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Business Law e-Report
April 2010
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This client alert is intended to inform you of developments in the law and to provide information of general interest.   It is not intended to constitute legal advice regarding a client's specific legal problems and should not be relied upon as such.  This client alert may be considered advertising under the rules of the Massachusetts Supreme Judicial Court. 
  Inside this issue:
 
CREDITORS' RIGHTS:
NAVIGATING BANKRUPTCY CLAIMS 
 
   1.  Bankruptcy Claims 
   2.  Preference Actions 
Claims in Bankruptcy

By Gina Barbieri 
 

Your company has just received a notice that your client, tenant, or customer (the "Debtor") has filed for bankruptcy protection.  The Debtor owes your company money for goods or services.  Here are some things to know about your claims in that bankruptcy case.

 

Chapter 7, Chapter 11, and Chapter 13.

 

Whether the Debtor files for bankruptcy protection under Chapter 7, Chapter 11, or Chapter 13 of the Bankruptcy Code may impact how you proceed as a creditor.  In Chapter 7, the Debtor permanently ceases operations and a bankruptcy trustee is appointed to liquidate the Debtor's assets and distribute the proceeds among creditors according to the priority scheme set forth in the Bankruptcy Code.  In Chapter 11, the Debtor continues operating at least for some period of time while it completes a sale of its assets or develops a plan of reorganization to pay what it can to creditors and ultimately emerge from bankruptcy as a leaner company.  In Chapter 13, the Debtor is an individual with regular income, possibly self-employed or operating as a "DBA," who must also develop a plan to pay something to creditors over time.

 

Deadlines and Filing Claims.

 

Under any type of bankruptcy case, you must pay careful attention to the deadlines listed in the Court's initial notice of bankruptcy and other notices you receive.  The bankruptcy process can move quickly.  If your company fails to timely file a proof of claim, your company may miss the opportunity to participate in any eventual distribution from the Debtor's bankruptcy case. 

 

In a Chapter 7 case, the Court may specify the deadline for filing claims (the "bar date") in the first notice of bankruptcy.  In a Chapter 11 case (and in some Chapter 7 cases), however, the Court may set that deadline weeks or months into the proceeding.  The proof of claim form is a standard form produced by the Bankruptcy Court on which you must describe your company's claim, quantify its value, identify any collateral securing the claim, and assert a basis for priority, if any. Some claims may be easily quantifiable, such as claims of trade creditors that supplied goods to the Debtor.  Other claims may be more difficult to determine, such as claims of landlords or counterparties to equipment leases, which may be subject to periodic adjustments or limitations imposed by the Bankruptcy Code.  Even if your claim cannot yet be fully quantified, it is best to file the proof of claim and preserve your rights rather than wait to determine its exact value.  Creditors are generally allowed to amend their claims, even after the deadline for filing claims has passed, as long as the amendment relates back to the original claim filed (as opposed to comprising an entirely new claim).  Note that by filing a claim, your company may be deemed to have acquiesced to the jurisdiction of the district in which the bankruptcy case was filed.

 

After your company files its proof of claim with the Bankruptcy Court, watch carefully for objections.  The Debtor or the bankruptcy trustee may object to a claim for administrative reasons, such as it being filed late, or for substantive reasons, like an inability to reconcile your company's claim with the Debtor's books and records.  Either way, you will have a short window to respond to the objection.  If you fail to respond, the Court may disallow your company's claim and your company will be prohibited from participating in any distribution.

 

The Automatic Stay and its Effect on Claims.

 

Immediately upon receiving notice (formal or informal) of the Debtor's bankruptcy filing, your company must cease all collection activity with respect to the Debtor's account and, specifically, with respect to pre-bankruptcy invoices.  Upon filing, the Debtor is protected by the "automatic stay," which operates as a stay of commencement or continuation of all recovery actions against the Debtor.  Not only can willful violations of the automatic stay expose your company to sanctions, but collection actions taken in violation of the automatic stay are generally void.  In certain limited circumstances your company may be entitled to seek relief from the automatic stay and proceed with collection activity.

 

Claims of Counterparties to Executory Contracts and Unexpired Leases.

If your company and the Debtor are counterparties to a pre-bankruptcy lease (for example, your company is a landlord or a lessor of equipment) or counterparties to a contract where performance remains due on both sides (as with an annual service contract), your company generally must continue to perform its obligations under that lease or contract even after the Debtor files for bankruptcy protection.  The Debtor or the bankruptcy trustee has the option of assuming or rejecting contracts and leases, subject to Bankruptcy Court approval.  If the Debtor rejects your contract or lease, your company may have a claim in the Debtor's bankruptcy for rejection damages as well as for unpaid rent.  In order for the Debtor to assume your company's contract or lease, the Debtor must "cure" any defaults that have arisen thereunder--which generally means that the Debtor must catch up on past-due payments--and also demonstrate that the Debtor will be able to continue to perform under the contract or lease in the future.  In either event, your company has an administrative claim (described below) and the right to payment for any time the Debtor utilizes contract services or remains in the premises after the bankruptcy filing.  To attempt to guard against non-payment for provision of post-bankruptcy goods or services, you can seek an order from the Bankruptcy Court forcing assumption/rejection or implementing other protective measures.

 

Claims of Secured Creditors.

 

Secured creditors have greater rights in a bankruptcy proceeding than unsecured creditors.  Secured creditors' claims are paid directly from the proceeds of the collateral securing their claims, if that collateral is liquidated.  Alternatively, the collateral may have no value to the Debtor's bankruptcy estate due to the presence of the security interests, and so the Debtor (or trustee) may instead choose to return or abandon the collateral. Accordingly, to the extent feasible, consider enhancing your company's rights by creating and perfecting security interests, such as consensual liens, mechanics' liens and judicial liens, as such opportunities arise early in the account relationship.  With a security interest properly in place, your company may be in a better position as a creditor.  Notably, security interests obtained within 90 days of a bankruptcy filing may be at risk of avoidance as a "preference" under the Bankruptcy Code.

 

As a secured creditor, your company might also have the ability to request that the Bankruptcy Court grant relief from the automatic stay, to permit your company to pursue its claim as it would outside of bankruptcy.  For example, if the Debtor has no equity in the property that secures your company's claim and if such property is not necessary to the Debtor's effective reorganization, your company may be entitled to relief from the automatic stay.  

 

Claims of Unsecured Creditors.

 

If there are funds available in the bankruptcy estate to distribute to creditors, such distribution is made in the order of priority set forth in the Bankruptcy Code.  Near the top of the list are secured claims and administrative claims incurred during the bankruptcy case.  Near the bottom are general unsecured non-priority claims.

 

Administrative Claims.
 
Administrative claims are the actual, necessary costs and expenses of preserving the Debtor's bankruptcy estate.  If the Debtor continues to operate its business after its bankruptcy filing, trade creditors and service providers are entitled to payment for such necessary goods and services.  If your company is working with a Debtor in bankruptcy, you should actively pursue any administrative claims by filing a request for allowance and immediate payment, since available funds may be limited.  In addition, any plan of reorganization that the Debtor proposes in a Chapter 11 case must provide for payment in full of all administrative claims before the Debtor can emerge from bankruptcy.  These protections should give some comfort to landlords, vendors, and other providers of goods and services to the Debtor's estate while it operates its business in bankruptcy.

 

"503(b)(9) Claims."

 

If your company provided goods to the Debtor shortly before the commencement of the bankruptcy case, you may also have a priority claim.  Bankruptcy Code § 503(b)(9) affords administrative priority status for the value of goods received by the Debtor within 20 days before the bankruptcy filing, as long as those goods were provided in the ordinary course of the Debtor's business. This priority is for movable goods only and does not apply to services; the amount of the priority claim, therefore, does not include delivery charges or other charges ancillary to the goods themselves.  In Massachusetts, creditors asserting § 503(b)(9) claims must file such claims in writing with the Bankruptcy Court within 60 days after the first date set for the meeting of creditors.  Failure to timely file such request will result in denial of administrative expense treatment for the claim.  In a case where administrative creditors are paid in full but holders of general unsecured non-priority claims are paid pennies on the dollar, this can have enormous implications. 

Timing of Distribution.

Even a high priority claim brings no guarantee that your company will receive full or immediate payment, however.  A Debtor's plan of reorganization may call for partial payment of claims over five or more years, from sources that are not yet funded.  Therefore, you should actively and aggressively pursue payment of administrative claims mid-case where appropriate.

Getting Paid from a Customer in Financial Distress Might Not be the End of it

When you learn that a customer is in financial distress, your first thought is likely to try to get paid as much as possible, as quickly as possible, of that customer's outstanding balance.  If you get paid, you likely consider yourself lucky and rarely think about it again.  However, a payment from a customer in financial distress may pose unfortunate future consequences for you. For example, a bankruptcy trustee or other creditor representative may subsequently demand that you return that payment if the payment arguably constituted a "preferential" payment under the Bankruptcy Code.  Even absent a bankruptcy proceeding, you may receive a demand for turnover from another creditor of your customer if the payment constituted a "preference" under the Uniform Fraudulent Transfer Act (the "UFTA").

Preferences Under the Bankruptcy Code.

Under the Bankruptcy Code, a payment made within 90 days prior to a customer's bankruptcy filing may constitute a "preferential" payment.  A bankruptcy preference is a payment by the debtor: (i) to a creditor, (ii) for payment of an antecedent debt, (iii) made while the debtor was insolvent, (iv) made within 90 days of the bankruptcy filing, (v) which enables the creditor to receive more than it would in a liquidation proceeding.  The 90 day look-back period is expanded to one year for insiders of the debtor.  There is no need for the debtor to have had the intent to defraud, delay or avoid payments to other creditors in order for the payment to constitute a preference.   

For up to two years after the bankruptcy filing, the bankruptcy trustee or estate representative has authority under the Bankruptcy Code to demand the return of preference payments.  If you receive such a demand and fail to respond, the trustee may file a lawsuit against you to recover the potentially preferential payment.  You will need to quickly assess your position and options.

Preferences Under the Massachusetts UFTA.

Preference exposure is not limited to bankruptcy proceedings.  Under the UFTA (adopted in Massachusetts as Chapter 109A of the General Laws), a payment can be deemed a "fraudulent transfer" where that payment was made (i) to a creditor who is an "insider", (ii) on account of an antecedent debt, (iii) when the debtor was insolvent, and (iv) when the insider had reasonable cause to know the debtor was insolvent.  Similar to a "bankruptcy preference", the state law version requires no nefarious "intent" on the part of the debtor.  Under the UFTA, however, preference recoveries are limited to creditors who are "insiders" of the debtor (i.e., those who have an ownership interest, serve in director or officer capacities, have another common ownership, or have another close and/or controlling relationship with the debtor).

A unique facet of the UFTA version of a preference, as compared to the Bankruptcy Code version, is that under the state law any creditor of the debtor may bring a claim against the payment recipient (i.e., the insider) as long as the debtor owed that creditor money at the time of the payment.  In addition, even if the debtor received equivalent value in exchange for the payment, the insider might still be compelled to return the payment.  The law seeks to prevent an insider from gaining an unfair benefit as a result of its relationship with the customer. 

Responses, Defenses and Other Strategies.

 

Receiving a demand for the return of a purported preference payment under the Bankruptcy Code or under the UFTA does not necessarily mean that you will ultimately be required to return the payment.  Although the payment at issue may appear on its face to qualify as a preference, you may have one or more defenses to the demand.  Under the Bankruptcy Code, creditors are entitled to raise, among other defenses, the contemporaneous "new value" defense, the subsequent "new value" defense, and the "ordinary course of business defense."  Similar defenses exist under the UFTA and there also may be a question of whether you truly have the status of an "insider."  There are also time limitations as to when these types of actions must be brought, where they must be litigated, and the minimum amount in controversy that will justify a law suit.  Finally, even if you determine that you have exposure, the debtor, trustee or other fiduciary seeking recovery of the payment will often be receptive to a negotiated settlement.  It is frequently worth the effort to attempt to negotiate a consensual resolution upon receipt of a valid preference demand.  Before returning any payments as a result of a preference or fraudulent transfer demand, consult with experienced counsel to evaluate your exposure, defenses, and strategy to resolve the matter.