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PROTECTING YOURSELF BEFORE AND AFTER A CUSTOMER'S BANKRUPTCY

OUTLINE

    KNOW THE TERMS OF YOUR CREDIT DOCUMENTS
  • Do the credit documents give you adequate rights and remedies?
  • Do your credit documents control the transaction?
  • To the extent the credit extension is with a "consumer," does the language of the documents comply with applicable state and federal law?
  • Have all necessary documents been executed and any security interests perfected?

    THE CREDIT APPLICATION

  • Comply with federal and state laws and regulations governing the granting of credit
  • Obtain information relevant to the credit granting decision

    ALTERNATIVES TO INCREASE LIKELIHOOD OF COLLECTION IN THE EVENT OF BANKRUPTCY

  • Obtain a purchase money security interest in the acquired goods
  • Structure the transaction as a consignment
  • Structure the transaction as a true lease or other type of executory contract
  • Obtain a guarantee from some third party
  • Obtain letters of credit
  • Obtain lien on the debtor's general assets
  • Enter into joint check arrangement

    PURSUING COLLECTION
  • General considerations in the pursuit of collection
  • Comply with the all laws governing collection practices

    THE INITIATION OF A BANKRUPTCY CASE
  • The initiation of a voluntary case and the debtor's options
  • Initiation and rationale for an involuntary case

    STRATEGIES FOR CREDITORS IN BANKRUPTCY

  • Stopping goods in transit and reclamation
  • Seek the imposition of a constructive trust
  • Protect right of setoff
  • Protect secured claim
  • Protect rights under lease or other executory contract
  • File a proof of claim
  • General strategies in the different chapters
    • Chapter 7 strategies
    • Chapter 11 strategies
    • Chapters 12 and 13 Strategies




I. KNOW THE TERMS OF YOUR CREDIT DOCUMENTS


An important part of practicing defensive credit is to know the terms of your credit documents. While perhaps obvious, this initial step cannot be overemphasized. There are several questions which you should ask in reviewing the documents.

A. Do the credit documents give you adequate rights and remedies?

Do the credit documents clearly specify when payment is due? To the extent that it allows payment in installments, does it provide for an acceleration of the entire balance in the event of a default? Does it specify a choice of law and or where an action may be filed in the event of a default? Does it clearly set forth the incidents of default. Does it provide for interest (at your cost of capital or higher) in the event of default? Does the provision for interest make clear that you are entitled to interest at the "contract" rate after judgement and until you are paid? Does it provide for the recovery of all "reasonable" costs and expenses of collection including attorneys fees incurred up through payment? Does it include a confession of judgement clause (where permitted under local law)?

An additional benefit of familiarity with your documents (and the rights and remedies they provide) is that it should better enable you to assist your legal counsel should legal action become necessary.

B. Do your credit documents control the transaction?

Closely related to the question of whether the credit documents give you adequate rights and remedies is whether they control the transaction. If they do not, then the terms and conditions of the other party's documents become important. If the other party's documents differ materially from the terms or conditions you need or want, the differences will need to be resolved.

In the ordinary case, it will be clear whose documents control. Occasionally, however, a "battle of forms" develops where a purchase order is placed by one party on a form with certain preprinted terms and conditions, which purchase order is then acknowledged by the other party on its own preprinted form which contains different preprinted terms and conditions. Whose terms and conditions control the transaction? The answer is provided by Section 2-207 of the Uniform Commercial Code. A discussion of the impact of the Uniform Commercial Code can become quite involved. The point is not so much how the Uniform Commercial Code would resolve the problem, but rather, the importance of avoiding the problem. This is accomplished by reaching a clear understanding of whose terms and conditions control where there are multiple versions being sent back and forth.

C. To the extent the credit extension is with a "consumer," does the language of the documents comply with applicable state and federal law?

A third reason why it is important to know your documents is so that you can be sure that they comply with applicable state and federal law, particularly in transactions involving consumers. Examples of laws with which a company extending credit should ensure compliance (at least in Pennsylvania) include the following:

(i) The federal "Truth-in-Lending Act" (located at 15 U.S.C. §§ 1601-1614,1631-1646, 1661-1665a, 1666-1666j, and 1667-1667b), and the related Regulation Z (located at 12 CFR §§2261.1-226.1503) which implements the provisions of the Truth-in-Lending Act. The Act and Regulation together set forth a number of requirements regarding the written disclosure of certain information to the consumer.

(ii) The Pennsylvania "Goods and Services Installment Act" (located at 69 P.S. §§ 1101-2303).

(iii) The Pennsylvania "Plain Language Consumer Contract Act" (located at 73 P.S. §§ 2201-2212).

D. Have all necessary documents been executed and any security interests perfected?

Another benefit of knowing your documents is that it decreases the risk that an important part of the transaction is accidentally omitted. This would include, but not be limited to, signatures on key loan or other credit documents, signatures on truth-in-lending disclosure documents (in a consumer transaction), signatures on guarantees, etc. In addition, knowing your documents decreases the likelihood that the perfection of a security interest granted as part of the credit transaction will be forgotten.


II. THE CREDIT APPLICATION

Defensive credit begins with the decision of whether to grant credit. Some important aspects of this part of the process include:

(A) Complying with federal and state laws and regulations governing the granting of credit.

The most significant of the laws governing the credit granting process may be the federal "Equal Credit Opportunity Act" (located at 15 U.S.C. §§ 1691-1691f), and its related regulation, Regulation B (located at 12 CFR §§ 202.1-202.14). The Act prohibits creditors from discriminating against a person seeking credit because of sex or marital status, or because of race, color, religion, etc. The Act and Regulation B set forth rules regarding the credit granting process including the identification of the kinds of questions which may not be asked (12 CFR §202.5), rules concerning the evaluation of applications (12 CFR §202.6), and rules regarding the extensions of credit (12 CFR §202.7). The Act and Regulation B also sets forth certain requirements concerning the creditor's duty to respond to inquiries from the applicant when credit is denied.

(B) Obtaining information relevant to the credit granting decision.

Make sure that your application process reveals, subject to any prohibitions set forth in the Equal Credit Opportunity Act, sufficient information and disclosure to allow you to make an intelligent decision as to whether credit should be granted. Relevant information may include: financial statements; pending lawsuits in which the debtor is involved; judgements filed against the debtor (and the debtor's principals if the debtor is a legal entity); the major unsecured and all secured creditors and the assets subject to the liens of the secured creditors; evidence that the debtor is current with both the filing and payment of taxes; persons or entities which jointly own assets with the debtor (and the nature of their ownership); and the debtor's legal status (proprietorship, partnership, corporation, other type of limited liability company, etc.) Of course, the amount of information requested and/or the extent of the investigation into the debtor's creditworthiness is a function of the size of the transaction.



III. ALTERNATIVES TO INCREASE LIKELIHOOD OF COLLECTION IN THE EVENT OF BANKRUPTCY

In the event that the debtor is not alone creditworthy on an unsecured basis, the creditor may consider alternatives to increase the likelihood of collection in the event of a default as a condition to the extension of credit. The alternatives include, but are not limited to, the following:

(A) Obtain a purchase money security interest in the acquired goods.

A purchase money security interest is a voluntary lien provided to the entity which either provides the goods in which the lien is granted, or, as the name implies, provides the funding used to purchase the goods. Purchase money security interests are of particular importance since they give the purchase money creditor priority over preexisting secured creditors in the same types of goods. The Uniform Commercial Code (13 Pa. C.S.A §9312 in Pennsylvania) sets forth the steps which need to be followed in perfecting a purchase money security interest. The requirements include notice to the holder of any preexisting security interest (in the case of inventory) along with the filing of UCC 1 financing statements within certain specified periods of time.

(B) Structure the transaction as a consignment.

Under the typical consignment arrangement the consignor (seller) retains title until the consigned goods are sold by the consignee. The consignee acts as an agent for the consignor. In a manner of speaking, the goods, although in the consignee's possession, do not become part of its balance sheet. From the consignor's perspective, the goods remain part of its inventory rather than being converted into an account receivable. While the transfer of title and, perhaps, the accounting treatment, are different than the standard purchase money security interest, it is still necessary to comply with the Uniform Commercial Code (13 Pa. C.S.A. §§ 2326 and 9114 in Pennsylvania). The requirements include the compliance with any applicable law regarding the evidencing of the separate interest by a sign, filing UCC 1 financing statements, and providing notice to any preexisting creditors in that type of collateral.

Particular care should be taken when the consigned goods constitute inventory to be used in the consignee's operations. Additional protective steps include such things as keeping the consigned goods in a physically distinguishable part of the consignee's facility, having a lease agreement for the consignor's "use" of the "storage area," using a defined procedure for documenting transfers (i.e., sales) of the consigned goods to the consignee for use in its operations, and a practice of regularly conducted physical inventories by an "employee" of the consignor. See, e.g., Thomas E. Raleigh and J. Jessop Hines, Selling to Troubled Companies: Consignment as a Strategy, ABI Journal, September, 1992, at 13.

(C) Structure the transaction as a true lease or other type of executory contract.

Property subject to a true lease or other executory contract remains the property of the "seller."

Under the bankruptcy code, the debtor, in order to assume a lease, must cure any defaults which exist (including arrearages), compensate the creditor for any losses it incurred as a result of the default, and provide adequate assurance of the ability to perform in the future. Thus, the party to a contract which the debtor wants to assume may even be in better shape in a bankruptcy than a secured creditor who may be limited to the value of its collateral.

To the extent the transaction involves goods which can also be sold rather than leased, it is imperative that the transaction be structured in a way to constitute a "true" lease, and not be a disguised financing transaction (i.e., a financing lease.) Factors considered by the courts in determining whether a transaction styled as a lease is a financing or true lease include whether the debtor has a nominal purchase option at the end of the lease and whether the debtor bears the risk of loss. If the lease is determined to be a "financing lease," it will be treated as an installment sales agreement rather than as a lease. It will then have been necessary for the creditor to have perfected its interest by filing UCC 1 financing statements. Thus, the creditor should take great care in pursing this alternative, and, in any event, file UCC 1s as a backup.

(D) Obtain a guarantee from some third party.

Guarantees are only as good as the creditworthiness of the guarantor. To the extent possible, a guarantee should be secured by the assets of the guarantor. A guarantee given by an individual in a common-law state (like Pennsylvania) should include the guarantor's spouse (provided that the guarantor is not creditworthy otherwise). In common-law states, property owned jointly by both spouses is exempt from execution against a creditor of only one of the spouses.

Guarantees can contain miscellaneous terms and conditions. They can be conditional or unconditional, containing or waiving such things as: notice to the guarantors of default; the requirement that the creditor first seek satisfaction from the primary obligor; etc. Any limitation on a creditor's ability to proceed immediately against the guarantors decreases its value. For example, if the guarantee requires the creditor to first collect from the primary obligor, and the primary obligor files for bankruptcy, the creditor may be forced to wait until there is a distribution in the bankruptcy before proceeding against the guarantors. In order to avoid such delays, and cut off other potential defenses, the guarantee documentation should: provide for a waiver by the guarantors of any notice of default; provide that the guarantors are jointly and severally liable with the primary obligor on the obligation; provide that the guarantors' obligations are primary and independent; provide that the creditor is not obligated to first seek or exhaust any remedy against the debtor before the guarantors become liable; and provide that the creditor may grant such extensions on the primary obligor's obligations, or otherwise modify the terms or release any collateral or other party liable on the debt, without affecting the guarantors' obligations.

(E) Obtain letters of credit.

Closely related to the concept of third party guarantees is letters of credit. While draws on letters of credit are occasionally enjoined, the majority view is that they are not property of the estate and that the beneficiary should not be prevented from drawing on the letter. Draws on letters of credit are typically not considered preferential unless the issuance of the letter of credit was preferential.

(F) Obtain lien on the debtor's general assets.

While this will require the creditor to participate in a bankruptcy, and the creditor will likely be stayed during the pendency of the bankruptcy, entering a bankruptcy as a secured creditor is obviously better than entering it as a fully unsecured creditor.

A lien will only secure the creditor to the extent of the value of the collateral less all higher priority liens. For example, if credit in the amount of $100,000 was extended, but the value of the collateral was only $50,000, the creditor would only be a secured creditor to the extent of $50,000. Likewise, if the collateral was worth $100,000, but higher priority liens against that property totaled $50,000, the creditor would still only be secured to the extent of $50,000. To the extent that the claim exceeded the value of the collateral and all higher priority liens, the creditor is unsecured.

Key considerations in accepting a lien to secure payment are the value of the collateral and the amount of prior liens against the collateral. Furthermore, it is necessary to understand the nature of the collateral and its rate of physical depreciation or depletion, and to make sure that the security interest is properly perfected in accordance with applicable law.

(G) Enter into joint check arrangement.

In certain circumstances, a joint check arrangement is a way of making sure that the creditor gets paid when the debtor gets paid. Such an arrangement should be clearly documented, should bind the third party responsible for issuing the check as well as the debtor, and should make clear that the debtor is obligated to endorse the check and then turn it over to the creditor for payment.

While joint check arrangements have been enforced in bankruptcy, either in accordance with the terms of the agreement or pursuant to the law of constructive trust, they cannot be considered an ironclad means of protection. A creditor relying on a joint check arrangement may find itself in litigation with any lenders with perfected security interests in the debtor's accounts in the event of a bankruptcy. In addition, in a bankruptcy, a trustee would likely argue that the funds remained property of the estate until actually paid over to the creditor, and, therefore, if the bankruptcy case was filed before the joint check was either issued or negotiated that the creditor should be treated as just another general unsecured creditor. Before relying on a joint check arrangement for a significant transaction, the possible ramifications in the event of bankruptcy under the law of the jurisdiction likely to control in the event of a bankruptcy should be carefully considered.


IV. PURSUING COLLECTION

(A) General considerations in the pursuit of collection.

The steps to be undertaken in the pursuit of collection depend on the facts and circumstances of the case. Options like the filing of a mechanics lien or making a claim against surety bonds may be available in certain construction cases. The filing of a complaint for confession of judgment may be an option if an enforceable confession of judgment clause was included as part of the original documentation. To the extent that the creditor has a lien in assets of the debtor, it can pursue its in rem rights against the collateral in accordance with the terms of the security agreement and applicable law. To the extent the creditor has recourse against some third party, as the result of a guarantee or otherwise, an action against that third party can be pursued. Where available, goods or services can be withheld until the account is brought current. Finally, notwithstanding the absence of any other alternative, the creditor can file a civil action for the balance due.

Typically, some demand for payment and/or declaration of default is made before a collection action is initiated. There may be some request from the debtor for a grace period, or some sort of an installment payment plan, in response to the demand. To the extent that the creditor is willing to negotiate something along those lines, it may be possible to obtain additional security or other assurance of payment as a condition of forbearance.

It is not unusual for debtors confronted with collection actions to threaten bankruptcy if an action is initiated or continued. If confronted with such a threat, and the threat has some merit, the creditor may elect to counter with an offer of a grace period and/or installment plan secured by assets of the debtor or a guarantee from some third party. Short of securing a repayment plan with assets or some guarantees, the creditor is no better off than any other creditor if the debtor subsequently files for bankruptcy.

Unlike the obtaining of security at the time of the initial grant of the credit, obtaining security for the payment of a past due debt constitutes a preferential transfer. While the grant of a security interest and/or payment within the preferential period may be subject to avoidance in a subsequent bankruptcy case, the creditor is still better off having received the transfer. The creditor may have a defense to at least part of the avoidance action (typically as the result of the grant of "new value"). The preference action may not be pursued. The creditor had the use of the money (where the transfer was payment) for at least some period of time. Finally, the creditor may be able to negotiate a settlement which allows it to keep at least some of the benefit of the transfer.

Notwithstanding the threat of bankruptcy, if the debtor is unwilling to provide security and/or an acceptable repayment plan, the creditor may still wish to proceed with the collection action. The threat may not be sincere. A debtor has certain risks, and bears a great deal of costs and expenses, in bankruptcy. Where the threat is simply a ruse to attempt to get the creditor to back off, proceeding to judgement is an effective collection mechanism. The creditor, of course, never knows for certain whether the threat will be carried through.

A judgment will, in Pennsylvania, serve as a lien against any real estate of the debtor in any counties where the judgment is filed. It would not act as a lien against personal property until a "levy" of the debtor's personal property by a sheriff, in accordance with the Pennsylvania Rules of Civil Procedure, was effected. Different states have different rules as to what property becomes subject to a judicial lien when a judgment is filed. In any event, once entered, a judgment becomes a lien on certain of the debtor's assets, can become a lien against other of the debtor's assets through further enforcement action, and finally, can result in collection through the judicial sale of the assets subject to the judicial liens.

In preparing for a collection suit, the creditor should ready itself for some attack on the quality of its goods or services. This is typically the only defense available to the debtor. Detailed record keeping during the initial grant of the credit, together with all subsequent correspondences or communications (oral or written), and all responses thereto, should aid the creditor and its counsel in the expeditious prosecution of its case.

(B) Comply with the all laws governing collection practices.

The federal Fair Debt Collection Practices Act (located at 15 U.S.C. §§ 1692-1692o) was enacted in 1977 to eliminate abusive debt collection practices by debt collectors. It applies to debt collectors seeking to collect a debt from consumers. The Act sets forth the types of things that are not acceptable in the course of attempting to collect a debt.

Many states have statutory and decisional tort law which also prohibits abusive and unfair collection practices. Accordingly, even if one does not fall within the parameters of the federal Act, care should still be exercised in pursuing collection, particularly where consumers are involved.



V. THE INITIATION OF A BANKRUPTCY CASE

(A) The initiation of a voluntary case and the debtor's options.

The voluntary bankruptcy case is commenced by the filing of a petition for relief with the clerk of the bankruptcy court. The debtor filing a voluntary petition will designate which chapter it is filing under. Its options are as follows:

(i) Chapter 7 - Liquidation. All nonexempt assets are liquidated by a trustee and the proceeds distributed to creditors in accordance with the statutory priorities. All debts, except those expressly excepted by statutory language, are discharged. The goal is to give an individual a fresh start. In the case of a corporate debtor, there are no exempt assets, and the debtor gets no discharge (or fresh start). The case typically culminates in the court approval of the trustee's final report and proposed distribution (where there are assets to be distributed).

(ii) Chapter 11 - Business Reorganization. The debtor remains in possession and control of the business, albeit subject to court control, and, in certain cases, subject to oversight by a creditors' committee. Utilizing various tools provided by the Bankruptcy Code, including the right to reject burdensome contracts, abandon burdensome property (subject to certain limitations), and modify the terms of secured and unsecured obligations, the debtor seeks to rehabilitate its business and/or reorganize its capital structure. If successful, the case will culminate in court approval of a reorganization plan. If the case is not successful, it will end in a dismissal, or conversion to a Chapter 7 liquidation.

(iii) Chapter 13 - Wage Earner Reorganization, or Chapter 12 - Family Farmer Reorganization. Like Chapter 11, the debtor remains in possession and control of his assets, subject to court control, and oversight by a standing Chapter 12/13 trustee. Like Chapter 11, there are various tools available to allow the family farmer/wage earner to reorganize his obligations. If successful, the case will culminate in court approval of a Chapter 12/13 plan and complete consummation of the plan. If not successful, the case will end in a dismissal, conversion to Chapter 7, or a hardship discharge (in Chapter 13).

(B) Initiation and rationale for an involuntary case.

Creditors ordinarily view bankruptcy as an event which makes collection (other than perhaps some pennies on the dollar) extremely unlikely. For that reason, the thought of creditors putting a debtor into bankruptcy may seem incongruous. There are, however, situations where creditors may be "collectively" benefited as a result of an involuntary filing. Examples include where the debtor is fraudulently, preferentially, or perhaps negligently dissipating its assets. The involuntary bankruptcy prevents any further dissipation and, to the extent that avoidable transfers occurred within certain specified periods of time prior to the filing of the involuntary petition (90 days for noninsider recipients of preferential transfers, 1 year for insider recipients of preferential transfers, 1 year for fraudulent conveyances), allows the transfers to be avoided and the value recovered.

The creditors' options with respect to an involuntary are Chapters 7 and 11. An involuntary petition requires the participation of at least 3 creditors (where the debtor has 12 or more creditors) who hold unsecured claims which aggregate at least $10,775, and which are not subject to a bona fide dispute. A bona fide dispute is a genuine issue over whether the debtor is liable on the debt and is not just a manufactured defense to delay payment, or a subjective belief by the debtor that it is not liable. In the event the debtor has less than 12 creditors, one (1) creditor may initiate the involuntary, although it is still necessary for the single creditor to have an unsecured claim not subject to a bona fide dispute of at least $10,000.

If the numerical requirements of the involuntary (number of petitioning creditors and amount of claims) are satisfied, the court will enter an order for relief which subjects the debtor to the rules and requirements of bankruptcy if the court is also satisfied that the debtor is not generally paying its debts as they become due. What constitutes general nonpayment is fact specific. Courts consider such factors as the number of creditors and the total debt, the amount and age of any delinquencies, the materiality of delinquencies, and the manner in which the debtor conducts its financial affairs.

The debtor has an opportunity to contest the involuntary petition by arguing that it is generally paying its debts as they become due and/or that the numerical aspects of the involuntary have not been satisfied. If the court dismisses an involuntary, it may grant judgment against the petitioning creditors for the debtor's costs and attorneys' fees, and for compensatory damages proximately caused by the involuntary. If the court concludes that the involuntary was brought in bad faith it may also assess punitive damages. Bad faith may be found where the petitioning creditors failed to make a reasonable inquiry into the number of creditors or the amount of their claims, or where the filing was motivated by some ulterior motive other than to effect an equitable distribution of the debtor's assets.


VI. STRATEGIES FOR CREDITORS IN BANKRUPTCY

To a large degree, the creditor's strategies in bankruptcy are a function of its prepetition status. The creditor will typically enter the bankruptcy either as a secured creditor, as a party to an executory contract, or as an unsecured creditor.

(A) Stopping goods in transit and reclamation.

If goods sold to the debtor are still in "transit" at the time the debtor's insolvency is discovered, and are not yet in the possession of a carrier or warehouse that is an agent of the debtor, the goods may be stopped under the Uniform Commercial Code. See UCC §2-705(1). In a situation where it is not clear whether the goods are still subject to being stopped, the better course may be to investigate both that remedy and the right of reclamation, so as to make sure that the automatic stay is not violated.

Under the right of reclamation, as incorporated into the Bankruptcy Code, the seller of goods may reclaim goods delivered to the debtor provided that a written notice of reclamation is served on the debtor within 10 days of the delivery of the goods, unless a bankruptcy occurs between the date of delivery and the 10th day thereafter in which case the creditor has 20 days from the date of delivery to serve the reclamation notice. As long as the notice is timely provided, the creditor is entitled to recover any goods delivered within the applicable time which are still separately identifiable and in or about the debtor's facility, or to be granted an administrative expense claim and/or lien to secure payment of the reclamation claim. Because of the fact that the creditor is only entitled to reclaim goods still in the debtor's possession, and, secondly, because of the difficulties of proof, a creditor pursuing reclamation should act quickly to perfect (by legal action in the bankruptcy case) the amount and priority of its claim following a bankruptcy filing.

One complexity that may arise in litigation over a reclamation claim is the priority of the reclaiming creditor vis-a-vis preexisting secured creditors with perfected liens in the debtor's after acquired inventory. Under state law (i.e., the Uniform Commercial Code), the reclaiming creditor's rights are subordinate to the rights of the preexisting inventory lender. Some courts seize on this fact to deny the reclamation claim where the rights of a lien creditor have intervened.

(B) Seek the imposition of a constructive trust.

Although looked upon with disfavor by many courts, one possible remedy for a creditor who believes that the debt is the result of fraud or other wrongful conduct is to ask the court to impose a constructive trust on its traceable funds (or goods) in the possession of the debtor. Under Pennsylvania law, a creditor seeking the imposition of a constructive trust must prove the existence of an identifiable res, some equitable reason for imposing the trust, and either wrongful conduct by the debtor, mutual mistake, or some statute or common law imposing such a trust. To the extent that the trust is imposed, the res is excluded from the bankruptcy estate.

(C) Protect right of setoff.

The right of setoff arises where there are mutual debts owed by both the creditor and debtor to each other. The Bankruptcy Code (11 U.S.C. §553) incorporates the state law right of setoff. A creditor's right to setoff a debt it owes the debtor, dollar for dollar, against the debt owe by the debtor to it is extremely valuable. Setoff results in the creditor realizing full value of its claim against the debtor to the extent of the setoff. Before a creditor can effect the setoff (on its books), it must obtain relief from the automatic stay.

(D) Protect secured claim.

To the extent that a creditor obtained liens in the debtor's assets prepetition, it will want to take immediate steps to protect its secured claim. The most common initial step is to obtain adequate protection or to seek relief from stay so that the creditor can execute on its collateral.

Adequate protection can be provided by, among other things, replacement liens, periodic payments, and/or an equity cushion in the collateral. In order to provide adequate protection it is also necessary to show that the collateral is being adequately maintained and insured. The purpose of adequate protection is to protect the secured creditor from any decrease in the value of its secured claim during the pendency of the bankruptcy case.

If the debtor is unwilling or unable to provide adequate protection, the creditor is entitled to relief from stay to pursue execution. See 11 U.S.C. §362(d)(1). Alternatively, if there is no equity for the debtor in the collateral and the collateral is not necessary to an effective reorganization, the creditor is entitled to relief from stay. See 11 U.S.C. §362(d)(2).

Even if, because of apparent adequate protection or equity in the collateral, relief from stay is unlikely, the secured creditor will, nevertheless, want either a court ruling or an agreement acknowledging that it is adequately protected. If a creditor is held to be adequately protected, and it later turns out that it was not, the difference, to the extent it arises from the debtor's use of the collateral, is, in accordance with 11 U.S.C. §507(b), accorded a superpriority administrative expense claim.

Beyond matters involving relief from stay and adequate protection, protecting a secured claim in Chapters 11, 12, and 13 includes consideration of such important topics as the valuation of secured claims in bankruptcy (11 U.S.C. §506(a), and the treatment of the secured claim in a reorganization plan. For a detailed discussion of the rights of, and limitations on, a debtor's ability to modify secured claims in a reorganization plan, see Owen W. Katz, Modification of Secured Claims in a Chapter 11 Plan, The Secured Lender, July/August 1995.

(E) Protect rights under lease or other executory contract.

To the extent that a creditor enters the bankruptcy as a party to a true lease or other type of executory contract, it will want to take steps including, but not limited to: seeking an expedited determination of whether the debtor can assume the executory agreement; and making sure that the debtor remains current on its postpetition obligations under the contract pending the assumption or rejection decision.

Under the Bankruptcy Code, a debtor in reorganization has up until the date of plan confirmation to accept or reject any executory contract other than nonresidential real estate leases. Nonresidential real estate leases in all Chapters, and all other types of leases and executory contracts in Chapter 7, must be assumed or rejected, or an extension of the time to assume or reject be sought, within 60 days of the bankruptcy filing. The lack of any specific deadline for most types of executory contracts in reorganization cases may put the nondebtor party to the contract in an extended state of limbo, particularly in cases that are dragged out for substantial periods of time. The creditor's remedy is to ask the court to shorten the time to assume or reject.

As previously discussed, in order to assume the contract, the debtor must cure or provide evidence of an ability to promptly cure prepetition defaults, must compensate the creditor for any damages the creditor suffered as a result of the debtor's default, and must provide adequate assurance that it will be able to perform under the contract in the future. The assumption will either be incorporated into the reorganization plan or will be the subject of a separate motion. The nondebtor party to the contract can object if it does not believe that the debtor can satisfy the conditions of an assumption. Unlike secured claims which can be modified over a creditor's objection (the so called "cram down"), an executory contract can only be assumed according to its terms.

Pending a determination of whether to assume or reject, the creditor is entitled to monthly lease payments (to the extent that the contract is the lease of real or personal property.) For nonresidential real estate, the obligation to remain current postpetition begins on the date of the bankruptcy filing. See 11 U.S.C. §365(d)(3). In the case of personal property, the obligation to remain current postpetition begins on the 60th day following the bankruptcy filing. See 11 U.S.C. §365(d)(10).

(F) File a proof of claim.

Although in Chapter 11, a liquidated, noncontingent, undisputed creditor need not file a proof of claim, in all other circumstances an unsecured creditor must file a proof of claim to participate in a distribution. The best policy is to file a claim regardless of Chapter. Proofs of claim must be filed with the clerk of court on or before the deadline set by the court. Compliance with the deadline is strictly construed.

There may be situations where, in order to preserve the right to a jury trial in the event suit is filed by the debtor against the creditor (e.g., the creditor has received a large preference or otherwise has reason to believe it may be sued by the debtor or trustee), the creditor should consider waiving the opportunity to file a claim. This is obviously a matter which would need to be discussed with counsel before a decision is made.

(G) General strategies in the different chapters.

(i) Chapter 7 strategies:

Elect trustee. Creditors have the right to elect as trustee at the Section 341 meeting an individual other than the person appointed by the Office of the United States Trustee. Creditors may want to consider this option where they believe a particular person will do a better job in liquidating the estate than the person appointed by the Office of the United States Trustee.

File complaint to determine dischargeability. In the case of an individual debtor, where the debt was incurred through fraud, willful and malicious conduct, or the breach of some fiduciary duty, the creditor can file a complaint asking the court to find that the creditor's debt is nondischargeable.

Object to discharge, exemptions, or pursue causes of action. While it is the responsibility of the trustee in the first instance to object to a general discharge, object to exemptions and/or pursue causes of action, individual creditors may do so if the trustee does not. Under certain circumstances, court approval to pursue a cause of action belonging to the bankruptcy estate should be obtained before initiating the action.

(ii) Chapter 11 strategies (see also Strategies for Unsecured Creditors in Chapter 11):

Join Creditors' Committee. The larger creditors of a Chapter 11 debtor often join together to form an official committee expressly authorized by Section 1102 of the Bankruptcy Code. An official committee formed in accordance with Section 1102 acts as the representative body for the creditor group it represents, and, on behalf of its constituency, communicates with the debtor, makes court appearances, investigates causes of action, and negotiates the treatment of its constituency in the reorganization plan. The official committee can engage professionals, at the expense of the debtor, to help it to perform its duties.

Seek appointment of trustee or examiner. While the debtor remains in possession at the commencement of the case, a court can appoint a trustee or examiner in certain circumstances.

Propose competing plan. The Chapter 11, if successful, culminates in a confirmed plan. While the debtor has the exclusive right to file a plan during the first 120 days, and any extensions thereof, creditors can seek to shorten or terminate the exclusivity period and, once terminated, file a competing plan.

Seek dismissal or conversion of case. Under certain circumstances, creditors can seek the dismissal of the case, or the conversion of the case to Chapter 7.

File complaint to determine dischargeability or object to exemptions. Where appropriate, in the case of an individual debtor, the creditor can seek to except from discharge the debt owed to it by the debtor.

Pursue estate causes of action. The debtor may decide to not pursue all causes of action which exist, particularly those against insiders or affiliates. The creditors can, with prior court authorization, pursue those causes of action in the name of the debtor.

Vote against plan. Although a reactive strategy, a creditor unhappy with a proposed plan and who believes that the debtor (or other plan proponent) could have done better, can vote against it. In order for a plan proponent to obtain court approval of its plan, it is necessary for at least two-thirds in dollar amount, and over one-half in number, of creditors in each impaired class who vote on the plan, to have voted in favor of the plan. Although a debtor can, under certain limited circumstances, obtain court approval over the rejection of an impaired class (the so called "cram down"), it is difficult to do. Accordingly, a simple vote against an unsatisfactory plan may prevent its confirmation.

(iii) Chapters 12 and 13 Strategies:

Object to plan. Under Chapters 12 and 13, a debtor must commit all of his disposable income to the plan. A plan which fails to commit all disposable income, or fails to provide for the creditor to receive as much as it would have received in a Chapter 7, can be objected to.

Seek modification of plan. Chapters 12 and 13 plans can last as long as 5 years. During that period, the debtor's income may change. Creditors can, under certain circumstances, seek an increase in plan payments if a debtor's disposable income should improve during the life of the plan.

File complaint to determine dischargeability. Most debts are dischargeable in Chapter 13, including most that were nondischargeable in Chapters 7 and 11. A debtor is only entitled to a full discharge if he satisfies the plan. If he does not, he is only entitled to a "hardship discharge", which is the same as he would have achieved in Chapter 7. If a hardship discharge is granted, the creditor can seek a determination of dischargeability of those debts that would have been nondischargeable in a Chapter 7. In a Chapter 12, the debtor gets no better discharge than he could have obtained in Chapter 11. Accordingly, in Chapter 12, a complaint to determine dischargeability, if appropriate, should be filed within the deadline set by the court.




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1995