Introduction To Bankrutpcy Law

INTRODUCTION TO BANKRUPTCY LAW.

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A. Historical Context
B. Primary Policy Considerations

INTRODUCTION

A. HISTORICAL CONTEXT

The term “Bankrupt” is derived form the Latin words “Bankus”, that means table and “Ruptus” that means broken. During the Roman rule a merchant who could not pay his obligation to the empire was put out of business. When this was done the table in the bazaar from which he had conducted his business would be broken.

During the infancy of out nation most colonies had laws that allowed for the imprisonment of debtors who could not pay their obligations. South Carolina was the first colony to adopt a bankruptcy law that allowed the discharge of indebtedness. North Carolina, New York and Rhode Island proceeded to follow South Carolina in the establishment of bankruptcy laws.

2. Early Federal Bankruptcy Law.

Article I, Section 8, of the Constitution of the United States provides Congress with the power to establish a uniform rule of naturalization and “uniform laws on the subject of bankruptcies throughout the United States.”

The Bankruptcy Act of 1800 was this country’s first federal bankruptcy law. That act was repealed in 1803. Then in 1841 this country’s second bankruptcy act was enacted and repealed in 1843. A third bankruptcy act was enacted in 1867, amended in 1874 and repealed in 1878. For the next 20 years this country had no federal bankruptcy law. In 1898 the congress enacted a new bankruptcy act, often referred to as the “Nelson Act.” This Act was amended in 1938 by the Chandler Amendments, which amongst other things created “courts of bankruptcy.” However, there continued to be substantial uncertainty about which matters these courts had jurisdiction.

The Bankruptcy Act was amended in 1978, and the surviving statutes are referred to as the Bankruptcy Code (the “Code”). The Code provided the bankruptcy judges with Article III powers, but did not make the judges Article III judges. This grant of power was successfully challenged in Northern Pipeline Construction Co. v. Marathon Pipeline Company and United States (in re Marathon) 458 U.S. 50 (1982). In response to the Marathon decision the Code was modified in 1984 to make the Bankruptcy Court a unit of the District Courts.

B. PRIMARY POLICY CONSIDERATIONS

The primary goals of the Bankruptcy Code are ending the creditors’ race to the courthouse and ensuring that similarly situated creditors are treated in a similar manner.

C. OVERVIEW OF THE BANKRUPTCY CODE

1. Chapter 1 – General Provisions
2. Chapter 3 – Case Administration
3. Chapter 5 – Creditors, The Debtor and The Estate
4. Chapter 7 – Liquidation
5. Chapter 9 – Adjustment of Debts of Municipalities
6. Chapter 11 – Reorganization
7. Chapter 12 – Adjustment of Debts of Family Farmer With Regular Income.
8. Chapter 13 – Adjustment of Debts of Individual With Regular Income.

II. POTENTIAL GOALS OF THE CHAPTER 11 DEBTOR IN POSSESSION

An understanding of why debtors sell assets requires an understanding of why Debtors file for Bankruptcy and what they seek to accomplish. Most business assets will be sold wither in chapter 7 or chapter 11. The provisions of chapters 3 and 5 apply to both chapters 7 and 11 of code. For ease of presentation, we will discuss the code in the context of chapter 11 Debtors.

A. GOALS IMPOSED BY THE CODE
1. Preservation of the Status Quo – The Automatic Stay.

The automatic stay is embodies in §362(a). This provision may be the single most important tool in the Code’s fight against the race to the courthouse. This stay stops all collection efforts, all harassment and all foreclosures. Congressional authority to enjoin collection actions even of secured creditors was upheld by the United State Supreme Court in In Ex Parte Cristy, 44 U.S. (3 How.) 292 (1845). For recent local cases interpreting the automatic stay see In re Frenz, 142 B.R. 611 (Bankr. D. Conn. 1992); Matter of Colonial Reality Co., 134 B.R. 543 (Banker. D. Conn. 1992).

The Code exempts from the automatic stay, inter alia, criminal proceedings, proceedings to collect alimony or child support and governmental actions to enforce police powers. §362(b). See Board of Governors v. MCORP Financial, 112 S.Ct. 459 (1991); Kelly v. Robinson, 107 S.Ct 353 (1986); Midlantic National Bank v. New Jersey Dep’t of Environmental Protection, 106 S.Ct 859 (1986); and In re Kovacs, 105 S.Ct. 705 (1985).

Relief from the automatic stay may be granted pursuant to section 362 (d). In order to be granted relief from the automatic stay a movant must establish: 1) that cause exists including lack of adequate protection, or 2) that both a] the debtor does not have any equity in the property and b] the property is not essential to an effective reorganization. See United Savings Association of Texas v. Timbers of Inwood Forest Association, Ltd, 484 U.S. 365 (1988).

In addition to the automatic stay provided by §362(a) the bankruptcy court has authority to issue injunctions pursuant to §105 of the Code. That provision allows the court to issue such orders as are necessary to carry out the intent of the Code.

2. Operation or Liquidation of the Debtor’s Business

Section 1108 authorizes the trustee to operate the debtor’s business.

Section 1107 provides that a debtor-in-possession shall have the rights (other than the right to compensation) and powers and shall perform all the functions and duties, except those set forth in §1106(a)(2), (3) and (4), of a trustee serving in a case under Chapter 11. See Ohio Corrugating Co. v. Security Pacific Business Credit, Inc., 16 C.B.C.2d 821 (Bankr. N.D. Ohio 1987).

The trustee or debtor-in possession is duty-bound to protect the property of the estate for the benefit of creditors. See sections 704, 1107 & 1108.

3. Identification and Management of Property of the Estate

Section 541 defines property of the estate to include all property in which the debtor has legal or equitable interest. See In re Crysen/Montenay Energy Co., 902 F.2d 10998 (2d. Cir. 1990).

Section 522 (d) identifies those interests of debtor that are exempt, and thus not property of the estate.
a) The debtor’s interest in his/her residence up to $7,500.
b) The debtor’s interest up to $1,200 in a motor vehicle.
c) The debtor’s interest up to $4,000 in furnishings and apparel.
d) The debtor’s interest up to $1,500 in jewelry.
e) The debtor’s interest up to $400 plus up to $3,750 of unused home exemptions.
f) The debtor’s interest up to $750 in professional tools.
g) The debtor’s interest in unmatured life insurance, other than credit life insurance.
h) The debtor’s interest in insurance in a deposit.
i) The debtor’s interest in professionally prescribed health aids.
j) The debtor’s interest in certain retirement benefits.
k) The debtor’s interest in money related to crime reparation or wrongful death.

See hanson v. First National Bank in Brookings, 848 F. 2d 866 (8th Cir. 1988).

4. Use and Sale of Property of the Estate

Section 363 relates to the use, sale and leasing of property of the estate. A debtor-in-possession may continue to use, sell and lease his property in the ordinary course of its business.

For transactions that are outside the ordinary course of its business, the trustee or debtor in possession must obtain court authorization.

Section 363(f) provides that a trustee or debtor in possession may sell property of the estate free and clear of the interests of a secured party if applicable nonbankruptcy law permits, if the secured party consents, or if the sale price exceeds the liens on the property, or if the secured claim is in bona fide dispute or if the secured party could be compelled to accept money in satisfaction of its claim See In re Lionel Corp. 722 F.2d 1063 (2d Cir. 1983).

Section 363(m) provides that a purchaser who takes material steps to complete a transaction with a debtor in good faith reliance on a court approved sale is protected from future reversals of the order approving the sale by Section 363(m).Inre Mann, 907 F.2d 923 (9th Cir. 1990).

5. Assumption, assignment or Rejection of Executory Contracts And Unexpired Leases

A trustee or debtor-in-possession may assume or reject an existing contract, or expired lease pursuant to §365.

If a debtor does not file a motion to assume or extend the time to assume an unexpired lease for nonresidential real estate within sixty days of the petition date, the lease will be deemed rejected pursuant to section 365(d)(l). The critical date is the date that the motion to assume the unexpired lease, or a motion to extend the deadline to assume or reject, it filed – not the date of the hearing. See In re Victoria Station, Inc. 875 F.2d 1380 (9th Cir 1989). Multiple extensions can be granted. See in the matter of American healthcare Management Inc., 900 F.2d 827 (5th Cir 1990). In order to assign an executory contract or unexpired lease, the debtor must assume it first. To assume an executory contract or unexpended lease, the debtor must cure all defaults under the contract. §365(b)(l). Further, the Debtor cannot assume part of a contract: it must assume all or nothing.

6. Determination of Claims Against the Estate

Section 502 sets the standards for allowance of claims or interests. If a proof of claims is filed and no objection is filed, the claim is deemed allowed. §502(a).

Section 502 also provides a mechanism for the bankruptcy court to estimate claims for the purpose of voting on a plan (allowing the court to delay ultimate determination of the claim amount, see Addison v. Langston, 737 F.2d 1338 (5th Cir 1984).

Determination of secured status of claims is made in accordance with section 506. Pursuant to that section a claim is secured “to the extent of the value of such creditor’s interest in the estate’s interest in [the collateral]”.

In determining the value of the secured party’s claim “The trustee may recover from property securing an allowed secured claim, the reasonable, necessary costs and expenses of preserving or disposing of, said property, to the extent of any benefit to the holder of such claim.” See Central Bank of Montana v. Cascade hydraulics and Utilities Service, Inc.., 815 F.2d 546 (9th Cir. 1987) and Bear v. Cohen, 812 F.2d 1088 (9th Cir. 1986).

7. Determination and Treatment of Priority Claims

Section 507 outlines the priorities of claims.

1. Administration expenses
2. Gap claims (involuntary cases)
3. Wage claims up to $2,000
4. unsecured claims of certain farmers and certain fishermen
5. Consumer deposits up to $900,000
6. Certain tax claims
7. Claims based upon a debtor’s commitment to the FDIC.

Section 503 determines what is allowed as an administrative claim. Boiled down to its simplest elements, section 503 allows the actual necessary costs and expenses related to preservation fo the estate. See In re Allied Mechanical Services, Inc., 885. F.2d 837 (11th Cir 1989). However, please see discussion of §§ 327 and 330 for the treatment of professional fees.

For example, post-petition use and occupancy will be permitted as an administrative expense. Memphis-Shelby County Airport Authority v. Braniff Airways, Inc., 783 F.2d 1283 (5th Cir 1986).

8. Employment and Compensation of Professionals.

Section 327 enumerates the requirements for the employment of professionals. Those regularly employed on salary can be retained, and paid, without court authorization. §§327(b) and 363. See, In re Lowry Graphics, Inc., 86 B.R. 74 (Bkrtcy S.D. Tex. 1988), and Park Terrace Townhouses v. Wilds, 852 F.2d 1019 (7th Cir. 1988).

Those not regularly employed on salary can only be employed if the court to authorizes pursuant to §327. The trustee, or Debtor-in-Possession, may retain professionas “that do not hold or represent an interest adverse to the estate, and that are disinterested persons….” §327(a). See, In re Marin, 817 F.2d 175 (1st Cir. 1987); Hunter Savings Association v. Baggot Law Offices, 750 F.2d 536 (6th Cir. 1984).

However, not all professionals are “Professionals” as that term is used in the Code. For example, numerous courts, including our won Judge Shiff, have held that §327 (a) only applies to professional persons who are to perform tasks related to the administration of the estate. In re Fretheim, 102 B.R. 298 (Bkrtcy D. Conn. 1989); In re John-Manville Corp., 60 B.R. 612 (Bkrtcy S.D.N.Y. 1986); In the matter of Seatrain Lines, Inc., 13 B.R. 980 (Kkrtcy S.D.N.Y. 1981); United States ex. rel. Kraft v. Aetna Casualty & Security Co., 43 B.R. 119 (Bkrtcy M.D. Tenn. 1984); and In re pacific Forest Industries Inc., 95 B.R. 740 (Bkrtcy C.D. Cal. 1989).

For professionals who will serve the estate as “special counsel” for limited purposes, such as an attorney hired to litigate an environmental issue, section 327(e) requires only that attorney “not hold any interest adverse to the debtor or the estate with respect to the matter on which such attorney is employed.” Unlike attorneys retained for the general administration of the estate they need not be “disinterested persons” within the meaning of §101(14). See, In re Statewide Pools, Inc., 17 C.B.C.2d 927 (Bkrtcy S.D. Ohio 1987).

In considering the application the court will consider, the value to the estae, the reasonableness of the fees charged and the estate’s ability to pay the fees. In re Montgomery Drilling Co., 121 B.R. 32 (Bkrty E.D. Cal. 1990); In re Wabash Valley Power Ass’n, Inc., 16 C.B.C.2d 457 (Bkrtcy S.D. Ind. 1987), In re Matter of Codesco, Inc 5 C.B.C.2d 738 (Bkrtcy S.D.N.Y. 1981).

8. The Plan and Disclosure Statement

A debtor emerges from Chapter 11 upon the confirmation of a plan or reorganization. Durning the first 120 days of a Chapter 11 case the debtor-in-possession has the exclusive right to file a proposed plan or reorgaization. Section 1121. Courst may extend the exclusive period for cause. See In re Texaco, Inc. 17 CBC2d. 169 (Bankr. S.D.N.Y> 1987).

The plan proponents have great latitude in crafting the plan. However the Code does prescribe what must, or may, be in the plan. The Plan must do the following:
· Designated classes;
· Specify which classes are impaired;
· Define the treatment of the impaired classes
· Treat similar claims in a similar manner; and
· Provide for an adequate means for implementation of the plan.

In addition the plan may do the following:

· Impair classes of creditors;
· Provide for the assumption, assignment or rejection of executory contracts or unexpired leases;
· Provide for adjustment or settlement of claims; and
· Provide for the sale of assets.

The plan may be confirmed if it complies with the requirements of the code, was proposed in good faith, and is voted for by at least the majority in number and 2/3rds in amount of at least one impaired class. See Section 1129.

B. POTENTIAL AGENDAS OF PARTICULAR DEBTORS

1. Strip Excess Debt.

The Failed LBO. A typical example is a debtor formed by an LBO of division. After the LBO the corporation may be too thinly capitalized to handle subsequent adverse changes in its market share.

2. Reduce Excess Capacity – Shed Outmoded Technologies.

In re Eastern Airlines, In re TWA and In re Bradley Flight Limited Partnership, are just some examples of the ongoing casualties of the excess capacity in this nation’s aviation industry.

3. Resolve Union Disputes

In re Brandiff Airlines.Some cite this case as one of the first cases to demonstrate the importance of bankruptcy law to corporate counsel. In this case the airline successfully used section 365 of the Code to reject a collective bargaining agreement.

4. Resolve Management Disputes

In certain cases, we have seen certain factions of management or shareholders use Chaper 11 effectively as a means to limit “out-of-control” management.

5. Insulate Corporation From Catastrophic Liability

In re Texaco, Inc. and In re Johns-Manville. Just two examples of corporations that filed for bankruptcy protection to insulate the corporation from liability resulting from an adverse court decision or an anticipated adverse ruling.

C. POTENTIAL AGENDAS OF PARTICULAR INDIVIDUALS

1. Corporations

A. Shielding officers and directors from personal liability;

B. Minimizing the impact on relatives of corporate officers; and

C. Preservation of stockholder equity.

2. Partnerships

A Limitation of Liability of partners;

B. Minimizing the Impact of family members of parners; and

C. Preservation of Partner’s equity

3. Individual Cases

A. Minimizing Liability of the debtor;

B. Maximizing Protection of Exempt Property;

C. Preservation of current and future income; and

D. Minimizing Impact of Family Member Preservation of Equity.

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