• EXECUTIVE SUMMARY AND CONCLUSIONS
  • Prior to Bankruptcy
  • After Your Customer Files Bankruptcy
    • What You Can Do Now to Collect Account Receivables
    • Extending New Credit to the Debtor
    • Evaluating Risk of Future Preference Claims
    • Defending Preference Claims
  • Policy Conclusions
• INTRODUCTION
  • The Importance of Security
  • Creditors v Creditors
  • Paradigm Shift
  • Public Policy
  • Bankruptcy Timeline and Terms
  • Types of Bankruptcy
    • Chapter 7
    • Chapter 11 Reorganization
    • Chapter 13 Plan
    • Involuntary Bankruptcy
  • Foreign Bankruptcies and Creditors
  • Consumer and Individual Bankruptcies
    • Means Testing
    • Credit Counseling
    • Discharge Every Eight Years
    • Homestead Exemptions
• THE BANKRUPTCY FILING
  • Notice of Bankruptcy
  • Automatic Stay
  • Proof of Claim
  • Schedules
  • No Notice of Bankruptcy
• THE BANKRUPTCY PROCESS
  • Getting on the Mail List
  • The Meeting of Creditors
  • Objection to Discharge
    • Discharge of a Specific Debt
    • Discharge of the Debtor
  • Objection to Exemptions
  • The Creditors' Committee
  • The Trustee
• DOING BUSINESS WITH THE DEBTOR IN BANKRUPTCY
  • Can You Be Forced to Do Business with the Debtor?
  • Do You Want to Do Business with the Debtor?
  • Administrative Expense Priority
  • Assumption or Rejection of Executory Contracts
  • Critical Vendors
• MOTIONS
  • Motion for Relief from the Stay
    • Foreclosing on Property or Repossessing Equipment
    • Complaint to Enforce Mechanic's Lien
    • Termination of a Lease
    • Setoff Rights
  • Deadline to Assume or Reject
  • Payment of Administrative Expenses
• ADVERSARY PROCEEDINGS
  • Adversary Proceedings or Complaints
  • Reclamation Rights
• PREFERENCES
  • Introduction
    • The Objective
    • The Preference Mechanism
    • The Perception Problem
    • The Policy Problem
    • The Information Problem
    • The Timing Problem
  • The Trustee's Burden of Proof
    • Secured Creditors
    • Assumption of Contract
    • Trust Fund Statutes and Agreements
    • Earmarking
  • Defenses to a Preference Action
    • Ordinary Course of Business
    • Contemporaneous Exchange for New Value
      • COD Sales
      • Release of Mechanic's Lien or Bond Rights
      • Triangulation
    • Subsequent Advance Rule
    • Equitable Liens

Appendix 32: Bankruptcy Checklist
Appendix 33: Notice of Bankruptcy
Appendix 34: Bankruptcy Proof of Claim
Appendix 35: Request for Service of Notices

EXECUTIVE SUMMARY AND CONCLUSIONS

This outline is intended to introduce construction contractors, suppliers and other commercial creditors to some of the issues and concepts in bankruptcy law. This is not a comprehensive explanation of bankruptcy and will not deal at all with many issues. We have generalized and simplified many legal concepts, so that the explanations are short, uncluttered and easily understandable. Every set of facts and circumstances raise different legal issues. You should consult this firm or another attorney in dealing with any specific problem.

Prior to Bankruptcy

If you deal with bankruptcy cases regularly, you will come to the conclusion that a creditor avoids bankruptcy preference problems by using the same techniques good credit managers already use to avoid collection problems. Good preference defenses are just an extra-added bonus for good credit management. The creditor that consistently forced the debtor to stay on terms will have a smaller receivable to lose in bankruptcy and also will not have preference problems. By definition, all of these payments were in the ordinary course of business.

Similarly, the creditor that always preserved and enforced mechanic's lien and bond rights are more likely to collect after bankruptcy and will have better defenses against preference actions for moneys received before bankruptcy. Mechanic's lien and bond rights are the single greatest mechanisms for construction suppliers to avoid bankruptcy problems. It is an opportunity to be a secured creditor, often with priority over all other secured creditors in the bankruptcy. If you still had mechanic's lien and bond rights at the time of pre bankruptcy payments, you will also have much better defenses to any preference action.

If a creditor is concerned with insolvency, they can refuse to deliver on any project that does not have good payment bond or mechanic's lien rights. Payment bond rights are probably the best and most efficient mechanism to enforce payment. Mechanic's lien rights can vary in strength and can be expensive to enforce. The creditor must research the payment bond and mechanic's lien rights on any particular project before beginning deliveries.

Creditors requiring some type of consensual security will have the same dual benefits in a subsequent bankruptcy. With a security interest in accounts receivable or liens on equipment, there is a much lower chance of default. The debtor is more likely to stay within terms. The prepetition unpaid receivable will be lower in the event of bankruptcy. Any payments received shortly before bankruptcy will not be preferences, because there was an enforceable security interest against the debtor.

By the same token, if a creditor has a personal guarantee, the debtor is more likely to stay on terms. The unpaid receivable will be lower. The payments received are more likely to be "in the ordinary course of business," because the invoices will not be as old. This creditor will also have a better chance of collecting an unpaid receivable after bankruptcy. The creditor is still free to sue the guarantor, unless the guarantor is also in bankruptcy.

Requiring C.O.D. shipments may be the surest way to avoid bankruptcy issues. You do not need to worry about collecting payment for materials, if you are collecting on delivery. These payments cannot be preferences. Even if the debtor gives you a bad check, you can probably object to a discharge from this debt because of fraud.

Joint check agreements and trust fund agreements are helpful mechanisms to collect receivables before and after bankruptcies. These mechanisms will also provide protections against preference claims.

If a creditor is genuinely concerned with insolvency, it is generally better to get payments from anyone other than the debtor.¹ Joint check agreements can be a good mechanism for this purpose.² Owners or bonding companies can agree to make direct payments to a creditor. This is the single best protection against preference problems. Even if a creditor has perfectly good mechanic's lien or bond rights, a bankruptcy estate is likely to bring a preference claim if a payment is made directly from the debtor to the creditor during the preference period. If a creditor has made a bond claim or mechanic's lien claim, it is preferable to demand payment directly from the bonding company or owner.

Reclamation rights can be helpful pre-bankruptcy tools. A creditor concerned with bankruptcy can make a reclamation demand. Reclamation rights would survive bankruptcy. Those reclamation rights can then be traded for cash or security. This would not be a preference, since it is a contemporaneous exchange for new value. Even if the creditor fails to provide the written reclamation demand in time, the creditor is still entitled to an "administrative expense claim" for any goods received by the debtor in the 20 days prior to the bankruptcy petition. Filing for an administrative expense claim provides the creditor a high priority in the bankruptcy that will normally result in payment.

It is helpful to get new financial statements regularly, especially if there is concern over a bankruptcy. First, this will help the creditor investigate the risk of bankruptcy and determine whether they wish to continue doing business. If a debtor refuses to supply any financial information, this should only add to a creditor's concern.

If the debtor does supply incorrect financial information, this may constitute a written misrepresentation concerning solvency. This misrepresentation can extend the creditor's reclamation rights more than ten (10) days and may be grounds to avoid discharge in bankruptcy from this particular debt.

After Your Customer Files Bankruptcy

Once a customer files bankruptcy, quick action can help collect a receivable and avoid preference problems. A bankruptcy checklist is attached as Appendix 32.

What You Can Do Now to Collect Account Receivables

On the outstanding account receivable, the most important thing to do now is establish security rights. This usually means mechanic's lien and payment bond claims. You are still free to make payment bond claims (as long as the bonding company is not in bankruptcy). This is true in all states.

In most states, the mechanic's lien is not a preference and does not violate the automatic stay. This means you are free to file mechanic's liens wherever you may have rights. In fact, you must still file your mechanic's liens within the normal deadlines, which could be as soon as 90 days after your last deliveries. This is true in Virginia and the District of Columbia. In Maryland and some other states, however, the mechanic's lien is not "inchoate." You are stayed from proceeding against the property of the debtor in a mechanic's lien action.

In Maryland and many other states, it may be possible to establish rights under a "Trust Fund Statute" even after a bankruptcy. You may also have a trust fund agreement with your debtor that brings you to the same result. You may be able to collect a receivable directly from an owner or general contractor. You may even be able to establish priority over money held by the bankruptcy estate.

Reclamation rights can also trump a bankruptcy, as discussed below.

You have less risk accepting payments from someone other that the bankrupt debtor, both before and after a bankruptcy filing. Encourage bonding companies, property owners and general contractors to make payment directly to you. A joint check is also better than a direct payment from the debtor, although after bankruptcy the debtor's endorsement of the check may technically require bankruptcy court approval.

After bankruptcy, the debtor can "assume" contracts that are profitable and "reject" unprofitable contracts. Creditors on rejected contracts become general unsecured creditors. The debtor must "cure all default" on assumed contracts. If you have a contract to supply all of the materials at a favorable price on a profitable job, the debtor may wish to assume the contract to complete the job. You would have to continue supplying the job, but the debtor would need to cure all default and pay your prepetition invoices also. The debtor may also wish to assume a profitable contract with a general contractor or owner. That contract may require the debtor to make sure all subcontractors and suppliers are paid on the project. Curing all default on that contract may require the debtor to pay invoices on that job.

If nothing else, you should be sure to file your proof of claim in the bankruptcy. This will insure that you share in any future distributions to general unsecured creditors. The notice of bankruptcy you receive will give you instructions regarding proofs of claim. File a proof of claim early, even if no deadline has been set. This helps insure that you will not miss a deadline, if the court later sets one.

You can also check on the bankruptcy court website whether there is a deadline for proofs of claim. This bankruptcy court sponsored website includes much basic information regarding a case. You can also subscribe to a service known as "Pacer," which allows you to access almost all papers filed in the case for a small fee. You can file a "Rule 2002" Request for Service of Papers, requesting hard copies of all papers filed in the case. You or your attorney can also request a CM/ECF (Case Management/Electronic Case Filings) ID and Password. You can then electronically file and monitor all papers filed in that bankruptcy case.

CM/ECF allows you 24 hour access to case file documents, to file electronically, automatically receive e-mail notice of all case activity and to download and print all documents filed in the case directly from the court's system. You will receive notice of future events in the bankruptcy, including any deadline for proofs of claim. In a large bankruptcy, this also means a large volume of paper and electronic files that you do not care about. The safest course, however, is to have someone keep track of motions and other events in the bankruptcy, either on Pacer or through a Rule 2002 Request for Service. Even if you include your e-mail address on your Rule 2002 Request for Service, you will not receive e-mail notification of case filings unless you also have a CM/ECF ID and Password. For more information on signing up with CM/ECF, go to: http://pacer.psc.uscourts.gov/cmecf/index.html.

Extending New Credit to the Debtor

The only truly safe way to do business with a debtor in bankruptcy is to require cash in advance. Otherwise, any creditor at least runs the risk of administrative costs and problems going to bankruptcy court to enforce payment. However, there are also risks of non-collection.

You will have a high administrative expense priority for postpetition sales, but there may be no money available for distribution no matter how high your priority. Another secured lender may have "super-priority" over all available cash flow. An administrative expense claim can also be denied if the expense was not "actual and necessary" for the preservation of the estate.

A creditor with an ongoing contract may be forced to continue doing business with the debtor. It is very risky, however, to continue performance and extend credit unless and until the contract is assumed. Otherwise, the creditor can have the same problems with an administrative expense claim just discussed. A creditor is better off requiring assumption of the contract, before continuing performance. This will also result in "cure" and payment of all prepetition debt. If the debtor is unwilling or unable to assume the contract immediately, the creditor should insist on cash in advance, a letter of credit, or other adequate assurance before continuing performance.

Evaluating Risk of Future Preference Claims

You are at risk for a preference claim for all payments you received in the 90 days prior to the bankruptcy. Unfortunately, the bankruptcy trustee does not need to bring a preference claim against you for two years. The "statute of limitations" for a preference claim is two years after the bankruptcy petition.

The bankruptcy trustee will get payment records from the debtor during the course of the bankruptcy. The trustee will probably make a preference claim on all payments made by the debtor in the 90 days prior to the bankruptcy, that were on invoices that were more than sixty days old. The critical date is the day the debtor's check clears their bank, not the date you receive or deposit the check. The trustee generally will not spend much time evaluating whether each payment is a preference, they will simply make demand on all creditors that received checks during the preference period and leave it to the creditor to show why it is not a preference. In a large bankruptcy, this can mean that hundreds of demand letters will go out in the second year of the bankruptcy.

First, collect and protect information now, as soon as the debtor files bankruptcy. It will be harder to locate invoices and find salesmen two years from now. Collect a summary of all checks received from the debtor in the hundred days prior to the bankruptcy. A check received one hundred days before the bankruptcy probably did not clear the debtor's bank until less than 90 days before the bankruptcy.

Then look at the invoices paid with each of the checks received. How old were each of the invoices at the time that the debtor's check cleared their bank? The trustee generally will not pursue any payments on invoices that were less than sixty days old, because those payments were in the "ordinary course of business."

Now pretend that you never received the payment and evaluate your ability to collect on these invoices. Again, this mostly boils down to security rights in the form of bond claims, mechanic's lien rights, personal guarantees, etc. Generally, you will have a defense to a preference claim if you could have enforced your rights to payment after the bankruptcy, even if the debtor had not sent you the check before the bankruptcy.

Look at each invoice and determine whether you have lien, bond or other security rights. This is going to be much easier to do now than two years from now. Your own documents and outside witnesses are easier to find now. Where is this project? Who is the owner? Who is the general contractor? Were you still in lien rights at the time you received the payment? Was there a payment bond on the project and were you within time to make a payment bond claim at the time you received payment? If you were a secured creditor, generally the payment was not a preference.

You may actually need to file your lien or bond claims for money you have received. You may want to force the debtor and bankruptcy trustee to litigate the preference case now, while you still have lien or bond rights to protect you. It is often advantageous to bring the debtor, the bankruptcy trustee, the project owner, general contractor and the bonding company into the bankruptcy court early. Litigate the preference and your bond claim simultaneously with all parties in one courtroom. These parties may be helpful now in proving you had security and forcing the debtor to resolve a preference claim, but this help may not be available two years from now.

It is always important to be careful with lien and bond claim waivers, to make sure your security rights are not waived if a preference claim is brought against you later. This is discussed in other chapters of this book.³ After bankruptcy you should deal the same with your (1) uncollected receivable and (2) all money received during the preference period. "Spread" the invoices to figure out where all the material went and whether you have security rights for uncollected receivable and for payments received shortly before the bankruptcy filing.

Defending Preference Claims

You will eventually receive a letter asserting that you received payments during the 90-day preference period prior to the Bankruptcy filing. This letter will demand you to pay this amount back to the bankruptcy court. At this point you should consider hiring an attorney, depending on the dollar amount or the issues involved. You or your attorney should write further information on the payments they allege are preferences. They can at least give you a copy of a computer printout showing the check numbers and dates.

This type of case can often be settled for about 50 cents on the dollar, especially in the early stages or before a suit is filed. If your defenses are better, you have a better chance of getting a good settlement. Unfortunately, you have to decide now whether you would rather just try to settle this claim for about 50 cents on the dollar or spend significant administrative time analyzing the accounts for defenses and later incur legal fees in defense.

You should confirm whether your company received this "Preference" amount during the 90 days prior to the bankruptcy. You should evaluate the strength of you defenses. You will then know more about the case than the lawyer on the other side. If you have no real defenses to the preference claim, you want to work hard on settling the case for less than the full amount of the debt. If you have some arguable defenses, you may be able to settle for a small percentage.

There are a few truly solid preference defenses. If you are sure you have a solid defense and the bankruptcy estate refuses to dismiss the case, your attorney can consider a motion for summary judgment to get the case thrown out of court.

Policy Conclusions

When a customer files bankruptcy, a creditor has a basic policy decision, whether to "participate in the bankruptcy process." Bankruptcy is a battle between innocent creditors. The bankruptcy process is an attempt to maximize the distribution to general unsecured creditors.

If a creditor tries to establish mechanic's lien rights, payment bond rights, trust fund or equitable lien rights, reclamation rights or some other priority, this will lower the amount available to general unsecured creditors. It may maximize this particular creditor's recovery, but it will lower the recovery to their brethren. This activity will also result in increased legal fees. The creditor will expend higher legal fees trying to establish priority. The debtor, the trustee, and the unsecured creditors committee will fight the creditor, to preserve money available for distribution. This further depletes the estate, whether the creditor succeeds in establishing priority or not.

If there is a genuine chance of a good distribution to general unsecured creditors, all creditors have a common interest in lowering the heat level, participating peacefully in the bankruptcy process and maximizing the distribution for all general unsecured creditors. For this reason it is important to evaluate the initial schedule of assets and liabilities and watch the activities of other creditors to evaluate the chances of a good distribution.

If there is little chance of a good distribution for general unsecured creditors, then each creditor has a stronger incentive to try and establish priority rights. The creditor's worst case is that it will waste time and money on legal fees. If there is no chance of a distribution from bankruptcy, this is not a risk, only an expense.

Unfortunately, the experience for most unsecured creditors is that they never see any distribution from a bankruptcy or very small distributions. Accordingly, most creditors are cynical of the bankruptcy process and will always do their best to establish their own priority over other creditors. This becomes a self-fulfilling prophecy. All creditors are pushing their own self-interest, expending legal fees in the process. The debtor, the trustee, the bankruptcy court, and the unsecured creditors committee are all expending time and money fighting these creditors. This process further reduces the likelihood of any distribution.

INTRODUCTION

The Importance of Security

Why are one-year adjustable mortgage rates 6%, while some credit cards charge 18% interest per annum? Each dollar costs the bank the same amount. How can it be cheaper to lend one dollar than the other? Security is the most important difference. Security increases the bank's chances of preventing default and collecting its money within terms. In the event of default, the bank increases its chances of collecting faster and at lower cost.

Why does security decrease the risk of non-collection? When you purchased your last home or automobile, the bank required you to sign at least two pieces of paper. One was your promissory note. This was your "contract" with the bank in which you agreed to make certain monthly payments. This is your "personal promise to pay." This allows the bank to sue you personally in the event of default.

The other paper you signed was a mortgage, deed of trust or other "security agreement." Your security agreement provides the bank rights against the "security property." In the event of default, the bank can foreclose upon the security property, whether it is a house, automobile or other property.

If the debtor is solvent, security is not as important. The lender will be able to go against the debtor on the "contract." The lender will be able to obtain a personal judgment against the debtor and will then be able to attach all assets owned by the debtor. This is discussed in other chapters of this book.⁴

If the debtor is insolvent or disappears, security becomes critical. The contract or promise to pay will be worthless if the debtor cannot be found or is insolvent. The lender with only a contract or personal promise to pay is a "general unsecured creditor." All of the general unsecured creditors go in one "big pot." All of the assets of the debtor that are not encumbered by a security interest also go in the same big pot. The general unsecured creditors share pro rata in the available assets, according to the amounts of their claims.

It does not matter which creditor filed their proof of claim first or who was the first to jump in the big pot. A bankruptcy estate is similar to a probate estate when someone dies. It is no coincidence that they are both referred to as an "estate." The objective is to "liquidate" the assets of the estate that are not encumbered by a security interest and then distribute the proceeds to creditors, pro rata, to the extent possible.

Any of you that have experience as a general unsecured creditor in a bankruptcy know that this usually means you will be paid nothing or a very small percentage of your claim. By definition, if a debtor is in bankruptcy, it has very few unencumbered assets to go in the big pot for distribution to general unsecured creditors. Almost all of the debtor's assets are encumbered by liens to some lender, and the debtor's liabilities generally exceed its assets.

In the event of bankruptcy, the "secured creditor's" rights in the "security property" are generally not affected by the bankruptcy. The debtor has, in effect, disappeared and the lender's contract rights against the debtor are now worthless. However, the secured creditor, while perhaps delayed⁵ from foreclosing against the property, will eventually collect as long as there is sufficient equity in the property.

Secured creditors generally have the option of simply "riding out" the bankruptcy. The debtor may eventually obtain a "discharge" from the debt as a matter of personal liability. A discharge from personal liability, however, will not eliminate the lien or security interest of the lender in the security property. After the debtor has obtained a discharge and the bankruptcy is closed, the "automatic stay" is also terminated and the secured lender is free to foreclose upon the security property.⁶

Secured lenders are often not satisfied to wait this long and can also request the bankruptcy court for "relief from the stay."⁷ If the debtor has no equity in the security property and the property is not necessary to a reorganization of the debtor, the bankruptcy court will probably grant the secured lender relief from the stay. The secured lender will now be free to foreclose.

Security can be either "consensual" or "judicial." Consensual security is provided with the consent of the debtor and is available to all types of lenders. Customers can agree to provide blanket consensual security applicable to all projects, such as personal guarantees, letters of credit or security interests in accounts receivable and equipment. These devices would be helpful to suppliers in any business, including construction materials, food service, or equipment dealers.

Most of the companies you are doing business with have a large credit line for the operation of their business. The bank that provides this credit line probably required a blanket security interest on all of the accounts receivable of the debtor, all of the debtor's contract rights, inventory, and equipment.⁸ If the company purchased trucks, vehicles, or heavy equipment, the seller of the equipment or a bank financing the acquisition again probably required a security interest. If the company owns real estate, there is probably a mortgage to a bank. All of these encumbered assets will not go in the big pot to be shared by general unsecured creditors, until the secured creditor has been paid in full. The bottom line in bankruptcy is that secured creditors get some or all of their money while unsecured creditors get very little or nothing.

Construction contractors and suppliers that have mechanic's lien or payment bond rights are generally in the same position as a secured lender. Mechanic's lien rights in most states are a security interest that will survive bankruptcy and result in secured creditor status. In states, such as Maryland, that do not have "inchoate" mechanic's lien rights, contractors and suppliers may be general unsecured creditors. Some states have higher priority on mechanics liens than others. This is something that a contractor needs to understand in each state in which they are doing business. Mechanic's lien rights vary from state to state and are discussed in greater detail in other chapters of this book.⁹ Rights under payment bond or guarantees will also generally be unaffected by bankruptcy. Unless the bonding company or guarantor is a debtor in bankruptcy, the creditor is still free to enforce rights under payment bonds or rights under guarantees.¹⁰

"General unsecured creditors," however, will share only in assets that are not already encumbered as security property for a secured lender. Typically, there are not many unencumbered assets. If there were, there would probably not have been a bankruptcy.

Creditors v. Creditors

Bankruptcy is often not a battle between the debtor and a creditor. It is a battle between creditors. Secured and unsecured creditors are certainly adverse. If a bank can prove it properly filed a UCC financing statement on accounts receivable¹¹, those assets are pulled out of the big pot and there is less for unsecured creditors to share. If a construction material supplier can establish mechanic's lien rights, this will give them "priority" in that particular receivable. That material supplier will be paid in full, leaving less for the unsecured creditors. If the material suppliers had failed to perfect mechanic's lien rights, however, this supplier would be another general, unsecured creditor. This receivable would be snatched up by another mechanic's lien claimant or would go into the big pot to be shared with other unsecured creditors. The debtor doesn't care which creditor gets this asset. The debtor will not get any of the assets.

Similarly, unsecured creditors are adverse to other unsecured creditors. The more unsecured creditors in the big pot, the less there will be to go around. If you are the only unsecured creditor that files a "Proof of Claim," you may get all available funds.¹² All secured and unsecured creditors are entitled to be paid. Fairness and justice would dictate that all of them get their money. Bankruptcy, however, is a battle between "innocents." The "bad guy" is gone. All that is left are "good guys" that never bargained for problems with the debtor. The bankruptcy process tries to provide order and fairness for the innocents battling over the limited assets.

Paradigm Shift

Creditors and their lawyers spend a lot of time trying to collect money. Especially when debtors are in default of their payment obligations, an adversarial relationship develops between creditor and debtor. The debtor is trying to keep from paying money at all or any sooner than they have to. The creditor is trying to get as much money as they can as fast as they can.

The creditor's frame of mind is to "win" this contest against the debtor. It is only fair that the debtor pay. The debtor agreed to pay in a solemn promise or contract. The creditor has delivered all labor and materials promised to the debtor. The debtor should perform its promises as well. This is only fair. The creditor is only looking for justice.

The creditor tends to take this same frame of mind into the bankruptcy forum. The creditor is still, of course, only trying to collect money rightfully due, and has still lost the value of all labor and materials supplied. The bankruptcy rules seem to thwart this basic justice, making it complicated and difficult for a creditor to collect debts justly due and owing. Why is this? Why do bankruptcy law and the bankruptcy court favor the debtor and make it so difficult for a creditor to obtain justice? The debtor often continues in business. The officers and directors of the debtor are often still seen running the company and driving the same valuable automobiles.

We could debate endlessly whether or not the bankruptcy process is fair or proper. I will not attempt to solve that problem. In order to understand how the bankruptcy works, however, the creditor must understand the philosophic foundation of this system. There is no doubt that many debtors abuse the bankruptcy process or that the system could use reforms. On the other hand, there must be good reasons a bankruptcy system has survived over one hundred years in most civilized countries. The United States Congress passed the current Bankruptcy Code into law after seeking the advice of many experienced lawyers, judges, and academics. Federal courts enforce the Bankruptcy Code as the law of the land and an important public policy objective. What are all these people thinking? This is not a conspiracy of insolvent debtors to avoid justice. Penniless individuals and insolvent companies have not succeeded in thwarting justice and the wishes of the successful and healthy businesses in this country.

The creditors of the world must step outside of their normal frame of mind in order to understand the bankruptcy system. There are important public policy considerations that make a Bankruptcy Code important to society as a whole. More importantly, however, bankruptcy is not a contest between the creditor and the debtor. Rather, the Bankruptcy Code is an attempt to generate fairness between a large number of participants, including all creditors, all employees of the debtor, the public at large, and the debtor itself.

In his influential book, The Seven Habits of Highly Effective People, Dr. Stephen Covey explains the importance of an ability to make a paradigm shift in order to be successful. There are as many points of view as there are people in this world. We can never succeed unless we can understand other points of view. Creditors will never succeed in the bankruptcy process until they understand the objectives of the Bankruptcy Code.

Public Policy

In Medieval times, the Government did put debtors in prison. This would seem fair to many creditors. The moneyed aristocracy made the rules. If you did not keep your agreements and pay your debt, creditors could make sure you were really sorry.

While creditors did obtain some satisfaction through this system, there were some obvious problems. Debtors could not earn any money to repay debts while they were in jail. Even worse, the Government was financing their room and board. On a larger philosophic level, society needed a system that encouraged risk taking and entrepreneurship. Why would anyone take a risk in starting a new business venture if failure meant spending the rest of your life in jail? We do not need potentially productive members of society sitting in jail at government expense. We need them out working at their jobs and caring for their families. Why would anyone get up and go to work everyday if all of what they earned for the rest of their lives would go to creditors? Not only was the debtor-prison system inhumane and costly, it decreased production and suppressed economic activity.

We as a society eventually decided that we needed a system that allowed individuals to obtain a clean bill of health, emerging debt free and encouraged to go back to work. Debtors would have to give up all assets they had. Those assets would be distributed fairly between creditors, but all debt would otherwise be "discharged" and eliminated.

Have you ever wondered why every civilized country in the world has limited liability entities? Creditors often perceive great unfairness when a corporation disappears with one swipe of a pen, but the former corporate president can still be seen driving her Cadillac in the neighborhood. Some of the first limited liability entities in history were the Dutch and English trading companies in the Age of Exploration. Why would entrepreneurs risk borrowing money to build ships and explore the world for new trading partners and natural resources when the result could so easily be financial failure, debtor's prison and a lifetime of repaying creditors?

Modern society needs entrepreneurs to create new businesses, new products and new jobs. This isn't going to happen if entrepreneurs face a lifetime of ruination. When dealing with a corporation, limited partnership, LLC, or other limited liability entities, you as a creditor simply have to understand that you will only be paid if the business succeeds. If creditors are not satisfied with this arrangement, they must decide to deal only with sole proprietorships or to always require personal guarantees. This would certainly limit the creditor's opportunities to do business.

When businesses fail, society often has a strong interest in finding a way to let the business continue. Historic problems with the steel, coal, and railroad industries are good examples. Bethlehem Steel has "failed." They are no longer paying their debts as they become due. Liabilities exceed assets and the company has a negative net worth. Are we better off if Bethlehem Steel disappears from the face of the earth? Tens of thousands of people will be out of work. The nation would lose a major source of steel, an important component of national industrial production. Recovery by creditors will also be limited.

If an insolvent company is "liquidated," when liabilities exceed assets, secured creditors will probably lose money while unsecured creditors are left with nothing. If the company has a workable, basic business plan, however, continuing the business will mean the generation of profits to pay unsecured creditors, jobs for employees, a tax base for the government, and a steel supply for industry.

Indeed, the shareholders often change in a "reorganized" corporation. When liabilities exceed assets, there is no "equity" for the shareholders (equity owners). Employees may become partial owners in exchange for lost pensions or the agreement to continue working. Unsecured creditors may receive stock instead of cash repayment of loans. Secured creditors sometimes become the "owners" of companies by agreeing not to foreclose on machinery and other assets.

This becomes all the more confusing because the former shareholders and managers of the failed business may continue as players. This can create the perception that the business continues unchanged while general unsecured creditors remain unpaid. The former shareholders and managers, however, may be mere employees in the reorganized company. The business may have failed only because of uncontrollable market conditions and the former managers may still be the best managers to work for the new employee or creditor owners. The former shareholder owners of the company must contribute cash or other "new value" to the reorganized venture in exchange for stock in the new reorganized company. They may also receive stock over time based on the success of the venture or services provided over time.

In general terms, the secured and/or unsecured creditors of the failed business become the owners and can make whatever deal they deem advisable with the former owners of the failed business. Generally the old equity owners must lose their interest in the company unless they contribute genuine new value or the creditors are paid in full. This is known as the "absolute priority" rule.

Bankruptcy Timeline and Terms

The bankruptcy timeline can generally be depicted as follows:

Bankruptcy Filing =Petition

Discharge Plan Confirmation

Prepetition					PostPetition
90 Days Preference Period					Stay					After Bankruptcy

The bankruptcy process normally begins when the debtor files a "bankruptcy petition." All transactions that occurred with the debtor before that time are now called "prepetition." All transactions after that are called "postpetition." It often becomes important whether a debt is prepetition or postpetition. It is the prepetition unsecured debt that goes into the big pot and shares in any eventual distribution to any general unsecured creditors. A debt for labor or materials supplied after the date of bankruptcy is postpetition debt, which is of higher priority and more likely to be paid.¹³

Immediately upon the filing of a Voluntary Petition in Bankruptcy, an "Order for Relief" is entered. In an Involuntary Petition, the court will enter an "Order for Relief" after the debtor is given an opportunity to oppose the petition.

Once the order for relief is entered, the bankruptcy process begins and the "automatic stay" is in place. The automatic stay ends the "race to the courthouse." All creditors are forbidden from taking aggressive action against the debtor or otherwise improving their position. General unsecured creditors will not be able to secure the amount owed to them, by judgment or otherwise. The debtor is no longer permitted to simply pay any creditor they wish.¹⁴ This automatic stay is one of the most important policy objectives of the Bankruptcy Code. All creditors are forced to simply stop aggressive behavior and participate in an orderly bankruptcy process.

This policy objective is so important that the Bankruptcy Code effectively pretends that the bankruptcy petition was filed 90 days earlier. The 90 days prior to the bankruptcy petition is called the "preference period." Not only are creditors prohibited from improving their position after the bankruptcy petition, Bankruptcy Code also "undoes" or eliminates many things that improved a creditor's position in the 90 days prior to the bankruptcy period.¹⁵ Any payments made by the debtor during the preference period may have to be repaid by creditors. If a creditor obtained a security interest in property of the debtor during the preference period, this lien can be removed.

The policy behind the automatic stay and preference period is to encourage creditors to work with a debtor, rather than force them into bankruptcy. A creditor is less likely to be aggressive with a debtor if the creditor knows that a bankruptcy petition within 90 days can mean that the creditor wasted legal fees for a judgment, garnishment, security interest or other aggressive attempts to collect.

Mechanic's lien rights are an important exception to this rule. In a state with an "inchoate" mechanic's lien, the contractor or supplier has mechanic's lien rights from the moment they supplied labor or materials. Accordingly, perfecting mechanic's lien rights is not a preference in such states. This is discussed in greater detail in other chapters of this book.¹⁶

Accordingly, advanced planning is very important in establishing security rights. If a creditor is depending on consensual security, the creditor must make sure to get this at least 90 days before a bankruptcy filing. The only way to be safe is to require some type of security before supplying labor and materials.

By the same token, it is important to determine whether payment bond rights exist and to evaluate your mechanic's lien rights before supplying labor and materials. If you are doing business in a state with strong inchoate mechanic's lien rights, you do not need to be as concerned with consensual security. If your mechanic's lien rights will be limited or lost in bankruptcy, however, it becomes more important to require security early.

Types of Bankruptcy

Chapter 7

This is a liquidation. All of the unencumbered assets of the debtor are thrown into the big pot. All of the general unsecured creditors are also thrown into the big pot and share pro rata in whatever assets are available (share pro rata in the proceeds of the liquidation). Secured creditors have their rights in their collateral and will be paid in full if there is enough equity in the security property.

An individual person can file a Chapter 7 and obtain a "discharge." The individual emerges from bankruptcy with no debts, and only those assets exempt under the code¹⁷. An individual will obviously continue to exist. The debtor is still responsible for postpetition debts and cannot get another discharge in bankruptcy for 6 years.¹⁸ This individual may not have been a good business risk and may have been poor at handling credit, but many creditors will want to do business with an individual after bankruptcy. Creditors can often charge premium rates and need not worry about another bankruptcy for 6 years.

A corporation or other limited liability entity can also file a Chapter 7, but this is less common. A corporation cannot receive a discharge in Chapter 7. The corporation is simply out of business. If a corporation is insolvent, it is not normally worth it to pay legal fees or filing fees for a bankruptcy. The business is simply abandoned. Creditors are free to obtain judgment, but will be unable to collect.

Sometimes corporations will file Chapter 7 in order to wind down the business in an orderly manner. There may be a few profitable projects or contracts that the debtor wishes to complete. The bankruptcy and automatic stay will keep creditors from harassing the debtor while this occurs. Indeed, the automatic stay may be the only reason a corporation files a Chapter 7 bankruptcy. Legal fees and administrative time may both be lower if general unsecured creditors are forced to stop aggressive action. The profits collected while the business is wound down may all go to a secured creditor with a security interest in all accounts receivable and the personal guarantee of officers and directors.

Creditors are not normally faced with the decision whether to do business with the debtor postpetition in a Chapter 7, but creditors should be especially cautious of a corporate debtor requesting credit in a Chapter 7. By definition, the business will disappear. The creditor does have "administrative expense priority" for the postpetition debt, but there may be no assets, cash flow, or debtor from which to collect.¹⁹

Chapter 11 Reorganization

This is usually only for corporations and other limited liability entities. The corporation can eventually develop a "plan of reorganization" and can continue in business. Secured creditors will normally retain their collateral rights. Unsecured creditors will have their right to a pro rata distribution of the unencumbered assets and may get a portion of future profits or a shareholder interest in the reorganized entity.

In general terms, the debtor can continue "business as usual" after the Chapter 11 petition. Normally, the management of the debtor remains in control of the business as a "debtor in possession."²⁰ The debtor in possession is authorized to operate the business and incur unsecured debt in the ordinary course of business.²¹ This postpetition unsecured debt will have administrative expense priority.²² There is no need for the debtor to get bankruptcy court approval to incur trade debt or pay such postpetition trade creditors in the ordinary course of business.²³

A Chapter 11 debtor can convert the case to a Chapter 7 liquidation at any time. Creditors sometimes request the bankruptcy court to convert the Chapter 11 to a Chapter 7 liquidation, if creditors feel that a continuation of the business will just deplete assets and there is little chance of a successful reorganization.

There is such a thing as a Chapter 11 liquidation. This is similar to a Chapter 7 liquidation. All of the assets of the corporation will be sold and the debtor will go out of business. Chapter 11 liquidations are preferred sometimes, however, in order to wind down the business of the corporation in the most profitable manner.

Normally, the objective of a Chapter 11 reorganization is to continue in business. Eventually, a "plan of reorganization" is adopted. Most plans of reorganization call for secured creditors to retain their collateral rights. If there is sufficient value in the collateral, the secured creditor will eventually be paid most or all of what they are owed. Federal, state and local governments are usually also paid in full for tax liabilities. General unsecured creditors will receive some percentage of their debt, to be paid over time as the reorganized business generates profits. The plan will typically call for the shareholders or equity holders in the business to lose some or all of their ownership interests. There is usually some change in the ownership of the entity in the plan of reorganization. Secured creditors, unsecured creditors, or employees may become the owners of some or all of the reorganized entity.

Only the debtor is allowed to propose a plan of reorganization for the first 18 months after the bankruptcy petition.²⁴ This deadline cannot be further extended by the court.²⁵ This deadline cannot be further extended by the court.²⁶ If the debtor's plan has not been filed or accepted within deadlines, the trustee, creditors committee, an individual creditor, or another party in interest may file a reorganization plan.²⁷

Under a plan, all creditors are separated into "classes," such as secured, unsecured, equity owners, governmental taxes, etc.²⁸ All creditors in each class must be treated the same under the plan. Creditors that will receive less than payment in full are "impaired." Creditors that will not lose any rights are "unimpaired."²⁹

All creditors will eventually receive a "disclosure statement" describing the plan and the debtor's financial circumstances. All impaired creditors with allowed claims will have an opportunity to vote on the plan.³⁰ Unimpaired creditors are conclusively presumed to have accepted the plan, since they will be paid in full.³¹

Each impaired class of creditors must accept the plan or the court must determine that a "cram down" is appropriate.³² A class of creditors has accepted the plan if more than one half (1/2) of the creditors have voted in favor and two thirds (2/3) of the amount of the claims in the class have voted in favor of the plan.³³ If one class of creditors has not approved the plan, the court can still approve the plan by "cram down," if all creditors in the class will receive at least as much as they would have under a Chapter 7 liquidation.³⁴ In any event, however, at least one impaired class of creditors must accept the plan.³⁵ This requirement sometimes causes debtors to artfully create classes of creditors, in order to make sure that one impaired class approves the plan. Once these and other requirement are met, the court can "confirm" the plan.

Once the plan of reorganization is confirmed, the corporation does obtain a discharge from general unsecured debt that arose before plan confirmation, whether or not a proof of claim was filed.³⁶ All property of the bankruptcy estate becomes vested back in the debtor. That property is free and clear of all claims of creditors or shareholders in the former company.

In a Chapter 11 reorganization case, the code states that "debts were discharged upon confirmation of a plan." Bankruptcies are sometimes dismissed, however, if the debtor does not make agreed payments under a plan. Chapter 11 bankruptcy is sometimes filed by wealthy individuals with complex business affairs. In an individual Chapter 11, debts are not discharged until all payments are made under a reorganization plan.³⁷

There is a Chapter 11 reorganization process for "small business debtors," with debts of less than Two Million Dollars. Some procedural rules are relaxed. For example, the debtor can dispense with a "disclosure statement" to all creditors, if the plan of reorganization itself provides adequate information for creditors to vote on the plan.³⁸ This may help small businesses get out of bankruptcy faster and successfully reorganize. Other rules regarding the automatic stay are applicable only to small business cases.

In a small business reorganization, the debtor has an exclusive right to file a plan of reorganization for only 100 days after the petition. This can be extended by the Court, but extensions become more difficult more than 300 days after the petition.³⁹ This will make it easier for creditors to have a case dismissed or converted to a Chapter 7, if no plan of reorganization has been approved within these deadlines.

Chapter 13 Plan

This is like a Chapter 11 Reorganization for individuals. The individual develops a plan that usually involves putting all "disposable income" in the big pot to be shared by all general unsecured creditors. Secured creditors have their collateral rights and will be paid in full if there is sufficient equity in the collateral. The individual gets to keep a large portion of their income during the Five-Year Plan for living expenses and general unsecured creditors normally receive only a small percentage of their claim. Only individuals with "regular income," basically salaried individuals, can file Chapter 13.

Individuals normally elect to file a Chapter 7, because they can receive an immediate discharge, start a new day free of any debt, and are able to keep all of their future income. Some people file a Chapter 13 out of a sincere desire to repay creditors to the best of their ability. Others utilize Chapter 13 in order to schedule out a non-dischargeable tax claim. Often, individuals file a Chapter 13 in order to obtain a discharge from debts that may be non-dischargeable in a Chapter 7. This is usually some type of fraud claim.

Involuntary Bankruptcy

It is possible for three creditors to put an individual or corporation into an involuntary bankruptcy.⁴⁰ The three creditors must have claims that are not contingent and not the subject of a bona-fide dispute.⁴¹ The bankruptcy court will enter an order for relief and start the bankruptcy process if the debtor is generally not paying its debts as they become due.⁴²

The debtor can continue to operate the business, but creditors can ask the court to appoint a trustee to take control of the business.

The involuntary bankruptcy petition could be Chapter 7 or Chapter 11. In either case, however, the debtor or creditors can later ask to have the case converted to another chapter.⁴³

Creditors may want to file an involuntary petition because the debtor is quickly losing money and creditors will be better off if all assets are immediately liquidated. Creditors may also want to file an involuntary bankruptcy if they think there is fraud in the company, gross mismanagement or if management is paying select creditors at the expense of others. Unpaid creditors may file an involuntary petition to establish the right and the timetable to require repayment of preferences.

For any individual creditor, an involuntary petition is often more valuable as a threat than action. Once the involuntary bankruptcy process begins, the creditor is not able to appropriate to itself the benefit of this action. All of the debtor's creditors will be involved and all of the debtor's assets must be equitably distributed pursuant to the Bankruptcy Code. All of the transaction costs and inefficiencies of any bankruptcy will exist and the eventual distribution to general unsecured creditors may be small. Petitioning creditors can recover the costs of filing a successful involuntary petition as an administrative expense. On the other hand, petitioning creditors may have to pay legal fees if they fail to prove that the debtor is legally bankrupt.⁴⁴ Punitive damages are a possibility if the involuntary petition was filed in bad faith.

Foreign Bankruptcies and Creditors

The Bankruptcy Code generally adopts the Model Law on Cross-Border Insolvency from the United Nations Commission on International Trade Law. The objective is cooperation between courts of the United States and courts of other countries in cross-border insolvency cases; greater legal certainty for trade and investment; and fair and efficient administration of cross-border insolvencies.

The process starts with a foreign insolvency proceeding. A "foreign representative" may then request recognition of the foreign proceeding in a US Bankruptcy Court in a District where the debtor has its principal place of business or principal assets or where a judgment enforcement proceeding is pending.⁴⁵ Once the foreign bankruptcy is recognized, the foreign representative can act for the debtor in the US Bankruptcy Court. The foreign representative has the automatic right to operate the debtor's business as a "debtor in possession."⁴⁶ Several U.S. Bankruptcy Code provisions will apply, including the automatic stay provisions which will now apply to assets of the debtor in the United States.⁴⁷ Creditors must be careful about violating the automatic stay as to foreign owned property in the United States.

Foreign creditors are now also entitled to non-discriminatory treatment in any US Bankruptcy with "the same rights regarding the commencement of, and participation in, a case under this title as domestic creditors."⁴⁸ They are entitled to the same notices given to creditors generally.⁴⁹ They are entitled to the same notices given to creditors generally.⁵⁰

CONSUMER AND INDIVIDUAL BANKRUPTCIES

Means Testing

Means Testing is designed to eliminate abuse by individual debtors by preventing individuals with high income from filing for a Chapter 7 discharge. The trustee or a creditor can request dismissal of a Chapter 7 case if the debtor's income is above the median income in that geographic area and the debtor has "sufficient available net income."⁵¹ There are complicated formulas to qualify a debtor, but a creditor can generally ask the court to dismiss a case if a debtor has available net income of at least $10,000 over a 5-year period for repayment of debts. If a debtor consents, the case can be converted to a Chapter 13, instead of dismissed, which has always required the debtor to repay a portion of debts over time.

These provisions may aide a commercial vendor that sells goods to an individual consumer or a creditor seeking to enforce a personal guarantee of a commercial account.

Credit Counseling

Individual debtors are also required to take mandatory credit counseling and education in order to obtain a bankruptcy discharge.⁵² This makes it more difficult generally for debtors to file bankruptcy and will hopefully avoid subsequent bankruptcies through education. A debtor must obtain credit counseling and perform a personal budget analysis from an approved non-profit budget and credit-counseling agency before filing a bankruptcy petition. In addition to pre-bankruptcy credit counseling, debtors must also complete a course on personal financial management in order to receive a discharge in Chapter 7 or Chapter 13. ⁵³

Discharge every Eight (8) Years

There must be eight (8) years between discharges under Chapter 7 or Chapter 11.⁵⁴ In Chapter 13, no discharge is available to a debtor that received a discharge in a Chapter 7, 11 or 12 Bankruptcy filed within 4 years prior to the current Chapter 13. A Chapter 13 debtor also cannot receive a discharge in a new Chapter 13 case filed within 2 years prior to the new Chapter 13 petition.⁵⁵

Homestead Exemptions

Homestead Exemptions protect certain types of property of an individual debtor from creditors. Homestead Exemptions, created by state law, have generally been respected by the bankruptcy code. These exemptions vary from state to state. Florida, Iowa, Kansas, South Dakota, and Texas have unlimited Homestead Exemptions for a debtor's personal residence. This has resulted in much abuse as debtors sliding into insolvency in any state would liquidate all available assets, move to a state with an unlimited homestead exemption and buy a mortgage free mansion. Once residence is established, the debtor would then file bankruptcy, discharge all debt, and still have an unlimited asset in the personal residence.

There are complicated provisions restricting abusive use of Homestead Exemptions. Homestead Exemptions are restricted, regardless of state law, to $125,000 if the debtor bought their residence less than 40 months before the bankruptcy filing.⁵⁶ The Debtor also loses their exemption as to any property disposed of in the 10 years prior to the bankruptcy petition with the intent to hinder, delay or defraud a creditor.⁵⁷ Assets protected from creditors in individual retirement accounts are also now generally limited to One Million Dollars.⁵⁸

THE BANKRUPTCY FILING

Notice of Bankruptcy

When a debtor files bankruptcy, you should receive a "Notice of Bankruptcy" if you are a creditor. The Notice of Bankruptcy is sent by the bankruptcy court clerk to all creditors listed by the debtor in their bankruptcy petition. An example is shown at Appendix 33. The notice will state the name and address of the debtor that has filed bankruptcy and provide the name and address of the bankruptcy court. The notice will also identify the name and address of the debtor's attorney, name and address of the bankruptcy trustee, and tell you whether the bankruptcy is a Chapter 7, Chapter 11, or some other type of bankruptcy.

Automatic Stay

The notice of bankruptcy will inform you:

Creditors may not take certain actions:

The filing of the bankruptcy case automatically stays certain collections and other actions against the debtor and the debtor's property. If you attempt to collect a debt or take other action in violation of the Bankruptcy Code, you may be penalized.

This is the "automatic stay." When a debtor files bankruptcy, creditors are automatically prohibited from taking action against the debtor or the debtor's property. The bankruptcy case may later be dismissed if the debtor fails to comply with their bankruptcy obligations. Creditors may bring a motion to "lift the stay" or dismiss the bankruptcy on various grounds.⁵⁹ Until the stay is lifted or the bankruptcy is dismissed, however, creditors are generally prohibited from harassing the debtor in any manner or taking affirmative steps to collect a debt.

Violating the automatic stay can result in severe penalties.⁶⁰ Creditors are not permitted to call or write the debtor in an attempt to collect, may not file suit, and may not take any further action in any pending lawsuit. Creditors are also prohibited from taking any action against the debtor's property, may not foreclose on any security interest, may not file a mortgage or judgment lien, may not repossess a vehicle, may not evict a tenant from real estate, and may not take rented equipment.

The automatic stay is an important part of Bankruptcy Code policy. This ends the "race to the courthouse." Bankruptcy is intended to be an orderly process to liquidate or reorganize the debtor and this is impossible if creditors are allowed to aggressively pursue the debtor. Fairness between creditors is also an important objective and the debtor's limited assets should not go to the creditor that is the most aggressive or the creditor that can afford the most attorneys' fees. The automatic stay is often the very objective of a bankruptcy filing, if a creditor is about to foreclose on property or has just filed some other legal action. Debtors sometimes file bankruptcy just to temporarily stop some foreclosure action and will thereafter allow their case to be dismissed.

An important exception to the automatic stay is the right to file a mechanic's lien in states with inchoate mechanic's lien rights.⁶¹ In states with inchoate mechanic's lien rights, contractors or suppliers had lien rights from the moment they supplied labor and materials to a property. Accordingly, filing a mechanic's lien is not a preference and is not an affirmative action against the debtor or the debtor's property. The mechanic's lien only provides public notice of the lien that the creditor always had. Filing a lawsuit to enforce mechanic's lien rights, however, is normally a violation of the automatic stay and requires a motion for relief of the stay.⁶²

Secured creditors are stayed from moving against their collateral. Secured creditors retain their security rights in the collateral, but may not foreclose or repossess without filing a "motion for relief from the automatic stay" to obtain bankruptcy court permission.⁶³

It is important to note that creditors are stayed only from taking action against the debtor in bankruptcy or against the property of the debtor in bankruptcy. Creditors often have rights against more than one debtor. If you have a contract with a husband and wife, and only the husband files bankruptcy, you may still take action against the wife. If a corporation files bankruptcy, but you have a personal guaranty from an officer, you may move against that personal guarantor. You may still enforce a payment bond claim, unless the bonding company happens to be in bankruptcy.

There are some limits on the automatic stay for "serial filers," that is debtors that repeatedly file bankruptcy petitions. Most of these provisions concern consumer bankruptcies, but some are also applicable to commercial debtors.⁶⁴

Proof of Claim

The notice of bankruptcy will also provide a deadline for filing proofs of claim or instruct you not to file a proof of claim unless you receive further notice. It is very important to file your proof of claim before the deadline, because you have probably waived your claim otherwise.

A proof of claim is essentially a lawsuit against the debtor. Creditors are stayed from filing a lawsuit in other courts, but are permitted to make their claim against the debtor in the form of a bankruptcy proof of claim filed in the bankruptcy court. Creditors may also include any pre-petition and post-petition contract-based claims for attorney's fees in their proof of claim.⁶⁵

A proof of claim form is shown at Appendix 34. If a proof of claim is "allowed" the creditor is entitled to its pro rata share of any distribution from the bankruptcy estate (the big pot). Creditors have an important advantage in that their filed proof of claim is deemed accepted, unless the debtor, trustee or another creditor objects.⁶⁶ The debtor has the burden of introducing evidence to disprove your claim.⁶⁷

Debtors usually do not have an incentive to object to any one particular claim, because all the debtor's assets will normally be split amongst creditors. The debtor will not end up with any assets and usually doesn't care how assets are distributed. Bankruptcy is often not a contest between the creditor and the debtor, but rather a contest between creditors. Another creditor or the trustee may file an objection to a proof of claim.⁶⁸

On the proof of claim form at Appendix 34, creditors are asked whether they have ever received notices in this bankruptcy. As discussed below, creditors will receive bankruptcy notices only if the creditor was listed as a creditor in the bankruptcy petition schedule of liabilities. If you have never received bankruptcy notices, it is important to check this box on the proof of claim form in order to have your name added to the "matrix" mailing list for future notices. Similarly, the proof of claim form invites the creditor to list a new or different address for notices. A debtor will often list a creditor's address the same as the address used to send payments. For large corporate creditors, this may be a lock box address or main headquarters address. If future notices are sent to this address, it may take awhile for these notices to be forwarded to the credit manager or other person making decisions for the creditor. Future notices could include a notice that the bankruptcy had been dismissed, an objection to a creditor's proof of claim, or other important activities in the bankruptcy court. These deadlines are often very short and it is important to get notices to decision makers promptly.

Box One of the proof of claim form asks for the "basis of claim." For construction contractors and suppliers, this will normally be either "goods sold" or "services provided" or both. The creditor is permitted to check more than one box.

Box Four of the proof of claim asks for the "amount of claim." This should be the total amount of the debt to this creditor as of the day of the bankruptcy petition, including principal, interest and service charges. Creditors should identify the "date debt was incurred" in Box Two and must separately account for the interest portion of the claim.

In determining the amount of claim for the purposes of Box Four, creditors should keep in mind that all debt for labor and materials provided pre-petition should be included. This amount includes charges for labor and materials provided pre-petition that were not invoiced until post-petition.

The creditor should identify any "security" for the debt in Box Five of the proof of claim. This asks whether the creditor has security in the property of the debtor. For example, the debtor could have provided the creditor with security interest or UCC financing statement in an account receivable, equipment or real estate. This could also be a mechanic's lien interest in the debtor's property. This would be true if you were supplying labor or materials directly to the owner of the real estate and that owner filed bankruptcy.

If your debtor was not the owner of the real estate (your debtor was a contractor or subcontractor), however, your mechanic's lien rights are not a security interest in the real property of the debtor. It may still be advisable to file a proof of claim as a secured creditor in this instance, however. Your mechanic's lien rights in an owner's property do give you priority over the receivable owed by the owner to your debtor. Your mechanic's lien interest is in the real estate of the owner (and not the debtor), but this gives you an interest in the receivable owed by the owner to the debtor. This receivable is property of the debtor.⁶⁹ It is not clear whether you are required to file a proof of claim as a secured creditor in this situation.

The status of trust fund rights is also questionable on a proof of claim. These rights can exist as a result of state trust fund statutes or as a result of a trust fund agreement. This is discussed in other chapters of this book.⁷⁰ A trust fund claimant is probably not a "secured creditor" because they are not claiming a security interest in property of the debtor. This money is simply not property of the bankrupt debtor. The trust fund was always the property of the creditor, and the debtor was only a trustee. It is probably advisable to make note of a trust fund claim in Box Five on a proof of claim, however. An "equitable lien" claimant, however, is more likely an actual secured creditor in bankruptcy.⁷¹

Any secured creditor, trust fund or equitable lien claimant should engage counsel to file a proof of claim. It is tempting to view a proof of claim as simple and unimportant. If a creditor is owed a small amount of money and is satisfied with general unsecured creditor status, credit managers and other laypersons can usually file proofs of claim on their own. It is unlikely there will be a distribution in most bankruptcies anyway. A creditor that hopes to be paid in full should take care in a proof of claim, in order to avoid taking inconsistent positions. Counsel should generally file a proof of claim in any case involving a large amount of money, any type of secured claim, a trust fund or equitable lien claim, an administrative expense claim, or any claim to full payment because of assumption of a contract.

Box Six of the proof of claim inquires whether the creditor has "unsecured priority" status. This would almost never be applicable to a construction contractor or supplier and generally involves employees of the debtor or governmental units.

The bottom of the proof of claim form instructs the creditor to attach documents relevant to the proof of claim, including contracts, invoices, or evidence of a security interest. It is important to attach documents. This is an easy way to show evidence or further detail of your claim. Remember, the proof of claim is deemed accepted if the debtor does not object. This essentially gets all these documents "into evidence" in proving your claim. If you have a pending lawsuit against the debtor, it may be convenient to attach a copy of the lawsuit with exhibits. This is an easy way to provide detail on your claim.

The bottom of the proof of claim form also provides instructions if you want a "File Stamped Copy" of your proof of claim. This is always advisable, so that you have evidence in your file of the date of filing and contents of your proof of claim.

A creditor should make sure that all of its claims are included in the proof of claim, including all principal, interest and attorney's fees. Proof of claim can later be amended or supplemented, however. Make sure you file something before the deadline expires, even if you are missing some information or documents. You may be able to add this additional information later.

Schedules

Soon after filing bankruptcy, the debtor is required to file a schedule of assets and liabilities, a schedule of current income and current expenditures, and a statement of the debtor's financial affairs.⁷² These are collectively referred to as "schedules." The debtor must file schedules along with its voluntary petition, unless the immediacy of the filing does not allow. In the event that debtor or debtor's counsel must file the petition in a short amount of time, a list of the names and addresses of all the debtors' creditors can be filed along with the voluntary petition. Such a filing is known as a "bare bones petition." The filing of complete schedules within 15 days of filing the petition must follow a bare bones petition.⁷³ Similarly in an involuntary case, the debtor must file its schedules within 15 days after the entry of the order for relief.⁷⁴

Any creditor will want to review these schedules before attending the meeting of creditors, in order to better question the debtor at the meeting. On larger and more complicated bankruptcies, the debtor will often get an extension of time to file these schedules. Bankruptcies are sometimes dismissed if the debtor never files schedules.⁷⁵

The schedules are essentially a complete financial statement of the debtor. The debtor is required to list all of its assets, secured creditors, unsecured creditors, income in the current year and past years.

The debtor is also supposed to list all creditors, the amount of the debt and whether the debt is "unliquidated," "contingent" or "disputed."⁷⁶ The debtor lists secured creditors on a separate schedule. In a Chapter 11, if a creditor is listed and the debt is not scheduled as unliquidated, contingent or disputed, then the creditor is deemed to have an allowed claim in the amount listed, even if this creditor fails to file a proof of claim. If a creditor wishes to claim a higher dollar amount, wishes to claim secured status, or if the debt is listed as unliquidated, contingent or disputed, then the creditor must file a proof of claim. It is advisable for all creditors to file a proof of claim, however, especially if the court has issued a "Notice of Need to File Proof of Claim," also known as a "bar date" order. In any event, all creditors must file a proof of claim in a Chapter 7 bankruptcy.

Reviewing the schedules is a good opportunity for a creditor to review the debtor's complete financial picture. This will help decide whether the debtor has any chance of reorganizing successfully, whether there is any chance of a distribution for general unsecured creditors, or whether there will be sufficient cash flow to pay administrative claims for creditors doing business with the debtor postpetition.⁷⁷ This information can be helpful to a creditor later, if the bankruptcy is dismissed for any reason. A creditor may wish to obtain a copy of the schedules for this reason.

If there is a chance of a good distribution, a creditor is more comfortable working within the bankruptcy process and not trying to assert equitable lien or administrative expense status. This will reduce legal fees for the creditor and the debtor, increasing the chances of a good distribution. If there is no chance of a distribution to general unsecured creditors, however, the creditor's only chance for payment will be to establish mechanic's lien, trust fund, equitable lien, administrative expense, or other priority status.

No Notice of Bankruptcy

What if you did not receive notice of the bankruptcy? This may be because the debtor used a bad address for you, or because of problems with the mail. It may also mean that the debtor did not list you as a creditor on the debtor's schedule of assets and liabilities.

If you are not listed as a creditor on the debtor's schedule of assets and liabilities, it will be necessary to file a proof of claim in the bankruptcy to share in any distribution to general unsecured creditors. A secured creditor, however, will not generally lose any rights in security property, even if they fail to file a proof of claim.⁷⁸

A creditor that receives no notice of the bankruptcy will technically be unaffected by the bankruptcy. As a practical matter, however, this will rarely be helpful.

If a corporate debtor is liquidating in bankruptcy, the distribution to creditors in the bankruptcy will be the only chance to collect anything. After the bankruptcy, the corporate debtor will have no assets and will simply be out of business. In a Chapter 11 Reorganization, a creditor not on the schedules and not filing a proof of claim will not be included in the plan.⁷⁹

If an individual files a Chapter 7 bankruptcy, an unlisted creditor that did not receive notice of the bankruptcy may technically be able to sue the debtor for the full amount of the debt after all other debts have been discharged and the bankruptcy is closed. If this was a "no assets" bankruptcy that resulted in no distribution, however, courts have allowed the debtor to reopen the bankruptcy later to add the unlisted creditor and obtain a discharge from that debt.⁸⁰

The bottom line is that it is generally better for creditors to participate in the bankruptcy process and file a proof of claim, even if they were not originally listed as a creditor and did not receive notice of the bankruptcy.

THE BANKRUPTCY PROCESS

Getting on the Mail List

If you received notice of the bankruptcy, then you were listed as a creditor on the schedule of assets and liabilities. As a listed creditor, you are also entitled to notice of meeting of the creditors, notice of dismissal of the bankruptcy or notice of discharge.⁸¹ You will not, however, receive notice of many other proceedings in the bankruptcy, unless you file a Rule 2002 request for service of papers. This is shown at Appendix 35.

Once you file a request for service, you will receive copies of everything that occurs in the bankruptcy. This is both good news and bad news. You will be aware of everything in the bankruptcy that may help you or may hurt you. You will have an opportunity to object to anything you think may hurt your ability to collect.

Receiving notice of all proceedings, however, means that you will receive many notices, motions, objections, and other proceedings. Someone has to sift through all of this to determine whether any of it impacts you. This will mean legal fees if you have an attorney file a Notice of Appearance by Counsel and Request for Service of the Papers for you.

This will also mean a large volume of paper, which must be stored somewhere. Fortunately, most bankruptcy courts use electronic filing. This saves a lot of space and speeds the process, but someone still must review all notices to make sure your interests are protected.

Remember that bankruptcy is essentially the same as lawsuits filed at the same time by everyone doing business with the debtor. Everyone that has done business with the debtor is filing a proof of claim, filing motions to foreclose on security property or filing motions for payment of administrative expenses. The debtor must file a motion to hire a lawyer, pay any creditor, or to settle any claim. All of this means many notices and motions to review.

If you are satisfied to be a general unsecured creditor and do not expect a distribution, you probably do not want to file a Rule 2002 request for papers. Simply file your proof of claim and close your file. You will receive notice if there is any objection to your proof of claim.⁸² If you are owed a large sum of money, however, you will need to get counsel to keep track of the bankruptcy. You want to object if the debtor is engaging in diseconomic behavior, if secured or unsecured creditors are overreaching and generally to maximize the eventual distribution to general unsecured creditors. You will also want to watch whether the debtor assumes a contract with you or any upstream contractors on a project to which you supplied labor and materials.⁸³ If you are claiming mechanic's lien, trust fund or equitable lien rights, you must respond if any secured creditor is claiming an interest in the same funds.⁸⁴

It is a common problem that creditors never receive notice of bankruptcy or that subsequent notices during the bankruptcy process are sent to a bad address. A creditor can send two communications to the debtor containing a current account number and creditor address for correspondence. If two such notices are sent to the debtor in the first 90 days of the bankruptcy, then the debtors are required to send further notices to the creditor at that address and include the account number.⁸⁵

It is also possible for any creditor to file a notice of address with any bankruptcy court that then has to be used by any bankruptcy court in any chapter 7 or 13 bankruptcy.⁸⁶ Most creditors should consider filing such a notice with their local bankruptcy court for all of their accounts to make sure that bankruptcy notices go to the proper credit managers of the creditor.

A monetary penalty for violation of the automatic stay cannot be charged against a creditor for actions taken before the creditor receives notice of the bankruptcy.

The Meeting of Creditors

The notice of bankruptcy you received probably also gave a date, time and location for the "meeting of creditors." See Appendix 33 . What is this meeting of creditors? Do you need to go? Do you need to have an attorney attend for you? Generally, no decisions will be made at the meeting of creditors that will prejudice you. It is an opportunity, however, to ask the debtor questions and collect information.

The meeting of creditors normally takes place at the US Trustee's office. There may be many meetings scheduled for many different bankruptcies at the same time. The debtor must attend. The U.S. Trustee will be present.

Any creditor has the opportunity to ask the debtor about assets and liabilities, transactions, or any possible fraudulent activity. A creditor can ask the trustee to compel the production of documents and other information.

The trustee operates something like a justice of the peace. The trustee will protect the debtor if necessary, but will also make sure that the debtor complies with all rules. It is the trustee's job to protect the bankruptcy estate assets in order to maximize the distribution to the pool of general unsecured creditors. In other words, it may not matter whether you as an individual creditor have been hurt, but rather whether the pool of creditors as a group has been hurt.

The trustee will help creditors both at and after a meeting of creditors, but there must be a "complainant" or someone bringing problems to the trustee's attention. If you are aware of assets that the debtor did not list on schedules, the trustee will almost certainly require the debtor to produce documents about these assets. If you think a debtor has committed a fraud, the trustee will probably also compel the debtor to produce information. The trustee could, for example, require the debtor to produce copies of tax returns or bank account statements.

Normally, there are limits to the time a trustee will expend in any one case. A Chapter 7 trustee is normally a private attorney paid a nominal flat fee and a percentage of money brought into an estate. Accordingly, it is normally difficult for a trustee to justify spending much time on the case. In a Chapter 11, the U.S. trustee is usually involved. They may not be so concerned about profitability, but are still trying to handle a large volume of cases.

You have the opportunity to ask the debtor questions about their business or financial matters. Meetings are usually recorded and transcripts can be ordered, but you will want to check on this in advance if it is important.

Whether you should go to a creditor's meeting, or have counsel attend, depends on your interest in the bankruptcy. If you are a relatively small, general unsecured creditor, there is no reason you have to attend. Nothing can happen at the meeting that will impact your rights. On the other hand, if you are a larger creditor, this is a good opportunity to collect information. This is particularly important if you believe the debtor committed a fraud upon you or you have another objection to discharge. Your objection to discharge must be filed within 60 days after the meeting of creditors, so this may be your only opportunity to collect information.⁸⁷

Objection to Discharge

A creditor generally must file any objection to a discharge from debts within 60 days after the meeting of creditors, although you should also check the notice of bankruptcy carefully for a different deadline for objection. See Appendix 33. There are generally two types of objections to discharge.

Discharge of a Specific Debt

A §523 objection generally involves fraud on one particular creditor, resulting in no discharge on that particular debt. This type of objection has great advantages for a creditor. The debtor will be discharged from all other debts. This one creditor can pursue the debtor after the bankruptcy is concluded. This creditor will have a better chance of collecting in full.

An individual debtor is not discharged from any debt for money, property, services, or credit obtained by:

a. False pretenses, a false representation or actual fraud (other than a statement concerning the debtor's financial condition), or

b. The use of a statement in writing concerning the debtor's financial condition that is materially false, that the debtor made with intent to deceive, and on which the creditor reasonably relied.⁸⁸

Generally a debt is nondischargeable if the debtor obtained money though fraudulent statements, whether the statements were verbal or written. There is a special rule, however, for statement concerning "financial condition." A debtor can make false verbal statements concerning its financial condition and still receive a discharge, but not false written statements.⁸⁹ This is a reason for creditors to require written financial statements or credit applications regularly. A debtor can obtain a discharge if he falsely stated verbally that he is solvent and has plenty of money to pay the debt. The debtor could not obtain a discharge if he stated that he was licensed and bonded, if this is not true.

A creditor will have the same problems with a §523 objection that exist in any fraud case. The creditor must prove that the debtor intended to deceive, must prove that the creditor actually relied on the deception, and must prove that the fraud actually caused damage. Mere promises to pay, however stupid, are not fraudulent. The debtor did not intend to deceive. False statements made after materials are shipped are not fraud, because the creditor did not rely on these statements to extend credit. False statements made to someone else will rarely be fraud, because the creditor could not have relied on these statements. Proving that the debtor is bad generally, and made many false statements will not prove fraud unless the creditor can prove the debtor made a specific statement in order to deceive this specific creditor and that the creditor actually relied on that statement in extending credit. As discussed below, however, proving that a debtor is bad generally may be a §727 objection, resulting in denial of any discharge from all debts.

Section 523 objections also exist to deny a discharge for alimony, child support, student loan repayments, injuries caused when driving while intoxicated, certain taxes, or other governmental claims. These sorts of objections normally do not exist in a commercial context and are not the subject of this outline.

Discharge of the Debtor

A §727 objection means that the debtor is "generally bad," should not be allowed to use the bankruptcy process at all and should not receive a discharge at all.

Section 727 Objections to discharge occur only in individual Chapter 7 cases and liquidating Chapter 11 bankruptcies. A corporation reorganizing under Chapter 11 cannot be denied a discharge under §727, rather, in a corporate Chapter 11 all debts of the corporation arising before the date of confirmation are discharged upon confirmation of the plan of reorganization.⁹⁰ Thus, the Court can deny a corporate debtor under Chapter 11 a discharge by refusing to confirm a plan of reorganization that is not offered in good faith. Corporations cannot obtain a discharge in Chapter 7, so there is no need to object. Individuals can obtain a discharge in Chapter 13 from debts that would not be dischargeable in Chapter 7. Individuals in a Chapter 13 are required to make payments under a three-year plan that may be extended for cause for up to five years.⁹¹

Any creditor or the U.S. Trustee can file a §727 objection if the debtor:

1. Has received a bankruptcy discharge in the last six years
2. Has transferred, removed, destroyed, mutilated or concealed property in the last year
3. Has concealed, destroyed, mutilated, falsified, or failed to keep books, documents, records, or papers concerning financial conditions or business transactions
4. Has dealt improperly with the court, including making a false oath on an account, presenting a false claim or withholding books, documents or other records relating to the debtor's property or financial affairs, or failed to obey orders of the court

If the court denies the debtor a discharge under §727, the debtor cannot obtain a discharge at all from any debt. Once the bankruptcy has been dismissed, all creditors will be able to pursue the debtor for collection. The problem is that an objecting creditor cannot appropriate all benefit to itself. All creditors will be able to pursue the debtor. The debtor's liabilities probably exceed their assets, or the debtor would not have filed bankruptcy to start with. Any individual creditor will have difficulty collecting. Also, the types of debtors that engage in bad behavior resulting in discharge denial are usually willing to engage in more bad behavior and make it even harder to collect. Still, a creditor may want to pursue a §727 objection to gain some satisfaction or to help police abuse of the bankruptcy process.

Objection to Exemptions

Similarly, a creditor must object within 30 days after the conclusion of the meeting of creditors to any exemption the debtor has claimed on any property. Exemptions involve only individual debtors and generally do not concern commercial creditors such as construction material suppliers. Exemptions could be an issue, however, when dealing with a sole proprietorship or when attempting to collect on a personal guarantee.

This outline will not deal in any depth with exemptions. Generally, however, an individual debtor can "exempt" certain property from the bankruptcy estate. Exempt property is not available for distribution to creditors.

The debtor may exempt property that is exempt under federal or state or local law, if the debtor was domiciled in the state or locality for 180 days immediately preceding the bankruptcy petition. Some states, such as Florida, allow the exemption of the debtor's principal residence, no matter what the value. This results in some abuse, with some debtors moving to Florida, putting all of their available assets into the acquisition of a valuable personal residence, waiting 180 days and then filing bankruptcy.⁹²

In any state a debtor can exempt certain property from the reach of the bankruptcy trustee and its creditors. The Bankruptcy code has set up standard Federal exemptions as shown below. In addition, state legislatures have the opportunity to opt out of the Federal exemption scheme in favor of their own.⁹³ This has caused most states, including Virginia, to opt out of the Federal exemption scheme, while some have chosen to adopt the Federal exemptions. Still others allow debtors to choose from the state or Federal exemption scheme. As a result, great diversity exists in the assets a debtor can protect in different states.

In any state, a debtor can exempt property held as tenants by the entirety or joint tenants, if the property would have been exempt from the debts of the debtor under state law.

In states following the Federal exemption scheme the debtor may also exempt:

1. Up to $16,150.00 in a residence
2. Up to $2,575.00 in a motor vehicle
3. Up to $8,625.00 in household furnishings, household goods, wearing apparel and other items for personal or household use
4. Up to $1,075.00 in jewelry
5. Up to $1,625.00 in professional books or tools used in the debtor's trade
6. Life insurance contracts
7. Social Security benefits, unemployment benefits, veteran's benefits, disability benefits, alimony or support payments "to the extent reasonable necessary", and certain pension, profit sharing, annuity or other plans
8. Payments received because of certain life insurance contracts, personal injury awards, or wrongful death awards⁹⁴

The Creditors' Committee

Very early in many Chapter 11 bankruptcies, a "creditors' committee" will be chosen. It is the committee's job to watch out for the best interests of the bankruptcy estate and the pool of unsecured creditors generally. The committee tries to maximize the eventual distribution to general unsecured creditors by keeping an eye on the debtor, the operation of the debtor's business and assets, making sure secured creditors do not over reach or claim too many assets, watching the bankruptcy process generally and making sure the debtor does not waste assets. The committee will also prosecute preference actions against other creditors, try to collect the debtor's receivables and other assets, collect on loans to principals or other "insider" transactions.

The committee's work is extremely important and someone must do it. It is, however, very much like being president of your local homeowner's association. While it is very important and you will benefit as a homeowner, it involves a lot of thankless work that will benefit a large group of people.

If you are one of the largest general unsecured creditors, it is very important to participate. The committee will have more influence than any one creditor over the conduct of the debtor and the bankruptcy process. The committee will normally hire an attorney to represent all of the general unsecured creditors. This is an expense of the bankruptcy estate. The bankruptcy estate essentially hires an attorney at its expense to protect your interest. If you are one of the largest unsecured creditors and expect a large percentage of any distribution you should participate on the creditors' committee.

Creditors' committees are not always appointed. In Chapter 11 cases a creditor's committee can be formed soon after the bankruptcy petition and order for relief.⁹⁵ A Chapter 11 Creditors' Committee ordinarily consists of willing participants that hold the largest claims against the Debtor.⁹⁶

In a Chapter 7 liquidation, creditors may elect a creditors' committee at the Section 341 Meeting of Creditors. Normally, there is no creditor's committee in a Chapter 7, however. A Chapter 7 Committee may be not have fewer than three and not more than 11 creditors.⁹⁷

The Chapter 11 Creditors' committee is chosen by the U.S. Trustee's office. The debtor must file a list of its twenty largest unsecured creditors with the bankruptcy petition. The U.S. Trustee will mail or fax acceptances to some or all of the twenty largest unsecured creditors, asking whether they are willing to participate. These acceptances should be returned promptly if you wish to be on the creditors' committee.

You must be a general unsecured creditor in order to be on the committee. A creditor claiming a security interest in property, trust fund or equitable lien rights, or mechanic's lien rights probably will not qualify. Secured creditors have a conflict of interest with the creditors' committee.

The United States Trustee has the sole power to appoint members of the creditors' committee in Chapter 11 reorganization. This would normally happen very quickly, because the U.S. Trustee wants a creditors committee in place to help manage the bankruptcy. Creditors' committee members are normally limited to the largest general unsecured creditors.

The court does have the power to change the membership of the creditors' committee on request, if the court determines that the change is necessary to ensure adequate representation of creditors.⁹⁸

The court can also add a creditor that is a small business concern, if the creditor's claim is "disproportionately large" in comparison to the annual gross revenue of that creditor. This allows a small creditor to get on the creditor's committee if the bankruptcy will have a large financial impact on that creditor.

Creditors' committees have responsibility to provide information to creditors not on the committee. Committee must provide access to information and must solicit and receive comments from general unsecured creditors not on the committee.

The Trustee

The United States Trustee is a full time employee of the United States Government. The U.S. Trustee has an important role in every bankruptcy, making sure that all cases are administered fairly and efficiently. The U.S. Trustee may raise any issue in any bankruptcy case.⁹⁹

In a Chapter 7 bankruptcy, a case specific "Chapter 7 Trustee" will also be appointed. A Chapter 7 Trustee or a Chapter 11 Trustee is normally an experienced private attorney appointed to a trustee panel by the bankruptcy court. The U.S. Trustee will appoint the Chapter 7 Trustee from the panel, but will still oversee the activities of the Chapter 7 Trustee. If no other case specific trustee is appointed, the U.S. Trustee is allowed to fulfill all trustee duties, but this is unusual.¹⁰⁰

In a Chapter 11 reorganization, by definition, the debtor's objective is to continue in business. There are obvious efficiencies in allowing the debtor to continue to run his or her own business. Normally, a Chapter 11 debtor continues to possess and operate the business as a "debtor in possession." A debtor in possession has all the rights and duties of the trustee.¹⁰¹ At any time, however, the U.S. Trustee, a creditor, or any other party in interest can request the appointment of a Chapter 11 Trustee to take over control of the business from the debtor in possession.¹⁰² The bankruptcy court shall order the appointment of a Chapter 11 Trustee for cause, including fraud, dishonesty, incompetence, or gross mismanagement, or if the appointment of a trustee is in the interest of creditors, shareholders and other interests of the estate.¹⁰³ The court could also leave the debtor in possession in place, but appoint an Examiner to investigate the past or present management of the estate.

The trustee in any case is the representative of the estate.¹⁰⁴ This is similar to the role of the executor under a last will and testament when someone passes away. The executor under a will is the person that died for all purposes until the estate is closed. The executor collects all money due to the decedent, tries to pay all creditors to the extent possible, and distributes anything left over the beneficiaries. Similarly, the bankruptcy trustee has the capacity to sue and be sued on behalf of the bankruptcy estate.¹⁰⁵ The trustee can run the business of the bankrupt debtor¹⁰⁶ The trustee can run the business of the bankrupt debtor¹⁰⁷ and hire attorneys, accounts, appraisers, and other professionals to assist.¹⁰⁸

A trustee is almost always appointed in Chapter 7 liquidation. Promptly after a bankruptcy filing, the United States Trustee will appoint an interim trustee.¹⁰⁹ A permanent Chapter 7 Trustee can be elected by the creditors at the §341 meeting of creditors, but this procedure is rarely employed.¹¹⁰ Normally, the interim trustee becomes the permanent Chapter 7 Trustee, assuming there is no conflict of interest and no election takes place at the meeting of creditors.¹¹¹

The bankruptcy court can authorize the Chapter 7 Trustee to operate the business of the debtor for a limited period if this is in the best interest of the estate and consistent with the orderly liquidation of the estate.¹¹² In any event, the Chapter 7 Trustee is required to:

1. Collect and liquidate all property of the estate
2. Close the estate expeditiously
3. Be accountable for all property received
4. Investigate the financial affairs of the debtor
5. If a purpose would be served, examine creditor proofs of claim and object to improper claims
6. If advisable, oppose the discharge of the debtor
7. Furnish information about the estate to any creditor or other party in interest
8. File periodic reports on the operation of the debtor's business, if the trustee is operating the business, including a statement of receipts and disbursements
9. Make a final report and file a final account of the administration of the estate¹¹³

The duties of the Chapter 11 Trustee (or debtor in possession) are to:

1. Be accountable for all property received
2. If a purpose would be served, examine creditor proofs of claim and object to improper claims
3. Furnish information about the estate to any creditor or other party in interest
4. File periodic reports on the operation of the debtors business, including a statement of receipts and disbursements
5. Make a final report and file a final account of the administration of the estate
6. File any required tax returns
7. As soon as practicable file a reorganization plan, report why a plan will not be filed, or recommend conversion of the case to a Chapter 7 or a dismissal
8. After confirmation of a plan, file reports as necessary

Either the Chapter 11 Trustee or the debtor in possession has all of the duties above. If a trustee replaces the debtor in possession, that Chapter 11 Trustee also must:

1. File a list of creditors, a schedule of assets and liabilities, a schedule of current income and expenditures and a statement of the debtor's financial affairs, (if the debtor has not already done so)
2. Investigate the acts, conduct, assets, liabilities, and financial condition of the debtor; the operation's of the debtor and the desirability of the continuance of such business, and then file a report on any such investigation¹¹⁴

The trustee or debtor in possession is authorized to operate the business of the bankrupt and may enter into transactions in the ordinary course of business without any court hearing.¹¹⁵ This includes the right to incur and pay postpetition debts in the ordinary course of business without prior approval of the bankruptcy court.¹¹⁶

DOING BUSINESS WITH THE DEBTOR IN BANKRUPTCY

Can You Be Forced to Do Business with the Debtor?

You cannot be forced to enter into a new contract with a debtor in bankruptcy. If you have completed all existing contracts with the debtor, you are free to simply decide you do not want to do any further business with the debtor.

If you are a true open account supplier, you are also free to discontinue doing business. If you have no set contract, proposal, or quote with a specific quantity or duration, the debtor is not obligated to buy material from you. The debtor is free to call any of your competitors for material on any given day. You also had no obligation to supply material on any given day. Each time the debtor telephoned or appeared at your office, this constituted a new separate contract for the purchase of materials. If you are such an open account supplier, you are free to decide at any time that you do not wish to enter into any new contracts with the debtor or supply any additional materials, whether or not the debtor is in bankruptcy.¹¹⁷

On the other hand, you could have a set contract with the debtor to supply a certain amount of materials over a certain period of time. Perhaps you sent a proposal to the debtor to supply all of the material necessary for a certain construction project. Similarly, you may have agreed to supply all the material the debtor needed for this entire year at set prices. If the debtor accepted this proposal or quote, you are no longer an open account supplier. Whether the debtor is in bankruptcy or not, you have an obligation to supply the materials described in your contract until the contract has expired. This is an "executory contract," discussed further below.¹¹⁸

An equipment supplier can also be on an open account basis and free to demand the return of equipment at any time. The same equipment vendor, however, might have entered into a one-month or one-year lease on the equipment. The equipment vendor in this case cannot demand return of the equipment, unless the debtor is in default on the lease. The vendor has committed to lease the equipment for one year and the debtor has the right to keep the equipment as long as rentals are current. This is also an executory contract.

An existing contract with the debtor that is not yet complete or has not yet expired is an "executory contract."¹¹⁹ If you have an executory contract with a bankrupt debtor, you may be required to complete your contract. The debtor may even be able to assign the contract and you can be forced to do business with some new entity not of your choosing. On the other hand, you may be able to require "adequate assurance" that the debtor or this new entity will be able to perform their side of the contract.¹²⁰ Also, if you are required to complete a contract, the debtor must "cure all default." You essentially become a preferred creditor, receiving payment in full for both prepetition and postpetition debt. This is discussed in greater detail below in the section on executory contracts.

Do You Want to Do Business with the Debtor?

If you have no "executory" or existing incomplete contract with the debtor, you cannot be forced to do business with the debtor. Some debtors will try to imply otherwise in convincing you to continue business, but this usually comes down to policy arguments and not any legal requirement on your part.

A debtor may say that they have no chance of a successful reorganization if vendors will not continue to supply material. Debtor's employees will lose their jobs and the general unsecured creditors will not receive any distribution if the debtor is forced to go out of business now. These may all be true statements, but they do not constitute a legal requirement on your part to continue doing business. The world as a whole may be better off if you continue to supply labor or materials to the debtor, but you as a creditor need to make your own decisions about the financial health of this particular debtor, the chances of receiving payment, the chances of a successful reorganization of the debtor and your chances of a long term business relationship.

By definition, a debtor in bankruptcy is a business that had serious problems. Their liabilities probably exceed their assets. In any event, they were insolvent and not paying their debts as they became due. This is usually at least partly because of management problems. There may also be overriding economic or market conditions that make this business less profitable than it used to be.

No matter what caused the insolvency, bankruptcy will not usually make things better and is guaranteed to make some things worse. If nothing else, the bankruptcy adds large additional costs to the business. There are large legal fees for bankruptcy lawyers, accounting fees to create schedules and operating reports. In many ways bankruptcy is much like everyone filing suit against the debtor simultaneously. Most creditors will file papers in the bankruptcy to protect their interest. The debtor must often respond, generating more legal fees. Meanwhile, many of the debtor's customers are now very leery of doing new contracts with the debtor. This certainly impacts the debtor's business and lowers revenue. At the same time, the debtor's vendors are also leery of doing business and usually increase prices, require security or other concessions.

After bankruptcy, revenues usually fall further and expenses go up for a company that was already insolvent. This adds up to an extremely difficult task for any business to successfully reorganize in a bankruptcy. Why would anyone want to do business with a debtor in bankruptcy?

Most vendors will agree to continue to supply any customer that has a reasonable chance of successfully reorganizing. Otherwise, a vendor is simply opening the door and inviting their competitors into a market. Vendors can often charge premiums to do business with a bankruptcy estate and require payment in advance or other security. In other words, this can be very profitable business.

A vendor's initial reaction is often to refuse further business, unless and until prepetition debt is paid. This stance is often short sighted. This prepetition debt is already "gone." There is nothing anyone can do about this now. The only question for the future is whether the vendor wishes to have some profitable business, protect their market and relationship with a potentially long-term customer. The only other choice is to allow a competitor to get this profitable business and cement a relationship with your customer, who may successfully reorganize and be in business for years to come.

Vendors must take care in doing business with a debtor in bankruptcy. Creditors must evaluate the chances of a successful reorganization and whether there is enough cash flow to pay postpetition obligations. If a vendor can be reasonably sure of payment, a vendor will normally want to do business.

Administrative Expense Priority

If you have no existing contract with the bankruptcy debtor and you voluntarily agree to extend credit by doing business with the debtor, you have a very high "administrative expense" priority for repayment of that new credit. The trustee or debtor in possession is authorized to operate the business of a Chapter 11 debtor and can obtain unsecured credit and incur unsecured debt in the ordinary course of business. This debt is automatically allowable as an administrative expense.¹²¹

Postpetition creditors are granted administrative expense priority to encourage them to do business with the debtor postpetition. No one would do business with a debtor in bankruptcy otherwise. No reorganization would ever succeed. The public policy reasons for aiding business reorganization would be thwarted.

The administrative expense priority will lower the money available to distribute to general unsecured creditors. Continuation or reorganization of the business, however, might result in a bigger payout to general unsecured creditors. Even in a Chapter 7 liquidation, there may be more assets for distribution if the business is wound up in an orderly manner and the debtor can complete profitable contracts. A successful Chapter 11 reorganization can generate future profits for distribution to unsecured creditors, in addition to saving jobs. These are the difficult decisions facing bankruptcy trustees and creditor committees, whether to slam the doors and immediately liquidate, expend some funds in an orderly liquidation, or expend even more funds in an attempt to reorganize. In any event, the Bankruptcy Code recognizes the need to grant an administrative expense high priority to any creditor doing business with the debtor after the bankruptcy petition.

An administrative expense has priority over all unsecured nonpriority prepetition debt. If the business has a steady cash flow, postpetition vendors will normally be paid in the ordinary course of business. Although a large amount of prepetition debt may have made the debtor insolvent, this prepetition unsecured debt will simply have to wait to the end of the Bankruptcy for any distribution. The trustee or debtor in possession is free of this prepetition debt for the purposes of moving forward.

Lawyers and accountants working for the bankrupt debtor have the same type of administrative expense priority.¹²² These attorneys and accountants do not have a high priority for payment because they are attorneys or accountants. It is because they are extending credit to the bankrupt debtor postpetition for the actual necessary costs and expenses of preserving the estate.¹²³ A creditor supplying labor or materials postpetition has essentially the same administrative expense priority.

It is still necessary to be cautious in extending credit to a bankruptcy estate. If there is no cash flow, it will not matter how high the priority. An estate can be "administratively insolvent." No one doing business with the debtor postpetition will be paid. Secured creditors may be entitled to eat up all cash flow that exists.¹²⁴ The business may fail, even free of the large prepetition debt. In other words, there may be a bad decision to continue or reorganize a business that simply should have been liquidated immediately.

If the debtor's bank agrees to reopen or extend new credit for the operation of the business, that bank may require "super priority."¹²⁵ If the trustee is unable to obtain unsecured credit, the court may authorize the new credit with a super priority over administrative expenses. The debtor may obtain a new line of credit to continue the business and pay postpetition vendors. If things go as planned, this line of credit will help the debtor pay postpetition vendors in the ordinary course. If it goes badly, however, the lender of that new line of credit may be able to consume all of the available cash flow. Your administrative expense priority may still leave you unpaid.

The only way to completely eliminate these risks for new sales are to require cash in advance, cash on delivery, payment bonds or other security. If you have no existing executory contract with the debtor, you have no obligation to do business at all. By the same token, you have the ability to require payment in advance. If you have an executory contract with the debtor, you may be required to do business. As discussed below, you can require "adequate assurance" of payment before the debtor assumes your contract, if there has been a default. If you continue performance and extend credit in the ordinary course of business before the trustee actually assumes the contract, however, you will have simple administrative expense priority and may still have the risk described above.¹²⁶

As discussed below in the subsection on Reclamation, a creditor can file for an administrative expense claim for any goods delivered within the 20 days prior to a bankruptcy petition.¹²⁷ Assumption or Rejection of Executory Contracts

If you have an existing contract or lease with the debtor that is not yet complete or has not yet expired, this is an "executory contract." Performance must remain due to some extent on both sides for a contract to be executory. A promissory note, for example, is not usually an executory contract. The only performance left is repayment. Performance on the lender's side of the contract is already complete.

A bankrupt debtor generally has the option to either "assume" or "reject" executory contracts and unexpired leases. If an executory contract is rejected, then the debtor has decided to breach the contract. The creditor has a prepetition claim for all damages resulting from this breach or "rejection." Court approval is required in order to reject an executory contract or unexpired lease.

The debtor also has the option to "assume" executory contracts or leases. The debtor and the creditor have the obligation to continue performance. The debtor can even assume and then assign an executory contract or lease. The creditor is then forced to continue doing business with someone new.

A debtor can assume and assign an executory contract, even if the contract purports to prohibit assignment. Similarly, if a contract states that it is a breach of contract to file bankruptcy or become insolvent, the Bankruptcy Code removes this provision from the contract.¹²⁸

Other than these specific contract provisions removed by the Bankruptcy Code, the debtor must "cure all default" in the contract or lease in order to assume or assign.¹²⁹ The creditor is entitled to the full benefit of the bargain in the contract. The debtor must cure all default and must provide adequate assurance of future performance.¹³⁰

Debtors continuing in business after bankruptcy almost always want to continue utility services such as electricity. The bankruptcy code requires "assurance of payment" to a utility serving a debtor in the form of a cash deposit, a letter of creditor, a certificate of deposit, a surety bond, a prepayment or another form of security agreed to by the utility.¹³¹ Bankrupt debtors will normally have difficulty obtaining a letter of credit, a certificate of deposit or a surety bond. Accordingly, most debtors desiring to continue utility services will probably need to post a cash deposit or prepay. A utility is allowed to alter, refuse, or discontinue service 30 days after a bankruptcy petition if it does not receive adequate assurance of payment that is satisfactory to the utility. Utilities are also allowed to offset prepetition debt against any security deposit held.

Creditors are often uncomfortable with a bankrupt debtor assuming and assigning an executory contract or lease. It is true that a creditor can be forced to do business with someone the creditor did not choose. On the other hand, this creditor becomes significantly preferred over almost all other creditors in the bankruptcy. All prepetition debt must be paid. Even attorney's fees must be paid, if the contract or lease required payment of attorney's fees on default.¹³² The creditor is entitled to adequate assurance of future performance, which could include security, payment bonds, or even payment in advance.

In other words, the creditor can be no worse off as a result of the bankruptcy, assumption, and assignment. In some respects, the creditor is better off. If the contract is not assumed then, the contract is rejected. The creditor will be a general unsecured creditor, unless the creditor independently had some type of security. This normally means a small percentage payout or no payment at all. Accordingly, creditors normally hope that their contracts and leases with a bankrupt debtor will be assumed.

Assumption or Rejection of Executory Contracts

If an executory contract or unexpired lease is eventually assumed, then any payments received by that creditor in the 90 days prior to bankruptcy also cannot be a preference. These are payments that the debtor would have been required to pay anyway in order to cure all default. Accordingly, this creditor has not been preferred and has not received more than it would have under a Chapter 7 liquidation.¹³³ Obligations that are assumed are generally regarded as priority administrative expenses.

The debtor is required to file a schedule of executory contracts and unexpired leases early in the bankruptcy process.¹³⁴ In a Chapter 7 liquidation, all executory contracts and unexpired leases are deemed rejected 60 days after the bankruptcy, unless the debtor takes affirmative action to assume. The debtor can, however, request additional time to make that decision.¹³⁵

In a Chapter 11 or Chapter 13, however, the debtor normally decides whether to assume or reject contracts in the plan of reorganization. In other words, the debtor will evaluate all executory contracts and unexpired leases, while evaluating the entire business. The debtor is not required to make a decision on assumption until the plan of reorganization is filed. One exception to this is nonresidential leases. If the debtor is a tenant in a shopping center, office, or industrial park, for example, the nonresidential lease is deemed rejected if not affirmatively assumed within 120 days after the bankruptcy.¹³⁶ This deadline can be extended by the court for one (1) additional 90 day period, but this extension must be granted before the original 120 day period expires and must be for "good cause shown."¹³⁷ In any event, a creditor can ask the court to require the debtor to decide on assumption or rejection earlier than the normal deadlines.¹³⁸

Lessees of personal property, including rental equipment must decide whether to assume or reject the equipment lease within 60 days of a bankruptcy petition. If the personal property lease is not assumed, it is deemed rejected.¹³⁹ The automatic stay automatically terminates if the debtor does not assume the lease within this time deadline.¹⁴⁰ This makes it easier for equipment rental vendors to retake possession of rental equipment sooner after a bankruptcy petition. If the debtor does assume the lease, of course, the debtor must "cure all default" and bring lease payments up to date.

It often frustrates creditors that bankrupt debtors have this much flexibility in dealing with executory contracts and leases. Creditors must remember, however, that this process is not a contest between the creditor and the debtor. Rather, the question is whether the group of creditors as a whole will be better off with rejection or assumption of a contract. The trustee or bankruptcy estate basically makes a business decision whether the executory contract is profitable. If so, the contract will be assumed and the profit generated will be available for distribution to creditors. This one creditor with the executory contract can be forced to continue doing business with the debtor, but has the advantage of being preferred over all other creditors and will be paid in full.

If the executory contract is unprofitable, the trustee or bankruptcy estate will reject. While this will certainly also frustrate, this puts the creditor in no worse position than any other general unsecured creditor in the bankruptcy.

Critical Vendors

There has been much discussion and publicity recently about the role of "Critical Vendors" in bankruptcy. It is possible for a creditor to be named a "Critical Vendor" and receive payment for prepetition debt.

Critical vendor status is relatively new. The standards, requirements, and process are uncertain. The courts that have allowed Critical Vendor status have done so under Bankruptcy Code §105. This is a general "power of court" code section, stating that the court may issue any order that is necessary or appropriate to carry out the provisions of the Bankruptcy Code. In other words, the United States Congress and the Bankruptcy Code did not explicitly create Critical Vendor status, describe the policy or the process. This is a court created concept.

It does make sense that a vendor could be absolutely critical to a business. This would have to be essentially a "sole source" vendor, however. There is no other way for the bankrupt business to survive, without doing business with this critical vendor.

If a vendor has any competitors in the market, by definition, they cannot be critical. The trustee (general pool of unsecured creditors) is essentially deciding whether to prefer one creditor over all other creditors. This is similar to the analysis of assumption of executory contracts. If there is enough future profit in an executory contract, the trustee will decide on assumption, even though the trustee must "cure" all default and prefer this creditor.

In a critical vendor analysis the trustee, court, and creditors committee is deciding whether to make a large lump sum payment to one vendor in order to preserve a source of supply. As a matter of basic business judgment, this will not make sense if the vendor has any competitors. Even if the estate must pay a premium to a competitor to purchase future materials, this is normally preferable to paying a large lump sum of prepetition debt. By granting critical vendor status, the estate is removing a large sum of cash from the pool available for distribution to creditors in exchange for the hope of getting more profit later doing business with this vendor. The estate would normally rather pay a premium to a competitor with each purchase in the future. In this way, the estate has not expended extra money unless and until it is doing new business.

A creditor interested in Critical Vendor status should normally start by communicating with the debtor about creating this "partnership." If the debtor does not think it is a good business arrangement to prefer this creditor, the vendor is probably not critical. If the debtor is in favor of the idea, it must be sold to the creditors' committee. Again, the creditors' committee is deciding whether it is good business judgment to let go of cash reserves now in order to get future supplies from this vendor. If the creditors' committee is in favor, it is appropriate to seek bankruptcy court approval. The court must, of course, be convinced that preferring this vendor as critical is a good business decision that will result in greater profits long term. Any creditor in the bankruptcy could object. This would likely be the competitor who is willing to do business with the debtor without payment of prepetition debt. If this competitor can supply the same product, it would make sense for the bankruptcy court to deny Critical Vendor status.

MOTIONS

Activity in bankruptcy cases is split into "adversary proceedings," "motions," "applications" and "contested matters." The distinction and differences are largely procedural. Lawyers must be very careful to structure their activities in the correct form. Business people are less concerned, as long as they have a good lawyer. Regardless, it is good to have some basic understandings.

Motion for Relief from the Stay

As discussed above, the automatic stay prohibits any creditor from taking aggressive action against the debtor after bankruptcy. A creditor must file a "motion for relief from the stay" in order to get permission to take various actions.

The debtor and any other party have an opportunity to object to the motion for relief from the stay, then the court considers the motion on an expedited basis. The court can deny the motion and leave the automatic stay in place or grant the motion.

In general terms, a creditor is entitled to relief from the stay only if it can show: (1) good cause, including lack of adequate protection for the creditor, or that (2) the debtor does not have equity in the property and it is not necessary to an effective Chapter 11 reorganization.

There are some limits on the automatic stay for "serial filers," that is debtors that repeatedly file bankruptcy petitions. Most of these provisions concern consumer bankruptcies, but some are also applicable to commercial debtors.

In small business cases the automatic stay does not apply if a debtor was in another small business case bankruptcy that was dismissed or had a final reorganization plan confirmed in the two years prior to the current bankruptcy petition.¹⁴¹

Debtors sometimes repeatedly file bankruptcy in order to stop imminent foreclosures. Mortgage lenders in such cases often obtain bankruptcy court relief from the stay, debtors allow their bankruptcy to be dismissed, only to file the bankruptcy again on the next eve of foreclosure. The automatic stay does not apply to a mortgage lender if the lender had received a bankruptcy court order terminating the automatic stay in any bankruptcy within the prior two years.¹⁴² The bankruptcy court can also enter an order prohibiting a debtor from filing any further bankruptcies. The automatic stay will not apply if the debtor does file again.¹⁴³

In an individual bankruptcy, the automatic stay will generally automatically terminate after thirty days if the debtor had a prior bankruptcy dismissed in the last year.¹⁴⁴

Foreclosing on Property or Repossessing Equipment

Secured creditors often bring a motion for relief from the stay to foreclose or repossess property. In general terms, a court will allow a secured creditor to enforce its rights against security property, unless the creditor has "adequate protection." In other words, the creditor's position will not be damaged by the passage of time. A secured creditor can bring a motion for relief, in order to force the debtor to provide more protection to the secured creditor.

Even if there is adequate protection, a secured creditor can request relief from the stay if the debtor has no equity in the property and the property is not necessary for a Chapter 11 reorganization. Obviously, if you are in a liquidating bankruptcy, no property will be necessary for the debtors' effective reorganization. If the creditor's security interest is equal to or greater than the value of the property, then the debtor has no equity. This is often true with real estate and equipment.

Lessees of personal property, including rental equipment must decide whether to assume or reject the equipment lease within 60 days of a bankruptcy petition. If the personal property lease is not assumed, it is deemed rejected.¹⁴⁵ The automatic stay automatically terminates if the debtor does not assume the lease within this time deadline.¹⁴⁶ This makes it easier for equipment rental vendors to retake possession of rental equipment sooner after a bankruptcy petition. If the debtor does assume the lease, of course, the debtor must "cure all default" and bring lease payments up to date.

Complaint to Enforce Mechanic's Lien

In most states with an inchoate¹⁴⁷ mechanic's lien, a creditor is allowed to file a memorandum of mechanic's lien without relief from the automatic stay. In order to later file a lawsuit, petition, or complaint to enforce mechanic's lien, however, the creditor must get relief from the automatic stay.¹⁴⁸

Obviously, a bankruptcy cannot be concluded without determining the validity, priority and amount of liens claimed by all secured creditors. This includes mechanic's lien claimants. The mechanic's lien case must be decided either in the bankruptcy court or in the state court. Bankruptcy courts are normally reluctant to delve into the factually complicated disputes in most construction cases and do not want to become experts in state mechanic's lien law. Accordingly, most bankruptcy courts will grant relief from the automatic stay, so that the creditor can file a complaint to enforce mechanic's lien rights in state court. The state court will then make factual findings regarding the labor and materials supplied and legal rulings on the validity of the mechanic's lien.

Theoretically, the creditor is usually required to return to the bankruptcy court once the validity, priority and amount of the mechanic's lien has been established in state court. As a practical matter, however, the owners, lenders, and title insurance companies normally want to settle the mechanic's lien case before it gets very far in state court. Accordingly, a mechanic's lien claimant must always obtain relief from the automatic stay to file suit, but often does not need to participate further in the bankruptcy process.

Termination of a Lease

The automatic stay prohibits any creditor from taking possession of any property from a debtor. A landlord, for example, cannot evict a tenant in bankruptcy without relief from the stay. The same is true of equipment leases. Even if a debtor has equipment on just a month-to-month or even day-to-day lease, the equipment owner cannot go pick the equipment up without getting relief from the automatic stay.¹⁴⁹

Set Off Rights

What if you owe money to a bankrupt debtor at the same time that debtor owes you also? You may supply materials to a carpentry subcontractor, who owes you a large sum on an open account. At the same time, you have hired the carpentry subcontractor to build you a new show room.

The bankruptcy estate can bring a complaint against you to collect what you owe the debtor, but what about your receivable? Are you forced to pay the debtor in cash now for your prepetition debt and then just hope there is a distribution later to general unsecured creditors to pay your pre-petition receivable?

A creditor is allowed to set off a prepetition payable and owed to the debtor against a prepetition receivable owed by the debtor, however, no other combination is allowed. In other words, you cannot off set your postpetition obligation to the debtor against the prepetition receivable still owed to you.¹⁵⁰

Set off rights are essentially a security interest.¹⁵¹ You must remember to assert the set off rights on your proof of claim.¹⁵² You must also bring a motion for relief from the stay in order to actually set off the monies. You can freeze money without relief from the stay, but must get relief before you start moving money.¹⁵³

Deadline to Assume or Reject

If you have an ongoing contract or lease with a bankrupt debtor, the estate has the right to choose whether to "assume" or "reject" that contract or lease. This is discussed in greater detail above.¹⁵⁴

You may want to force the debtor to decide whether to assume or reject. A creditor should be reluctant to extend new credit postpetition until a debtor has decided whether to assume or reject. A landlord may want to be free to re-lease a premise to a new tenant if the debtor is not going to cure all default and pay prepetition arrearages.

A creditor can file a Motion to Compel Assumption or Rejection for this purpose. The bankruptcy court will decide whether the debtor has had sufficient time to evaluate its contracts and can set a deadline to assume or reject.

Payment of Administrative Expenses

After a Chapter 11 reorganization petition is filed, it is "business as usual." As discussed above, the debtor is free to incur trade debt in the ordinary course of business. This trade debt has a "high administrative priority."¹⁵⁵

What if the debtor does not pay this administrative expense? You can file suit in the bankruptcy case in the form of "Motion to Compel Payment of an Administrative expense." This is essentially a lawsuit against the debtor, similar to a collections lawsuit in state court.

ADVERSARY PROCEEDINGS

Adversary Proceedings or Complaints

An adversary proceeding is a separate, freestanding lawsuit. It starts with a "complaint," just the same as any federal lawsuit and most of the same federal rules of civil procedure apply. It is a lawsuit that had to be filed in this bankruptcy court, because it is related to a pending bankruptcy. Adversary proceedings often concern lawsuits to collect money, either by the debtor or from the debtor. Examples of adversary proceedings are:

1. Preference actions¹⁵⁶
2. Objection to a discharge or a dischargeability of a debt¹⁵⁷
3. Actions to collect receivables or other property¹⁵⁸
4. Any proceeding to determine the validity, priority or extent of a lien
5. Action to claim reclamation rights

Reclamation Rights

The right to reclaim goods is always been important to creditors when a debtor files bankruptcy. A vendor with the right of reclamation becomes a secured creditor and may be able to retake possession of the goods sold. If there is no right of reclamation, the vendor is a general unsecured creditor.¹⁵⁹

The right of reclamation has been a part of the Uniform Commercial Code (UCC), applicable in most of the United States.¹⁶⁰ The bankruptcy code has always generally respected the state law right of reclamation. Creditors could formerly "reach back" to reclaim goods delivered within state law time limits, generally within 10 days of the bankruptcy. The Bankruptcy Reform Act of 2005 extended this to goods delivered within 45 days of the bankruptcy.

A vendor must still remember to provide the debtor written notice in order to have reclamation rights. That notice formerly had to be given within 10 days of delivery under the UCC. The Reform Act of 2005 extended this deadline. The creditor must provide the debtor written reclamation demand within 45 days from the debtor's receipt of the goods. Even if the creditor fails to provide the written reclamation demand in time, the creditor is still entitled to an "administrative expense claim" for any goods received by the debtor in the 20 days prior to the bankruptcy petition. Filing for an administrative expense claim provides the creditor a high priority in the bankruptcy that will normally result in payment.

In other words, a creditor can reclaim goods delivered within the 45 days prior to a bankruptcy petition, as long as written reclamation demand is delivered within 20 days after the bankruptcy petition.¹⁶¹ A creditor can file for an administrative expense claim for any goods delivered within the 20 days prior to a bankruptcy petition in any event, regardless whether any reclamation notice has been sent.¹⁶²

You must file an adversary proceeding to actually reclaim goods. You can and must send your notice of reclamation without relief from the stay.¹⁶³ However, you cannot pick up reclaimed goods without getting bankruptcy court approval in an adversary proceeding.

A creditor should be sure to send notice by some method providing third-party verification of receipt, such as commercial courier, Federal Express, certified mail or service by the Sheriff. Otherwise, it will be difficult to prove receipt of written demand.

The UCC, however, also made an exception to the 10-day limitation where the buyer has made a misrepresentation regarding his solvency, in writing within three months prior to the delivery.¹⁶⁴ In such a case, the 10-day rule does not apply and the seller can reclaim even after the 10-day period has expired. For this reason suppliers should get a new financial statement from buyers that make them nervous. Seller can also simply get a written statement before delivery that "the buyer will be able to pay within agreed terms."

The right of reclamation is important in a buyer's bankruptcy. If the seller has made a reclamation demand, then the seller is in a superior position to unsecured creditors. This seller can simply reclaim and regain ownership of the goods. The bankruptcy court can deny a proper right of reclamation only by granting the reclamation claimant security with a lien or an administrative expense priority.¹⁶⁵ If no reclamation demand is made, then the seller has to stand in line with the rest of the creditors. The goods would be part of the bankruptcy estate. Under those circumstances, a seller is a general unsecured creditor and may not have a right to reclaim the goods, but may have an administrative expense claim or state law mechanic's lien or payment bond rights.

A secured lender with a floating lien on the debtor's assets will have superior rights to a reclamation claimant.¹⁶⁶ The secured creditor's superior claim would not entirely defeat the reclamation claim, but would reduce the reclamation claim to a secondary lien.¹⁶⁷

The key factor is that the buyer be insolvent at the time of receipt. No claim can be made if the buyer becomes insolvent after receipt of the goods. Also, if the seller knows that the buyer is insolvent and makes delivery anyway, the seller cannot reclaim the goods. Under the UCC, the right to reclaim goods is exclusive of all other remedies. A seller cannot also sue the buyer for damages.

If materials are supplied and then incorporated into a project, a seller cannot reclaim the materials. Title would have passed to the owner of the project or the property. Under these circumstances also, a seller may not have a right to reclaim the goods but may have an administrative expense claim or state law mechanic's lien or payment bond rights.

The UCC also allows a seller to refuse future deliveries of materials unless the buyer can give adequate assurances of payment for future deliveries and makes payment for all materials delivered up to that time. If the seller discovers buyer's insolvency, the seller can stop making deliveries or require cash in advance.¹⁶⁸

PREFERENCES

Introduction

Your customer files bankruptcy and you are burned for thousands of dollars. Your profit for at least a month is down the drain. You and everyone in your company work overtime for months to make up for the loss, but you get over it and move on.

Two years after the bankruptcy you get a letter demanding that you pay more money to the bankrupt debtor. Soon after that, your bankrupt customer files suit against you. What is up with this?

Preference litigation has increasingly frustrated creditors. The preference law has been on the books for many years, but litigation was rare until the late in the twentieth century. Preference claims have become quite fashionable and can now be expected in almost every bankruptcy.

The Objective

Historically, the objective of preference law was to keep a bankrupt debtor from preferring friends, family and related entities instead of paying general creditors. Otherwise, an insolvent debtor could simply pay his brother's company in full, and then file bankruptcy, and all other creditors would receive nothing. Modern commerce often has related entities doing business with one another, including, parents, subsidiaries, and companies with common shareholders. It would be a problem if an insolvent debtor could prefer these related creditors over others.

Another important objective of the Bankruptcy Code is to "stop the race to the courthouse."¹⁶⁹ If a debtor starts to get into financial trouble, we do not want creditors filing suit as soon as possible, in order to force a quick payment before the debtor files bankruptcy. We want creditors to work with debtors for the better good of all. If a creditor knows that payments received shortly before a bankruptcy must be repaid, then a creditor is more likely to work with a debtor towards an amicable resolution.

To fix these problems, we just pretend that the debtor filed bankruptcy 90 days earlier than the actual petition date. Just like the automatic stay keeps creditors from advancing their position after bankruptcy, this 90-day preference period keeps a creditor from advancing their position in the 90 days prior to bankruptcy.

The paradigm shift necessary to understand bankruptcy is particularly important in the context of preference actions. The creditor is now being forced to pay money back to the same debtor that burned him for thousands already. It is particularly confusing that preference litigation is brought in the name of the bankrupt debtor. It is technically your defaulting former customer that is suing you for more money. This makes the process seem particularly unfair.

However, bankruptcy preference litigation is not a battle with the debtor. It is a battle between creditors. Why should one creditor end up being paid in full while other creditors are paid nothing? For that matter, why should one creditor end up with 50 percent of their receivable when other creditors end up with 10 percent? After bankruptcy, the "estate" is the pool of general unsecured creditors represented by the trustee. The debtor is gone, except in a salaried management role. The shareholder or equity holders do not own the company any longer. Secured creditors also generally stay out of the bankruptcy process. The process is primarily intended to protect the general unsecured creditors.

The Preference Mechanism

The preference law essentially pretends that bankruptcy was filed 90 days earlier than the actual petition date. Any advantage a creditor obtained during that 90-day "preference period" can be undone or "avoided." The preference law applies to any "transfer" of money, property, or any interest in property.

The most common example is payments received. The operative date for this purpose is the date a check cleared the debtor's bank, not the date of the check or the date of receipt by the creditor.¹⁷⁰ Creditors can be at preference risk longer than they think, if the creditor holds checks for a long period of time or if checks travel out of state to a corporate lockbox for deposit.

The preference law can avoid a security interest, just the same as avoiding a payment. If a debtor transfers a security interest in all accounts receivable to one creditor and then files bankruptcy within 90 days, this security interest can be avoided as a preference. Accordingly, early planning is important for creditors to obtain consensual security agreements.

A judicial lien can also be avoided and is often the very cause of a bankruptcy filing. If a contractor sues a real estate developer and "wins" the case, the judgment lien will attach to all real estate owned by the developer in the county. If the developer files bankruptcy within 90 days, however, that judgment lien can be avoided. The creditor contractor has wasted months and thousands of dollars in legal fees for nothing.

When a garnishment is filed, the judgment lien actually attaches to the funds in a bank account. This lien can also be avoided by filing bankruptcy within 90 days. Garnishments are often the cause of bankruptcy by consumers and small business debtors.

The Perception Problem

While the theory behind preference law makes sense, the proliferation of preference litigation has also exposed many problems.

The system generates large transaction costs, relative to the questionable benefit. Creditors that have already lost money dealing with this debtor are now spending more money defending preference claims and repaying preferences. Bankruptcy estates that are already badly overburdened with legal and accounting fees are now incurring more of both. The costs of handling this money may not be worth the benefit derived.

Many businessmen feel that lawyers are the only beneficiaries to this system. Indeed, preference litigation has made it more profitable to practice debtor bankruptcy law. The debtor filing bankruptcy chooses the lawyer or law firm to represent the debtor in bankruptcy. This generates a fee, often paid in advance. This lawyer then often represents the bankruptcy estate or unsecured creditors' committee for the purpose of pursuing preferences. If a case specific trustee is appointed, this is normally a private bankruptcy attorney that can and will hire other attorneys in the same firm to pursue preferences and other litigation. Many businessmen perceive this as a "cottage industry," with lawyers generating cases and then generating fees prosecuting these cases.

It is sometimes questionable whether there is any "client" reviewing the costs or benefits of this activity. In a normal commercial context, a client would be outraged if it cost 90 dollars in legal fees to collect a 100-dollar debt. There is a client very interested in controlling costs and a lawyer that must answer to the client. Sometimes, this does not seem to be true in preference litigation currently.

Creditors could certainly lower transaction costs by simply readily agreeing to send their preference money back. It is certain that some creditors fight preference actions longer than they should, because of perceived unfairness. It is also certain that many frivolous preference actions are filed.

This is a "volume" legal business, just like any collections practice. The preference collection lawyer has no real client to communicate with or collect information from. The current practice is to take the check ledger from the bankrupt debtor and send blanket demand letters to every creditor that received a check in the 90 days prior to bankruptcy. It has gotten to the point that many lawyers go straight to filing suit without even a demand letter. If you are already filing 50 identical lawsuits, it does not take much more effort to simply file 100. The costs of defense are so high that many creditors will simply pay blood money to get out. It is questionable, however, whether any of this is helping the pool of general unsecured creditors.

The Policy Problem

Anecdotal evidence suggests that none of this preference litigation is benefiting general unsecured creditors. Although preference litigation has become the norm in every bankruptcy, distributions to general unsecured creditors are still rare in any bankruptcy. It is not clear where all of the money is going. Certainly, much is lost in transaction costs and legal fees in collection of the preferences claims. This leads to the perception amongst creditors that preference litigation is just a cottage industry created by lawyers for lawyers.

Much of the proceeds go to other administrative costs of running the bankruptcy estate. These are again largely legal fees for the bankruptcy estate, the trustee, and the general unsecured creditors committee. Trade vendors and other creditors that extend new credit to the bankruptcy estate also have administrative expense priority. While an orderly bankruptcy process is an important policy objective, it is questionable whether general unsecured creditors who have already lost money should be paying the cost of this bankruptcy process by paying in even more money, especially if they do not benefit generally from the process they finance.

It is also certain that the preference rule has not ended preferential payments, although it does make them more difficult. The 90-day rule for preferences is very arbitrary. A debtor can still prefer any creditor of their choosing. They just have to make sure that payment is made more than 90 days prior to the bankruptcy petition, or more than a year¹⁷¹ if the payment is made to an "insider."¹⁷² if the payment is made to an "insider."¹⁷³ It is unusual for insolvents to be this "organized," but there is also no question that this happens.

The "venue" rule is a particular problem in preference litigation. "Venue" concerns the city or state where any lawsuit must be filed. A bankruptcy generally must be filed in the district of the debtor's principal place of business or state of incorporation.¹⁷⁴ Any litigation related to that bankruptcy must then take place in that same court. This venue rule generally makes sense, but creates fairness problems when the debtor has been doing business outside of their home state.

A real estate developer from Los Angeles, California may build apartments buildings in Arlington, Virginia. If that California real estate developer files bankruptcy, many Virginia subcontractors and suppliers will lose money. When the bankruptcy estate begins preference litigation two years later, however, these same Virginia contractors are forced to travel to California to defend these preference claims. This runs afoul of the general venue rule that the plaintiff must travel to the defendant's place of residence to litigate or at least to the state where the contract was performed and the problem arose. It also dramatically increases the transaction costs to a preference defendant. A small Virginia carpentry contractor is not going to travel to California and hire a California lawyer to defend a ten thousand dollar preference action, no matter how frivolous the preference claim. This defendant really has no choice but to pay blood money to be left alone.

Under the Bankruptcy Reform Act of 2005, a preference case under $10,000 must be filed where the Preference Defendant resides and not where the original bankruptcy petition was filed.¹⁷⁵ A corporate defendant resides in its state of incorporation or in the state containing its principal place of business.¹⁷⁶ This $10,000 limit does eliminate some of the unfairness in many small preference actions, but this limit should be increased or the venue rule changed for all preference actions.

There is no question that the preference litigation system still needs reform. On the other hand, the preference rule serves some important policy objectives. It is very difficult to say how this system should be reformed. The venue rule may be the most obvious. If a debtor decided to travel cross-country to do business, the bankruptcy estate should be forced to travel cross-country to pursue a preference claim. A bankruptcy court in Virginia could hear a preference claim just as well as a bankruptcy court in California. Much of the evidence and many of the witnesses will be there anyway. This is not such a fundamental portion of the bankruptcy that is cannot be separated to another court.

Under the Bankruptcy Reform Act of 2005, preferences must be at least Five Thousand Dollars ($5,000.00).¹⁷⁷ If it is less, the case simply cannot be filed. This is a good start. It is still questionable whether many of these cases are truly benefiting general unsecured creditors and the unproductive transaction costs are high. Preference Defendants will still face familiar problems with small cases above $5,000.

It may also be a good idea to adopt a higher limit de minimis rule. Defendants will not have to pay back a preference unless it is 30 percent more than what they would have received in a Chapter 7 liquidation. Maybe there should be a ten or twenty thousand dollar minimum claim. In other words, bankruptcy estates can only go after big money or big discrepancies. Many preference defendants have already lost money by doing business with the debtor and did nothing wrong except allow the debtor to go too long without paying invoices. This would at least lower the overall transaction costs and lower the heat level, and may not significantly lower the proceeds to the bankruptcy estate.

Finally, preference litigation should not benefit attorneys or even the bankruptcy administration system generally at the expense of general unsecured creditors. It would be nice to have some mechanism to insure that preference litigation cannot and will be instituted unless the substantial majority of the recovery will actually be distributed to general unsecured creditors.

The Information Problem

In any legal case, the "burden of proof" can be important. If there are no documents and few witnesses, the judge may not be able to tell what happened. Whichever party had the burden of proof will lose. Normally the plaintiff that filed the suit has the burden of proof. If the judge cannot tell what happened, the plaintiff will lose, because the plaintiff failed to meet its burden of proof.

The burden of proof in preference litigation is on the estate (trustee) on some issues and on the creditor-defendant on other issues. This is discussed below. The burden of proof is particularly important in preference litigation, because there is normally a shortage of documents, witnesses, and other evidence.

In a bankruptcy, the debtor is normally going out of business. Even in reorganization, the employees and managers often change. Bankrupt debtors are normally poor record keepers to start with. This gets worse in the 90 days prior to bankruptcy. During the preference period, the debtor is normally losing employees and very busy trying to put out fires. This gets worse after bankruptcy is filed. Many records are lost and the rest are thrown into storage. The few remaining employees find new jobs and move on as fast as they can.

Two years after the bankruptcy petition the preference actions are filed. To the extent the bankruptcy estate has the burden of proof and must produce information, they have a horrific problem of no witnesses and no documents.

In preference litigation, the estate (trustee) often operates entirely off of bank records and check registers. The debtor's bank will always be organized and can always produce bank statements showing what checks cleared the debtor's bank in the 90 days prior to bankruptcy. Debtors should compare this bank ledger with the debtor's accounts payable information and then file only meritorious cases that will benefit the general unsecured creditors. The more abusive preference lawyers will simply file suit against anyone who received a check during the preference period, sometimes referred to as "suing the checkbook." The better preference lawyers will not file suit unless the creditor was paid for invoices more than 60 days old.¹⁷⁸ It is rare for the estate (trustee) to do any further investigation on preference defenses. They normally do not have the records or witnesses to do so. In any event, they leave it up to the creditor-defendant lawyers to investigate the case.

To the extent that the creditor-defendant has the burden of proof, it will also have a problem collecting documents and other evidence. As discussed below, many preference defenses involve whether the creditor had mechanic's lien, payment bond, or trust fund rights. Most preference complaints are filed two years after the fact. Will the creditor be able to produce delivery tickets showing the delivery project? Will the creditor be able to identify the project owner or general contractor and determine whether they were holding funds on the bankrupt debtor? The creditor-defendant has an opportunity to have superior information, better documents, and better witnesses than the estate (trustee) in a preference action. In order to preserve this advantage, however, the creditor must collect information at the time of the bankruptcy petition.

When a customer files bankruptcy, the creditor should promptly take note of checks received from that debtor in the one hundred (100) days prior to bankruptcy. Remember, it is the date the check clears the debtor's bank that determines a preference payment. Then, collect the invoices paid with those checks and determine the age of unpaid invoices. If they are all less than 60 days old, the creditor will probably not have a preference problem. These documents should be carefully placed in a credit management file, however, for easy reference two years later.

The creditor should now pretend that the payment was not received and determine whether there is an avenue to force payment. As discussed below, many of the defenses to preference actions involve mechanic's lien rights, payment bond rights, trust fund rights, or other enforcement mechanisms. If the creditor could have enforced payment after bankruptcy, then the payment received may not be a preference. The creditor was not "preferred" by the payment. It is money the creditor would have received anyway through the mechanic's lien or bond process, even after the bankruptcy.

The creditor defendant that has good documents, good witnesses, and other information about the transactions in preference litigation will have a tremendous advantage over the trustee who has only bank statements and invoices.

The Timing Problem

It will be difficult to collect information on lien and bond rights two years after the fact. Delivery tickets particularly will be much easier to collect 90 days after delivery rather than two years after delivery. Where was this construction project? Who was the owner? Who was the general contractor? Were they holding money or had your debtor been paid in full? Is there a payment bond on the project? As discussed below, these facts may be defenses to a preference action.

Your own documents and witnesses will be much easier to find now than two years from now. Other witnesses that work for the owner or general contractor on the project will certainly be easier to find while the project is still ongoing. These witnesses will also have a much easier time getting documents to help you. In two years time, projects end, people change jobs, companies throw out documents and companies go out of business. It will take you less time now and you will have more success now. You can be pretty confident the preference claim will eventually be filed against your company, if it received large payments just before the bankruptcy. You might as well get ready now.

A claimant must normally enforce lien or bond rights less than a year after supply of labor or materials. If you lose a preference case two years from now, it will certainly be too late to enforce your bond rights for the money you have to pay back. It may not help that you could have enforced your lien or bond rights back at the time the debtor paid you. It depends on whether the payment "depleted the estate."¹⁷⁹ You may actually need to file a mechanics' lien or bond claim now for money that you have been paid, in order to make sure you have security if you must repay a preference later. This makes more sense if you need to file a lien anyway on an uncollected receivable.

Consider requesting a bankruptcy court order shortening the time for the debtor to bring a preference action. It seems counter intuitive to force the debtor to sue you now, but it can solve a lot of problems. You can bring into the preference lawsuit the bonding company, the property owner and other players on the construction project, while you still have security rights and while they still have records or witnesses readily available. If you must repay the preference, the bonding company, general contractor or property owner may be liable to you.

As a practical matter, one of these players may be holding money on the debtor anyway. You can force the debtor to admit that the debtor would be paid less, if you did have to repay the preference. This will solve the triangulation problem for you.¹⁸⁰ More importantly, it removes the incentive for the debtor to litigate with you, because the debtor will not increase assets. The debtor will be motivated to settle or abandon the preference claim, particularly if they have hopes of reorganizing and continuing in business. It also helps that the business people for the debtor will still be involved in decision-making early in the bankruptcy, especially if these are the same people the creditor has dealt with. Two years after the bankruptcy filing, the debtor's business people have all found new jobs. Lawyers are now running the preference cases for the trustee and do not care about any business relationships. You will have a much harder time proving you would have had lien rights two years earlier and there is no chance to establish those rights now.

The Trustee's Burden of Proof

The estate (trustee) has the burden of proving that:

1. The creditor received property of the debtor within 90 days of the bankruptcy petition and while the debtor was insolvent
2. The preference enabled the creditor to receive more than it would have in a Chapter 7 liquidation
3. The payment was for or on account of an "antecedent debt¹⁸¹"

Once the trustee proves these three "above the line" issues, the burden is on the creditor to prove that a "below the line" defense exists.

The trustee will generally have an easier time with this "above the line" burden than the creditor-defendant will have with "below the line "defenses. It is normally easy to show that a payment or security interest was received within 90 days of the bankruptcy filing.¹⁸² The trustee only needs the debtor's bank account statements to see what checks cleared in the 90 days prior to the bankruptcy petition.

Normally, it is not difficult to prove that the payment was for an antecedent debt. This means only that the debtor owed the money before the payment was made. If, however, a creditor receives payment before supplying labor or materials, however, this cannot be a preference.¹⁸³

In addition, any payment received by a creditor will normally be more than the creditor would have received in a Chapter 7 liquidation. If a debtor is in bankruptcy, liabilities typically exceed assets and the debtor has a negative net worth. In most Chapter 7 liquidations, secured creditors receive all proceeds and general unsecured creditors receive nothing. Accordingly, any payment received by an unsecured creditor during the preference period will normally be more than the theoretical Chapter 7 liquidation payout.

Bankruptcy trustees and the lawyers prosecuting preference actions normally have the frame of mind that they will have an easy time proving their case and the creditor-defendant has all of the problems. This is significant because of the problem with information, discussed above. It is not always accurate, however, and creditors have several opportunities to show that the trustee has not met its burden.

A creditor need not return a payment from the debtor if the creditor is no better off compared to other creditors of the bankruptcy estate than if the creditor waited for liquidation and distribution of the assets of the estate.¹⁸⁴ Unless the transfers by the debtor diminish the estate of the debtor, the creditor cannot be charged with a preference.¹⁸⁵

Secured Creditors

If a secured creditor received a payment during the preference period, this may not have been a preference. If there were sufficient equity in the security property, the secured creditor would have been paid in full in a Chapter 7 liquidation. The trustee will fail to meet the burden of proving this element of a preference.

Mechanic's lien claimants may be in this posture.¹⁸⁶ If the owner of the real estate is the bankrupt debtor, then a contractor supplying labor and materials has mechanic's lien rights in the debtor's real estate. If the contractor received payment during the preference period while the contractor had mechanic's lien rights, then it is not a preference. The contractor could have enforced its mechanic's lien rights and would have received the same payment in a Chapter 7 liquidation.

It is important to note that the contractor must still have mechanic's lien rights when the check cleared the bank. If the contractor allowed mechanic's lien rights to expire by the time the check cleared the bank, then the payment has again become a preference. This again goes to prove that contractors should never let mechanic's lien rights expire.

If the bankrupt debtor was not the owner of the property, the creditor is in a different preference situation. The contractor may have mechanic's lien rights in property, but it is not property of the debtor. The contractor may need to prove "triangulation," discussed below.¹⁸⁷ In short, the contractor may need to prove that if it had enforced mechanic's lien rights, the owner of the property could have withheld money from the debtor and that the bankruptcy estate was not diminished.

There are court cases suggesting that the preference creditor-defendant would have the burden of proof, since this is a "below the line" defense.¹⁸⁸ Other cases support the view, however, that this is an "above the line" issue on which the trustee has the burden of proof. The creditor's mechanic's lien rights did provide an interest in the receivable owed to the debtor and held by the real estate owner. This is essentially a security interest in property of the debtor that the creditor could have enforced in a Chapter 7 liquidation.

In any event, the creditor can end up the same place using this argument as a defense, as is discussed below.¹⁸⁹ It could be important, however, whether the trustee or the defendant creditor has the burden of proof on this issue.

Assumption of Contract

As discussed above,¹⁹⁰ the debtor can "assume" a contract with a creditor. Both sides are forced to continue performance of the contract, but the debtor must "cure all default." The prepetition account receivable to this creditor must be paid in full. By the same token, if this creditor had received a payment during the preference period, it cannot be a preference. The creditor would have received the payment even in a Chapter 7 liquidation.¹⁹¹

Similarly, if a general contractor files bankruptcy, it may wish to assume a profitable contract with a real estate owner. That prime contract probably states that the general contractor must pay for all labor and materials supplied to the project. If any of these subcontractors or suppliers receive payment shortly before the bankruptcy, these payments likewise cannot be preferences. The general contractor would have been required to make these same payments in a Chapter 7 liquidation, if the contract had been assumed.

The assumption of a contract precludes a later attempt to recover payments made under that contract as a preference.¹⁹² It is significant that the trustee has the burden of proof on this issue.¹⁹³

Trust Fund Statutes and Agreements

Trust fund statutes and trust fund agreements are discussed in greater detail in other chapters of this book.¹⁹⁴ Such statutes or agreements dictate that that when the owner of real estate pays a general contractor for labor and materials, the general contractor holds these funds "in trust" for the benefit of all subcontractors and suppliers that supplied the labor and materials. The general contractor may "hold" the money, but it does not "own" the money.¹⁹⁵ The subcontractors and suppliers are the real owners of the money. When the general contractor "pays" subcontractors and suppliers, they are only receiving their own money. It is not "property of the estate" of the general contractor. If the general contractor files bankruptcy, these payments cannot be preferences.¹⁹⁶

A subcontractor or supplier can come to the same result in any state with the use of a trust fund agreement in their contract to supply labor or materials. Please review other chapters of this book for further information.¹⁹⁷ However, state (not federal) property law creates and defines the scope of a trust for purposes of the Bankruptcy Code.¹⁹⁸ Federal bankruptcy law recognizes and enforces the property rights created by state law.¹⁹⁹

In any event, this has great potential as a preference defense, especially in states with trust fund statutes. The trustee has the burden of proof on this "above the line" element of a preference claim. The trustee must prove that these payments enabled the creditor to receive more than the creditor would have received in a liquidation case under Chapter 7. This may include the burden of showing that the funds were not subject to the Trust Fund Statute.²⁰⁰ This is difficult to do when the trustee has only a check register.²⁰¹

A payment by a trustee to a trust beneficiary cannot diminish the trustee's estate, since the funds were never part of the estate. Unless the transfers by the debtor diminish the estate of the debtor, the creditor cannot be charged with a preference.²⁰²

A creditor may not even be aware that trust fund protection exists while they are doing business. Trust provisions in contracts create a trust without any "perfection" by the creditor.²⁰³ Once the credit agreement or other contract is signed, the trust mechanism is passive and does not require further action from the creditor. Investigation after a preference complaint, however, can reveal a complete defense to the preference action.

Earmarking

Earmarking of payments for the benefit of a creditor (subcontractors and suppliers that supplied labor and materials), is another possible above the line defense to a preference claim. If an owner pays a creditor directly, the transfer is not " property of the debtor."²⁰⁴ The payment is "earmarked" for distribution to the creditor and no preference occurs. Earmarking is an amorphous concept that receives various names and treatments by courts.

Earmarking is more complicated where the debtor receives funds with specific instructions to use the funds to pay a specified creditor. The debtor and new creditor have an agreement that the funds are to pay an old creditor.²⁰⁵ There must be an express agreement for the use of the funds.²⁰⁶ There must be an express agreement for the use of the funds.²⁰⁷

Defenses to a Preference Action

Once the trustee proves that the creditor received a payment for an antecedent debt within 90 days of bankruptcy that enabled the creditor to receive more than it would have in a Chapter 7 liquidation, the burden of proof shifts to the creditor-defendant. Because of the problem with information, discussed above²⁰⁸, the shift in the burden of proof to the creditor is important. The creditor that collected information early in the bankruptcy process will have a big advantage.

Ordinary Course of Business

This is probably the best-known defense to a preference action. It is also over utilized and will not help creditors as often as they think. This defense has a three-part test and the creditor must pass at least two. Most creditors will fail at least the third test. The creditor must prove:

(1) the debt paid was "incurred by the debtor in the ordinary course of business" and

(2) the payment was made in the ordinary course of business for this debtor and this creditor (subjective test) or

(3) the terms were ordinary for this industry (objective test).

First, the debt being paid must have been incurred in the ordinary course of business. This can be an issue with promissory notes or liquidation agreements. The debtor may have fallen way behind on an account, the creditor filed suit and later agreed to a promissory note. The debtor may have made regular and timely payments on that promissory note for several months, but was that debt "incurred in the ordinary course of business?"²⁰⁹ Also, if the debt was not ordinary trade debt, but incurred by the debtor for some extra ordinary or personal purpose, this also may not be incurred in the ordinary course of business. This creditor may not have an ordinary course defense, no matter how quickly the invoices were paid.

If the creditor can pass this first test, the creditor must then only show either that the payment was consistent with the payment history between this debtor and this creditor (subjective test) or that the payments were ordinary for this industry (objective test).²¹⁰ In other words, the creditor-defendant can choose between the last two parts of this test.

When considering the second "subjective test", creditors often have the feeling that it was "normal" for this debtor to pay late, that there was nothing unusual about the payment received and that it was "in the ordinary course of business." Investigation will usually reveal, however, that the debtor's habits changed in the months leading up to bankruptcy. A debtor that normally paid within 30 days of invoice began paying within 60 or 90 days of invoice shortly before filing bankruptcy. Even the debtor that always paid "late" stretched from 60 days after invoice to 90 or 120 days after invoice in the year of the bankruptcy. While the creditor feels the payment was "ordinary for this debtor," it was really just "ordinary for this debtor in the last six (6) months."

If the creditor cannot satisfy the second subjective test, the creditor must also show that the payment terms were ordinary for this industry as a whole. Creditors will rarely be able to pass this test. Even if it was ordinary for this debtor to pay invoices in the 60 to 90-day range, this will rarely be ordinary for the industry in that particular market. The creditor normally also has to find an "expert witness" to testify about this particular industry in this particular geographic area. This adds significantly to the costs and legal fees in establishing an ordinary course of business defense.

This option to choose between the subjective and objective tests does make it considerably easier and cheaper for creditor preference defendants to establish an ordinary course of business defense to a preference action. It also helps creditors with short payment histories. Often, when a debtor starts getting in trouble, their regular trade vendors will cut them off. Debtors are then forced to move to new vendors for goods. These new vendors often have only a couple of months of credit history before the debtor filed bankruptcy. This makes it difficult for the new trade vendor to show any ordinary course of business history with this debtor (subjective test)²¹¹ and adds considerable risk to any trade vendor taking a chance on a debtor in trouble. In this case it can be important whether the payment was within the terms of any credit agreement.²¹² Now, a trade vendor with a short subjective payment history may need only to prove that the payments were ordinary for that industry and that geographic area (objective test). It is still very risky to take a chance on debtors in trouble, however, because there is still a high risk of bad debt write off and a high risk of preference actions for payments received.

The limited information in the possession of the bankruptcy trustee will normally include the debtor's check register, the bank account statements and invoice information. The attorneys for the estate (trustee) will develop a computer printout showing the date the check cleared the bank, the invoices paid with that check and the dates of those invoices. The trustee may not pursue the case unless the invoices were at least 60 or 75 days old. The trustee may also do an analysis on the average "days outstanding" for that industry to decide which cases to pursue.

In other words, if the estate (trustee) is pursuing the case, they may know the creditor has no ordinary course of business defense. Nonetheless, the creditor-defendant should do this same analysis to confirm the absence of an ordinary course defense. Some lawyers have been known to file preference actions on any creditor that received a check in the 90 days prior to bankruptcy, without any investigation.

Ordinary course of business defenses can also be expensive and time consuming. The creditor-defendant can probably use their own witnesses to prove that the debt was ordinary and that the payment terms were ordinary for this debtor (subjective test). Expert witnesses are necessary, however, to prove that the terms were ordinary for this industry in this market (objective test).²¹³ This can be expensive.

An interesting question exists with "pay when paid" clauses in a construction contract. If there is a pay when paid clause in a contract, a debtor will never pay an invoice until it has received payment from the owner or general contractor above. That payment, however, may come 120 or 180 days after invoice. It was ordinary for this debtor and ordinary for this industry, however. There is no known case law on this subject, but it would seem to be a viable defense. By the same token, it could be argued that construction contractors never pay invoices until they themselves have been paid, whether or not there is actually a pay when paid clause in the contract.

The moral to this story is that creditors must keep debtors current. This becomes even more important as debtors get into trouble and close to insolvency. The creditor that forced the debtor to stay current may avoid preference problems. Credit managers have long known that they have a better chance of collecting if invoices never get over sixty (60) days. On top of that, these credit managers may avoid preference problems.

Contemporaneous Exchange for New Value

The estate (trustee) may not avoid a transfer (payment or security interest) if it was "intended by the debtor and the creditor to be a contemporaneous exchange for new value."²¹⁴

C.O.D. Sales

The most obvious example of contemporaneous exchange for new value is a COD sale. The creditor gave the debtor $100 of products and received $100 cash at the same time. This transaction cannot be a preference.

For this reason, it can be a good idea to put customers in trouble on COD. In addition to making sure they get paid for this transaction, creditors are also making sure they will not need to give the money back later as a preference.

Release of Mechanic's Lien or Bond Rights

The "new value" given by the creditor could be the release of a security interest. If a secured lender gives up a security interest on valuable equipment in exchange for the $100 payment, this release is new value given in a contemporaneous exchange.²¹⁵ It is an issue, however, whether the security interest had any value. If the security interest was worthless, the payment will still be a preference. Although the debtor and creditor intended the transaction to be a contemporaneous exchange for new value, the transaction actually was not. This problem could arise if the security property had no value, had been destroyed, or if the creditor had failed to actually perfect the security interest.

Notice that this "defense" is very similarly to the "above the line" argument that the creditor did not receive more than it would have in the hypothetical Chapter 7 liquidation.²¹⁶ The same facts could give the creditor both arguments, although the "above the line" argument is better because the trustee has the burden of proof.

In a construction-contracting context, a creditor may provide a mechanic's lien release or payment bond release in exchange for a payment. This could create a new value defense as well as an "above the line" argument.²¹⁷ The release of claims against surety on a bond²¹⁸ or a release of lien rights²¹⁹ or a release of lien rights²²⁰ can be an exchange of new value.

Again, however, the creditor must show that the security interest had value.²²¹ In other words, if mechanic's lien or bond rights had expired before the creditor received money, then the payment is still a preference. Even if the debtor demanded a mechanic's lien release, even if both debtor and creditor thought it had value, the release was actually worthless. The creditor did not actually provide value.

Some courts have implied that a creditor must actually enforce mechanic's lien or bond rights before a release has any new value.²²² These are lower court opinions and are not entirely clear what the court is saying. This would be bad law, however, because it would encourage diseconomic behavior.²²³ Society does not want creditors wasting legal fees and disrupting construction projects by filing mechanic's liens, just to make sure the payments they are receiving can never be recovered as preferences. Most courts seem to say that the creditor must only show that there was still time to file the mechanic's lien²²⁴ or bond claim²²⁵ or bond claim²²⁶ when the payment was received.

A similar issue can exist in states with a "defense of payment" to a mechanic's lien.²²⁷ This is discussed in greater detail in other chapters of the book, but in such states the mechanic's lien will only be enforceable if the owner is still holding money on the general contractor, the general contractor is still holding money on the subcontractor, etc. Once the owner has paid in full for the project, no mechanic's lien can attach to the property. In defense of payment states, the mechanic's lien release provided by the creditor is also worthless if the owner has already paid for the project. A remote supplier can actually end up in the difficult position of trying to prove, two years after the fact, that the owner was holding money on the general contract at the time the supplier was paid. Developing this proof will be difficult in any event, but it will be impossible if the creditor has no information on the project or the owner. This again illustrates the importance of collecting project information in any case and especially once a debtor has filed bankruptcy.

Triangulation

This defense of payment issue introduces the concept of "triangulation." To establish a preference defense, the creditor must also show that the bankruptcy estate was not diminished by the payment to the creditor.²²⁸ Unless the transfers by the debtor diminish the estate of the debtor, the creditor cannot be charged with a preference.²²⁹ If the owner was holding money on a general contractor and had the right to withhold the money for a mechanic's lien claim, then the payment to the creditor did not diminish the estate. If the debtor had not paid the creditor, the creditor could have filed a mechanic's lien, the owner could have withheld money from the debtor and the debtor would end up with the same amount of money. In other words, the bankruptcy estate would have had the same amount of money to distribute to general unsecured creditors whether this allegedly preferential payment was made to this creditor or not.

This is obviously much simpler if the bankrupt debtor was the owner of the property. There is no need to prove triangulation. As long as the creditor was still in time to file a mechanic's lien, the bankruptcy estate was not diminished. The creditor would have had a mechanic's lien in the property of the debtor. Exchanging these mechanic's lien rights for payment cannot be a preference.²³⁰ This would constitute both an "above the line" argument and a "below the line" defense.²³¹ The creditor will obviously have an easier time if successful in making this an "above the line" argument where the trustee has the burden of proof, especially where so much evidence will be necessary.

This triangulation analysis also becomes very important in cases involving bond claim releases. A creditor and debtor may both actually intend to trade a payment for a bond claim release. The creditor may still actually have plenty of time to file its bond claim to enforce payment. However, the question still remains whether this payment diminished the bankruptcy estate.²³²

Again, this analysis is easier if there are fewer parties involved. If the debtor was the principal on the bond²³³ and the bond company had subrogation rights or a security interest on assets of the debtor, then triangulation exists and the payment was not a preference. If the payment was not made, the creditor could have enforced rights against the payment bond to receive payment. The bonding company could have then enforced its interest on the assets of the debtor, pulling that amount of money out of the pool available for distribution to general unsecured creditors. The bankruptcy estate was not diminished.

This analysis gets a little more difficult if the debtor was not the bond principal. Let's say you are supplying material on a government project to a subcontractor, but the prime contractor bonded the project. Your subcontractor customer files bankruptcy within 90 days after giving you payment on an old invoice. You may have had perfectly good bond rights at the time and could have enforced your bond rights against the prime contractor and bonding company. In order to use this as a preference defense, however, you will have to show first that you had bond rights, but also that the general contractor was still holding money on your subcontractor customer at the time the debtor paid you. If you had made your bond claim, the prime would have refused to pay the subcontractor. The bankruptcy estate is not diminished. If the prime contractor had already paid the subcontractor, there is no triangulation. The payment by the sub did diminish the estate.

If triangulation did not exist, the payment was still a preference, even though the creditor had perfectly good bond rights at the time. This can have diseconomic and fairly ridiculous results. A creditor may supply materials to a bonded project, but may have concerns about the debtor's solvency. The creditor has no way to know at that point whether the parties involved would have the ability to pull this money out of estate in the event of bankruptcy. There are only three ways this creditor can be safe. One way is to refuse payment from the debtor and insist on payment directly from the bonding company or owner. Another choice is to enforce bond rights even though they have been paid. A third possibility is an agreement from the bonding company giving you more time to make your bond claim, in the event of a preference claim two years later. All of these choices have obvious problems.

Unfortunately, you do not know now whether those property owners or bonding companies had recourse against the debtor's property. If the bonding company had no recourse, you may need to repay this money as a preference two years from now, even though you could have enforced your rights against the bonding company back at the time. Two years from now, when the preference claim is brought against you, it will be too late to enforce your bond rights. This can put you in the ridiculous position of enforcing your bond rights now for money you have actually been paid. This may be the only way to make sure you get to keep this money, however. This decision is a little easier to make if you are still owed money on a project and will be making a bond claim in some amount anyway.

You can make a bond claim or assert mechanics' liens rights, stating that you make your claim only if the debtor later makes a preference claim against you. You can agree with the bonding company to leave the lawsuit pending and not spend any time on it unless and until the trustee makes a preference claim against you. The bonding company may also agree to give you evidence that they were secured in the debtor's property and that the debtor's payment to you did not deplete the estate. The bonding company may agree to pay you if you agree to simultaneously pay back the same amount of money you received from the debtor. I am not trying to tell you this is logical. Logic has nothing to do with it. You will just need to decide from a business point of view how much money you have at risk and whether it is worth going through some of these gyrations to protect yourself.

Some bonding company is sure to make the argument that you have no bond claim now for money that you have already been paid, even though it will be too late to make a bond claim later if you get unpaid. It is not clear what would happen with this argument. The only way to avoid this problem, however, is to refuse money from any debtor that might go into bankruptcy and insist on making your mechanic's lien or bond claim instead. We are clear that you would always prefer to get paid by the property owner bonding company instead of the debtor, but it is an obvious problem to refuse payments from your debtor. It is always important to be careful with lien and bond claim waivers, to make sure your security rights are not waived if a preference claim is brought against you later. This is discussed in other chapters of this book.²³⁴ After bankruptcy you should deal the same with your (1) uncollected receivable and (2) all money received during the preference period. "Spread" the invoices to figure out where all the material went and whether you have security rights for uncollected receivable and for payments received shortly before the bankruptcy filing.

It is often a good strategy to force the debtor and bankruptcy trustee to litigate the preference case early in a bankruptcy, while you still have lien or bond rights to protect you. It is often advantageous to bring the debtor, the bankruptcy trustee, the project owner, general contractor and the bonding company into the bankruptcy court early. Litigate the preference and your bond claim simultaneously with all parties in one courtroom. These parties may be helpful now in proving you had security and forcing the debtor to resolve a preference claim, but this help may not be available two years from now.

There is no doubt that the U.S. Congress and bankruptcy courts struggle with a difficult battle between innocents in determining bankruptcy law. It is respectfully submitted, however, that Congress should amend the preference statute to clarify that it is not necessary for a creditor to prove triangulation in order to have a new value defense to a preference action. It does make sense to require a creditor to prove that it was still within time to file a mechanic's lien or payment bond claim at the time payment was received. If a creditor could prove that it could have forced payment from anyone, however, this should constitute a defense to a preference action. At a minimum, the preference plaintiff (debtor) should have the burden of proof that the payment diminished the estate.

Creditors are never in a position to know whether the bonding company on the project has a security interest in the assets of the debtor, whether the general contractor is still holding money on the subcontractor customer, or whether there is other recourse against the bankruptcy estate. Since they will never have this information, the only safe course for a creditor is to refuse payment from a debtor, insist on filing mechanic's liens or bond claims and demanding payment directly from an owner or bonding company. The only other choice is to enforce mechanic's lien or bond rights even though they have been paid in full. This generates unnecessary legal fees and frustration on construction projects. The law should not force or encourage this type of diseconomic activity.

The moral to this story for creditors is to always get payment from someone other than the debtor, if there are concerns about insolvency. If payments are received from an owner or a bonding company, the payment cannot be a preference.²³⁵ The new value defense will also be stronger if the creditor actually filed a mechanic's lien or made a bond claim before receiving payment. The defense will also be easier to prove if the creditor can produce the release provided in exchange for payment. These are all documents that a creditor should locate and carefully store soon after bankruptcy is filed, in anticipation of a later preference action. In any event, a creditor should never let mechanic's lien or payment bond rights expire. This is a very risky practice, because the creditor may never be paid and be completely unable to force payment. On top of this, payments actually received may have to be paid back as preferences.

Subsequent Advance Rule

You may be able to show that you extended new credit to the debtor after receipt of allegedly preferential payments. A creditor can take the position that it would not have extended new credit and would have "cut off" the debtor if the payments were not received. This is known as the "subsequent advance rule."²³⁶

To determine the subsequent advance rule credits, a creditor should start with a list of the allegedly preferential payments received. The amount of the first check is the "positive preference balance." This balance is reduced by the amount of new credit extended after receipt of this payment. The positive preference balance goes down with each new extension of credit. The positive preference balance then goes up again in the amount of the next allegedly preferential payment received. The positive preference balance then goes down again with extensions of credit made thereafter. The positive preference balance can never go below zero, however.²³⁷ It is not possible to simply add up the total allegedly preferential payments received and then subtract the total extensions of new credit during the preference period. No courts allow such a "net result" rule.²³⁸

Subsequent advances of new value may be used to offset prior (although not necessarily immediately prior) preferences. A creditor is permitted to carry forward preferences until they are exhausted by subsequent advances of new value.²³⁹ In other words, the creditor is allowed to apply new value against the immediately preceding preference as well as against all prior preferences.²⁴⁰ The majority of courts hold that this rule reflects a more realistic view of commercial practices, because it accounts for the debtors' entire financial picture and repayment history and not solely on the latest payment.²⁴¹

A new value defense is permitted "unless the debtor repays the new value by a transfer which is otherwise unavoidable."²⁴² This actually means that "paid" new value can still provide a subsequent advance credit against a preference (as long as it is otherwise unavoidable).²⁴³ This is sometimes referred to as the "no double dipping" rule. If a creditor extends a subsequent advance of new credit after a preferential transfer and the debtor later pays for that new credit, the creditor can still claim a subsequent advance for that paid new credit as long as the paid subsequent advance could not be used as a payment in the ordinary course of business or another defense. In other words, you cannot claim a subsequent advance and claim that the payment from the debtor for that subsequent advance was a payment in the ordinary course of business.

Equitable Liens

Other chapters of this book explain the operation of trust fund statutes, trust fund agreement and equitable liens. These theories can be used to collect money and also to defend preference actions.²⁴⁴ Trust fund theories are "above the line" arguments, discussed above, on which the trustee has the burden of proof.

Equitable lien theories are less tested and more uncertain than trust fund theories, but have many similarities. When a contractor supplies labor or materials to a customer and that customer later receives payment for those labor and materials, those funds are impressed with an "equitable lien" in favor of the creditor. The debtor would not have those funds, unless the creditor had supplied the labor and materials. This theory has had some success for the purpose of collecting funds held by an owner in construction contracting cases.²⁴⁵ There is no known bankruptcy court case using this theory as a preference defense, but it is a viable theory.²⁴⁶ It is also not clear whether this would be an above the line argument or a defense.

James D. Fullerton, Esq.
Clifton, VA
703-818-2600
www.FullertonLaw.com
COPYRIGHT (1997,2010) James D. Fullerton (703) 818-2600