative claim is or administrative priority in lieu of the vendor payments can be approved in
probable. In cases where the debtor’s actual return of goods. Accordingly, it appropriate circumstances. As recently
Chapter 11 proceeding is “insolvent”, is unclear what value the current as September, 2008, the Delaware
the likelihood of payment is reclamation claim will have. Bankruptcy Court in the Hines Nursery
compromised. However, payment on case approved $2 million of critical
such claims nevertheless exceeds what – Sellers of goods should nevertheless vendor payments.
would be paid absent the 20 day continue the practice of sending a
administrative claim. reclamation demand which must be – Vendors who are truly critical to a
sent within 20 days after the Chapter debtor-customer should continue to seek
11 filing and can cover invoices for critical vendor status as a means of
goods delivered within 45 days prior getting paid. In doing so, vendors should
to the bankruptcy filing. be careful to not violate the automatic
For more information on stay by conditioning future business on
For more information on payment of pre-petition debt. Moreover,
20 Day Administrative vendors should be aware that getting
Reclamation:
Claims click here and click here paid as a critical vendor will likely be
click here. conditioned on providing normal lines
of credit, pricing and terms, or other
• Critical Vendor “customary trade procedures.”
– Critical vendor is a creditor remedy For more information on
based on a theory that a particular Critical Vendor:
vendor is so essential to a debtor’s click here
• Reclamation ability to continue operating that with- and
out the uninterrupted flow of the click here
– Historically, reclamation has been the seller’s goods, the debtor cannot con-
standard bearer of a vendor’s remedies. tinue to operate and thus has no
Reclamation is a state law remedy realistic chance of a successful re-
arising from the Uniform Commercial organization. In these instances, a
Code’s provisions on sales of goods. In bankruptcy court has broad authority
particular, most states allow a vendor to order relief that facilitates a
to reclaim goods delivered to a customer successful reorganization.
(or stop goods in transit), if the seller
learns of the customer’s insolvency.
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5. November 2008
• Set-off and Recoupment to the vendor or is limited to amounts – Unlike a voluntary petition where an
directly related to the goods in its order for relief is entered essentially
– An often overlooked remedy, setoff possession. simultaneously with the filing of the
arises from the settlement of mutual petition, in an involuntary case, upon
debts or accounts owed between a • Disclosure the filing of the involuntary petition by
debtor and a creditor. Simply, if A owes creditors, a debtor has 30 days to file an
B $100 and B owes A $50, then the debts – The Bankruptcy Code provides all answer to the petition. If the debtor
can be resolved as follows: $100 - $50 creditors substantial rights to learn contests the bankruptcy, the Bankruptcy
= $50, so A pays B $50 and the accounts details about the debtor’s financial Court will schedule and conduct a trial
are settled. The Bankruptcy Code condition, historical transactions and on whether the creditors’ petition meets
codifies this common law remedy and prospects for reorganization. Although the requirements of Section 303 of the
in fact provides that the creditor has a creditors have the right to appear at Bankruptcy Code.
secured claim to the extent of the value and attend the Section 341 “first
of its setoff claim. meeting of creditors”, this is rarely – During the “gap” period (time period
productive. Modern practice has been between the date of the involuntary
– The debts owing must be owed to that the Office of the United States petition and the date a Bankruptcy Court
and from precisely the same legal Trustee conducts the 341 meeting and enters an order for relief) note the
entities and the debts must arise either covers primarily administrative issues following:
both pre-petition or both post-petition. with limited opportunity for creditors
The debts do not, however, have to arise to examine the debtor’s representatives. 1. The automatic stay is in effect
out of the same transaction. upon the filing of the involuntary
– Rule 2004 of the Bankruptcy Rules petition;
– The exercise of a setoff remedy permits creditors broad rights to
requires relief from the automatic stay examine the debtor under oath and 2. Claims arising during the “gap”
from the Bankruptcy Court. Moreover, penalty of perjury about its financial period, including extensions of
there are somewhat complicated rules affairs, historical transactions and unsecured credit, are second-tier
regarding exercise of setoff during the prospects for reorganization, and to priority claims, which are
90 days prior to the bankruptcy filing, obtain relevant documents. subordinate to claims arising after
which if not followed, could result in the order for relief is entered;
preference exposure. – These tools allow a creditor to obtain
details about the debtor’s financial 3. If an order for relief is entered,
For more information on Set-off: condition necessary to evaluate the risk payments on pre-petition debts
click here and probability of payment. made during the “gap” period can
be voided as avoidable post-petition
– Recoupment is similar to setoff, except • Involuntary Petition transactions if no value was
that the mutual debts must arise from provided in the “gap” period.
the same transaction. – Normally a bankruptcy proceeding
is commenced by the filing of a – Creditors may seek the immediate
• Statutory Liens voluntary petition for relief by the appointment of an interim trustee if there
debtor. However, Section 303 of the is a concern that the debtor may be
– Vendors in possession of goods Bankruptcy Code permits three or dissipating assets.
belonging to a debtor may be able to more creditors to file an involuntary
assert a valid possessory lien under petition against a debtor, in either – Debtors have the absolute right to
state law. The Bankruptcy Code Chapter 7 or Chapter 11, if certain convert an involuntary Chapter 7 case
recognizes these liens, and treats the requirements are met. The to a Chapter 11 proceeding or vice versa.
vendor as a secured claimant to the requirements are that the aggregate
extent of the value of the goods in the debt owed to the three or more – A creditor considering an involuntary
vendor’s possession. States’ laws differ creditors is at least $13,475 for 2008, petition should always analyze payments
on the extent and priority of the lien such debts are not contingent as to received in the prior 90 days, as the
and whether it covers all amounts owed liability or subject to a bona fide involuntary filing will establish the 90
dispute, and the debtor is not generally day preference period.
paying its debts as they come due.
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6. November 2008
• Motion to Convert to Chapter 7 – A conversion to Chapter 7 will end – Claim purchasers will only purchase
Chapter 11 administrative expenses; claims that are not disputed or
– A party in interest including a creditor however, the Chapter 7 trustee and its contingent as to liability. Claim
or creditors’ committee may file a counsel will incur administrative purchasers will usually agree to buy
motion seeking to convert a Chapter 11 expenses that will have priority over claims based on the debtor’s schedules
case to a Chapter 7 liquidation case if the Chapter 11 administrative of assets and liabilities. However,
the creditor can establish “cause” and expenses. Moreover, the Bankruptcy purchasers will not buy claims based on
that a conversion is in the best interest Code allows the trustee to be paid a a creditors’ proof of claim if it is
of creditors. “Cause” includes: percentage of funds distributed to materially greater than the claim listed
creditors, which can be as high as 3%. on the debtor’s schedules, at least until
1. Substantial losses and no the claim is resolved in the claims
reasonable likelihood of • Motion to Appoint a reconciliation process.
reorganization. Trustee or Examiner
Executory Contracts
2. Gross mismanagement of the – A party in interest including a creditor
estate. or creditors’ committee can also file a • Executory Contract is the Bankruptcy
motion seeking the appointment of a Code term given to essentially any
3. Failure to maintain insurance. trustee or an examiner. A Chapter 11 contract between a debtor and a non-
trustee would supplant management debtor party where both parties owe
4. Unauthorized use of cash and take control of the debtor’s performance to the other. A promissory
collateral. bankruptcy estate and assets. An note would NOT be an executory
examiner does not supplant contract since the holder of the note has
5. Failure to pay taxes. management or take control of the no performance obligation. However, a
debtor’s estate; rather, an examiner supply contract or other sales agreement
6. Failure to file or confirm a plan investigates discrete issues, usually would almost always meet the
of reorganization within the relating to questionable transactions, requirements of an executory contract
applicable time period. and reports findings to the Court and under the Bankruptcy Code. Real estate
creditors. leases are also treated as executory
– Assuming a creditor has the contracts. The Bankruptcy Code Rules
appropriate grounds for conversion, – A creditor may seek the appointment for rejecting executory contracts and
the creditor should nevertheless of a trustee or an examiner for cause leases are debtor-friendly which is
consider several issues. including fraud, dishonesty, precisely why retailers who want to close
incompetence or gross mismanage- stores often choose Chapter 11 as the
– Since a Chapter 7 trustee cannot ment, if such appointment is in the vehicle to accomplish such goal.
operate the business, a conversion will best interest of creditors or if grounds
likely result in a closure of the business to convert to Chapter 7 exists. • The Bankruptcy Code provides debtors
operation and a quicker liquidation or the unfettered right to assume or reject
auction of the assets, or an aban- • Claims Sale executory contracts and leases. If a
donment of the assets to the secured debtor rejects an executory contract, the
lender. – At least up until the 2008 economic non-debtor party receives a general
crisis, there has been a vigorous market unsecured claim for damages arising
– The Chapter 7 trustee will take control for the purchase of bankruptcy debt, from the debtor’s “breach” of contract.
of the debtor and its assets and any particularly in larger bankruptcy cases. Thus, a debtor escapes the contract with
creditors’ committee or individual The purchasers are usually Wall Street little cost. On the other hand, the debtor
creditors will have less influence in the funds that are in essence seeking to also has the right to assume or assign a
bankruptcy process. For example, a purchase claims at a discount in hopes contract. In this instance, the Bankruptcy
Chapter 7 trustee may have more that the ultimate dividend, whether in Code requires that the debtor “cure” the
incentive to aggressively pursue the form of cash payments or stock in contract by paying existing defaults.
avoidance actions such as preferences the reorganized entity, will provide a Presumably, debtors would assume
against creditors. return on such investment. contracts that they deem to be valuable
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7. November 2008
Proof of Claim Section 363 Sale
• A proof of claim is the document by • Section 363 of the Bankruptcy Code
The potential costs and which a creditor registers its claim with allows a debtor to sell substantially all
the debtor’s bankruptcy estate, of its assets free and clear of liens with
vagaries of a jury trial indicating the type of claim (secured, liens attaching to proceeds of sale. This
might provide leverage administrative, priority or unsecured), provision allows for the quick and
to a preference the amount of the claim and the basis efficient liquidation of a debtor’s assets
for the claim. without having to first resolve the extent,
defendant. validity and priority of liens on assets.
• Bankruptcy courts almost always set This allows assets to be sold relatively
a bar date for filing proofs of claim quickly and avoids further erosion of
several months after the bankruptcy value due to operating losses.
petition is filed. To be considered, all
claims must be filed within this bar • Buyers of assets often favor acquiring
date. assets in a Section 363 sale (thus requiring
either because they insure an a Chapter 11 filing) since sales to good
uninterrupted supply of goods or • If the debtor’s Schedules of Assets faith purchasers are not subject to later
contain favorable pricing or terms. For and Liabilities lists a particular challenge.
a creditor who is a party to an executory creditor’s claim correctly, and does not
contract, the assumption of such list it as unliquidated, contingent or • Generally a Section 363 sale is teed up
contract can be an effective vehicle to disputed, and the creditor otherwise as an auction with a stalking horse sale
obtain payment of pre-petition debt. agrees with the debtor’s Schedules, as the initial bid. After appropriate
there is no need for the filing of a proof advertising and marketing, an auction
• Debtors in Chapter 11 must assume of claim. is conducted where interested buyers
an executory contract before or in are permitted to overbid the stalking
conjunction with the confirmation of • In order to assure participation in horse bid and thus allow the estate to
the Chapter 11 Plan. The non-debtor any distribution to creditors or vote on obtain the greatest possible value for its
party to the contract can ask the court a Chapter 11 plan, creditors often file assets. There is usually a required
to set a shorter time if it will be harmed a proof of claim, rather than rely on percentage bidding increment and the
by the delay in the debtor’s decision. the debtor’s Schedules of Assets and stalking horse bidder often has bid
Liabilities. protection in the form of a break-up fee
• The Bankruptcy Code requires that and expense reimbursement.
the non-debtor party to an executory • Creditors who file a proof of claim
contract must continue to perform its waive the right to demand a jury trial • Secured creditors are generally entitled
obligations under the contract pending in, for instance, a preference action. to “credit bid” their secured debt,
the debtor’s decision to assume or reject The potential costs and vagaries of a provided the secured claim is not
such contract, and provided that the jury trial might provide leverage to a disputed.
debtor is in fact performing its preference defendant.
obligations of the contract post-petition.
• A supply agreement impacts a
creditor’s rights as a critical vendor
since the leverage of not shipping is
arguably eliminated in the context of
an executory contract.
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8. November 2008
• Although a Section 363 sale can be a Plan of Reorganization – The so called “absolute priority rule”
valuable tool for maximizing the requires that a junior class of creditors
liquidation value of a debtor’s assets, • A Plan of Reorganization is cannot receive value on its claims unless
such sales can also create an inherent essentially the debtor’s contract senior classes are paid in full or vote to
tension between the secured creditor detailing how the debtor will satisfy accept the plan. Thus, unless unsecured
who asserts liens on the assets being pre-petition claims. This can be in the creditors are paid in full, equity holders
sold and other creditors of the estate. form of cash distributions, an allocation are not permitted to retain their equity
The secured creditor’s goal is payment of future profits, and/or redistribution interest absent a capital contribution
of its secured debt and nothing more, of the debtor’s equity. commensurate to the value of the
while other creditors seek to achieve a reorganized debtor’s stock.
sale in excess of secured debt to • For a Plan of Reorganization to
generate proceeds for other creditors. become effective, it must be confirmed – To be confirmed, a Plan must also be
The quickest sale does not necessarily by the Bankruptcy Court. feasible. A key element of feasibility is
produce the best sale, however, usually whether or not a debtor has
prolonged sales processes have the – For purposes of Plan confirmation, committed exit financing. The current
disadvantage of higher administrative similarly situated creditors are placed credit crisis may undermine the ability
costs. in classes of creditors, usually roughly of Debtors to obtain exit financing, and
corresponding to the claim priorities thus exit Chapter 11.
• With increasing frequency, and due set forth above. If a class of creditors
to the recent trend of high loan to value is unimpaired, meaning their claims
ratios, many Section 363 sales have are satisfied, that class is deemed to
produced sales proceeds less than the have accepted the Plan. For creditor
amount owed to secured creditors. classes that are impaired, the class must The current credit crisis
These “short sales” create an either consent to the Plan or be
administrative insolvency where only “crammed down”. For a class to may undermine the
secured creditors benefit from the sale. consent to a Plan, of the class members ability of Debtors to
Many courts have required the secured who vote, there must be more than 1/2
creditor to pay administrative claims
obtain exit financing,
in number and 2/3 in dollar amount
associated with the Chapter 11 of creditors accepting the Plan. and thus exit Chapter 11.
proceeding to obtain the benefit of the
Chapter 11 process and protections. – A debtor can “cram down” its plan
This has been euphemistically referred on non-consenting classes if the Plan
to as the “pay to play” rule. In addition, is “fair and equitable,” does not
creditors often assert that the Chapter “discriminate unfairly” within classes,
11 process contemplates a benefit to all and is in the “best interests of
creditor classes and thus unsecured creditors,” primarily that creditors will
creditors should receive a “carve-out” receive more in the Plan than in a
of the sale proceeds to fund a dividend Chapter 7 liquidation.
to unsecured creditors.
• In the recent Clear Channel case, the
Ninth Circuit (includes California)
Bankruptcy Appellate Panel (BAP)
ruled that in the case of a “short sale”,
the Section 363 sale was NOT “free and
clear”, and the buyer acquired the assets
SUBJECT TO the junior liens. Whether
Clear Channel is an aberration or the
beginning of a trend remains to be seen.
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9. November 2008
Avoidance Actions - Contemporaneous exchange for Non-Bankruptcy
value is where the parties intended
• Preferences. the payment to be substantially Alternatives
contemporaneous with the creditor
– Bankruptcy Code Section 547 allows providing new value. The classic • The two most common non-
the debtor to recover pre-petition example of contemporaneous bankruptcy alternatives are the out of
payments to third parties that were exchange for value is where a debtor court workout, which may involve a
made within 90 days prior to filing as desperate for goods promises to composition agreement, or an
to non-insiders and within one (1) year send a check if the creditor will assignment for the benefit of creditors
prior to filing with respect to insiders. release goods. Documentation of under state law.
The requirements to assert a preference the parties’ intent of payment in
are that the payment in question be exchange for specific value is critical • A non-bankruptcy workout
made within the appropriate time to this defense. generally involves a forbearance
period, made while the debtor is agreement with secured lender(s) and a
insolvent, the payment is on account forbearance or composition agreement
of antecedent debt and the payment with unsecured creditors. Such
allows the creditor to receive more than composition agreement may involve a
it would in a Chapter 7 liquidation.
For more information on moratorium or delay in payment of debts
Debtors or trustees pursuing preference Preferences click here owed and/or a compromise of the
claims rarely have difficulty establishing amount owed. Immediate cash
and click here. payments for creditors usually require
these basic requirements.
a discount, a longer term payout may
– The statute of limitations on result in payment in full.
preference actions is two years from
the petition date. • Fraudulent Transfers • Assignments for the benefit of creditors
are governed by each states’ laws, which
– Creditors who have received – Fraudulent transfers is a partial differ materially from state to state.
allegedly preferential payments have misnomer because fraud is not There is little uniformity among states’
several defenses, the most common required. The debtor can recover laws on assignments with some states
three being that the payment was made payments made to non-insiders for having highly developed statutes and
in the ordinary course of business, that transfers occurring within one (1) year procedures and other states having
the creditor provided subsequent new prior to bankruptcy and for two (2) virtually nothing.
value after the payment at issue, or that years with respect to insiders. The
the payment constituted a debtor can recover transfers that were • Conceptually, an assignment involves
contemporaneous exchange for value. made in an attempt to defraud creditors a transfer of all of the debtor’s assets to
but also when the transfer was simply a third party assignee, whose duties and
- The ordinary course of business for “less than reasonably equivalent responsibilities are similar to a Chapter
defense is based on the notion that value”. 7 trustee. Assignees can operate a
the payment in question was business enterprise, but assignments
consistent with the ordinary course – A statute of limitations on asserting generally involve the ultimate sale of the
of business between the debtor and fraudulent transfer claims is two (2) assets.
the particular creditor or consistent years from the petition date.
with industry standards generally. • Assignments for the benefit of creditors
– Debtors and trustees in bankruptcy are usually limited to smaller business
- Subsequent new value is simply are also entitled to assert claims under enterprises whose assets are located
that creditors provided additional state law fraudulent transfer statutes within one state since the assignment
value in the form of goods or which are similar to the Bankruptcy laws in one jurisdiction cannot be
services after receipt of the payment Code fraudulent transfer statute but imposed on assets in another jurisdiction.
that in essence replenished the often have a longer statute of
estate’s assets. The defense exists limitations, and the reach back period
to the extent of such new value. may be longer.
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10. November 2008
Cross-Border Insolvency – ALI NAFTA Transnational Insolvency – In the recent Bear Stearns case, two
Project Bear Stearns hedge funds, registered
• When a multi-national business faces under the laws of the Cayman Islands,
insolvency, assets in more than one • COMI (or Center of Main Interests) and with their primary operations in
country likely require administration is a key concept in Chapter 15, the New York, filed “winding up”
and protection. It is sometimes not UNCITRAL Model Law and the proceedings in the Cayman Islands.
clear what country’s law will apply, European Union Insolvency However, in response to investor
and which jurisdiction will control the Regulation, all of which presume lawsuits arising from sub-prime
insolvency process. This can be COMI is where an entity has its investments, the Hedge Funds needed
determinative of outcome since corporate registration. protection in the United States. The
countries’ laws and approach to Hedge Funds’ administrators thus filed
business insolvencies can differ – COMI impacts where the main Chapter 15 petitions in New York seeking
materially. proceeding should occur, based on recognition of the Cayman Islands
where a business has its “center of proceedings as “foreign main”
• Typically, a multi-national business main interests”, which is analogous to proceedings or in the alternative as
located outside the United States with the principal place of business. Thus, “foreign non-main” proceedings.
assets in the United States would seek if COMI exists in a foreign country, a
insolvency protection under the laws U.S. Bankruptcy judge should – Even though no party objected to the
of its country, but will also file an recognize a foreign insolvency Chapter 15 petitions, the U.S. Bankruptcy
“ancillary” proceeding in the United proceeding as the “foreign main” Court refused to recognize the Cayman
States. proceeding and the U.S. Chapter 15 Islands proceedings as either “foreign
proceeding as an “ancillary” main” or “foreign non-main”
• There are many laws, treaties and proceeding. If a debtor does not have proceedings since the Court found that
regulations that address these issues, COMI in the country where it files its the Cayman Islands was neither the place
including: insolvency proceeding, but has an of COMI nor of an “establishment”.
“establishment” in such country, the Rather, the Court concluded that the
– Chapter 15 of the Bankruptcy Code U.S. Bankruptcy Court should Hedge Funds were in New York. The
on Ancillary Cases recognize the foreign proceeding as a effect of this ruling is that to obtain the
“foreign non-main” proceeding. protections of the U.S. Bankruptcy Code,
1. Mostly follows the United Nations’ the Hedge Funds would be required to
Model Law on Cross-Border – If the foreign insolvency proceeding file Chapter 11 proceedings in New York.
Insolvency is recognized as a “foreign main” The Court also suggested that involun-
proceeding, the approval of the tary proceedings might be filed against
2. Chapter 15 passed as part of the Chapter 15 proceeding will invoke the the Hedge Funds in New York.
2005 Bankruptcy Code Amendments automatic stay. If the foreign
insolvency proceeding is recognized – The Bear Stearns opinion has been
– UNCITRAL (United Nations as a “foreign non-main” proceeding, sharply criticized internationally as a
Commission on International Trade the Chapter 15 proceeding will not U.S. attempt to control international
Law) Model Law on Cross-Border invoke the automatic stay protections. insolvencies through Chapter 11. Among
Insolvency other things, critics argue that it is
disingenuous for a U.S. Bankruptcy
Goal: to “modernize and harmonize Court to find Chapter 11 jurisdiction, in
the rules on international business and Delaware for example, based solely on
to enhance predictability in cross-border the place of incorporation, while
commercial transactions”. applying a different, more stringent
standard to foreign insolvency
– European Union Regulation on proceedings.
Insolvency Proceedings
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11. November 2008
• Many countries have also recently In many respects, these laws tend to The contents of this update are offered
enacted new insolvency laws including make insolvency laws more similar in as general information only and are
the following: different jurisdictions, and many are not intended for legal advice on
in fact based on the UNCITRAL Model specific matters.
– Brazil (2005) Law (above).
– China – Enterprise Bankruptcy Law • A key difference between the U.S.
of the People’s Republic of China Bankruptcy Code and most foreign
(2007) bankruptcy laws is the concept of
– Columbia (2006) “Debtor in Possession”. In U.S.
bankruptcy cases, it is extraordinary
– France (2006) for a trustee or examiner to be imposed,
– Italy – 2005/2006 reforms and 2008 while most foreign insolvency laws
Corrective Decree require the appointment of a third party
administrator or liquidator with
– Japan – (2000) varying degrees of responsibility and
– Mexico – Ley de Concursos involvement regarding the business.
Mercantiles (2000)
– Spain (2003)
– United Kingdom (2005)
© David H. Conaway
Shumaker, Loop & Kendrick, LLP
dconaway@slk-law.com
November, 2008
For more on the author
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For more on Shumaker’s Bankruptcy, Insolvency and Creditors’ Rights Practice
click here
For more on Shumaker’s Practice Areas
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