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Bankruptcy Primer for Creditors




The Bankruptcy Reform Act of 2005 became effective on October 17, 2005. It generally applies only to bankruptcies filed after that date.

The greatest changes and publicity regarding the Reform Act concern consumer bankruptcies. These provisions would concern a commercial creditor only when dealing with a sole proprietorship or when enforcing a personal guarantee on a commercial account. These Reform Act "consumer provisions," require a debtor to take mandatory credit counseling and will force more debtors to pay back a portion of their debt over time. These provisions are generally outside the scope of this outline, but will be discussed briefly below. There are also various procedural changes and attempts to limit retention bonuses and abuse by highly paid executives. These changes will impact commercial debtors filing bankruptcy and has caused a large number of bankruptcy filings prior to the October 17, 2005 effective date. These changes will not otherwise significantly impact commercial creditors, however, and they are also outside the scope of this outline.


The huge volume of frivolous preference actions over the last several years has finally resulted in some reform. The changes are limited but are accurately characterized as a "good start." We can only hope that this good start will be expanded to eliminate a greater percentage of frivolous preference actions that benefit only lawyers or pay for the administration of a bankruptcy, rather than distribution to unsecured creditors.

Commercial Creditors that become Preference Defendants in bankruptcy have several procedural disadvantages in the current system. The bankruptcy trustee (Preference Plaintiff) will normally file many preference complaints in a single court simultaneously. In the modern world of word processors, this means that the Preference Plaintiff needs to draft only one (1) complaint and then change only the defendant's name and the dollar amount in the scores of lawsuits filed. These cases then generally move through the bankruptcy court docket together meaning that the Preference Plaintiff attorney can appear one day in court to cover 100 cases. Meanwhile, 100 different Preference Defendant lawyers have to travel to court to keep a pace. The result has been that many Preference Plaintiffs file a large number of cases that are very small or that lack merit. It is a volume business that is much cheaper to prosecute than to defend. Defendants are often willing to pay some "blood money" to settle a case because of the difficulty and expense. This in turn encourages Preference Plaintiffs to keep filing suits.

Another problem has been the "venue rule", stating that any preference action must be brought in the same bankruptcy court as the original bankruptcy petition. While this procedural rule is logical, it can greatly disadvantage a defendant and has lead to unfair results. If an out-of-state defendant comes to your home state for a construction project and then pays for your construction materials shortly before filing bankruptcy, you will be faced with hiring an out-of-state attorney to defend the later preference action. Particularly if the preference is a small amount, defendants are again faced with paying "blood money" to settle a case because of the difficultly and expense.

Limit of $5,000 Dollars on Preference Cases

Preferences must now be at least Five Thousand Dollars ($5,000.00).{footnote}11 USC §547(c)(9).{/footnote} If it is less, the case simply cannot be filed. This is a good start. It is 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, however, with small cases above $5,000.

Limit of $10,000 on Preference Actions against Out-of-State Defendants

A preference case between $5,000 and $10,000 can still be filed, but must be filed where the Defendant resides and not where the original bankruptcy petition was filed.{footnote}28 USC §1409(b).{/footnote}A corporate defendant resides in its state of incorporation or in the state containing its principal place of business. A foreign corporation can be sued in any district court where the defendant has "minimum contacts."

Ordinary Course of Business Defense

It is has always been a defense to a preference action that the payment was received "in the ordinary course of business." It is also been difficult for defendants to prove this defense, however, because the defense had three necessary parts. The creditor had to 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 (subjective test) and

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

Proving all three parts of this defense has always been difficult for Preference Defendants. Even if a creditor could show a long payment history and that the debtor had always made late payments (subjective test), the creditor still had to show that this practice was ordinary between other creditors and debtors in this industry (objective test). This normally meant that the creditor had to find an "expert witness" to testify about this particular industry in this particular geographic area. This added significantly to the costs and legal fees in establishing an ordinary course of business defense.

The reform act made the ordinary course of business defense considerably easier for creditors. Now the creditor must only show either that the payment consistent with the payment history between this debtor and this creditor (subjective test) or that the payments were ordinary for this industry (objective test).{footnote}11 USC §547(c)(2).{/footnote}In other words, the creditor-defendant can choose between the last two parts of this test.

This will make it considerably easier and cheaper for creditor Preference Defendants to establish an ordinary course of business defense to a preference action. It will also help creditor Preference Defendants with a short payment history, which has always been a problem in the past. 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 would often have only a couple of months of credit history before the debtor filed bankruptcy. This made it difficult for the new trade vendor to show any ordinary course of business history with this debtor (subjective test) and added considerable risk to any trade vendor taking a chance on a debtor in trouble. Now, a trade vendor with a short subjective payment history need only prove that the payments were ordinary for that industry and that geographic area (objective test). It will still be 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. It will be easier, however, to prove an ordinary course of business defense.


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 or reclamation, the vendor is a general unsecured creditor.{footnote}11 USC §546(c).{/footnote}

The right of reclamation has been a part of the Uniform Commercial Code (UCC), applicable in most of the United States, if a seller delivers goods while a buyer is insolvent. The bankruptcy code has 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 Reform Act extends this to goods delivered within 45 days of the bankruptcy.

A vendor must also 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. The Reform Act extends this deadline. The creditor must provide the debtor written reclamation demand within 45 days from the debtor's receipt of the goods, or within 20 days from the commencement of the bankruptcy case if the 45-day period expired after commencement of the bankruptcy case.

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.{footnote}11 USC §546(c).{/footnote} 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.{footnote}11 USC §503(b)(9).{/footnote}

Assumption and Rejection of Leases and Contracts

Generally in a Chapter 11, a debtor will continue in business and reorganize.{footnote}See section below, Types of Bankruptcy.{/footnote} After bankruptcy, a debtor can decide which contracts and leases it wishes to "assume"and which the debtor wishes to "reject."{footnote}See section below, Doing business with the Debtor In Bankruptcy, Assumption or Rejection of Executory Contracts.{/footnote} Creditors with rejected contracts become general unsecured creditors. In order to assume a contract, a debtor must "cure all past default"and "provide adequate assurance of future performance."

Lessors of real estate have often been frustrated with bankruptcy debtors delaying any decision on whether to assume or reject. The bankruptcy code normally provided deadlines to assume or reject, but courts would commonly grant extensions to a debtor up to the date a plan of reorganization was approved. A Chapter 11 reorganization can often last for years before confirmation of a reorganization plan. Lessors would be left in limbo for many months. The debtor could reject the lease at any time, but did not need to decide whether the assume the lease. This made long term planning very difficult for lessors of real estate and often proved expensive, with lessors losing prospective tenants because of the uncertainty.

Under the Reform Act, debtor must assume or reject any non-residential real property lease within 120 days after the bankruptcy petition. This deadline can be extended by the court for only 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.{footnote}11 USC §365(d)(4).{/footnote}

The Reform Act does assist debtors in one respect. It is no longer necessary for a debtor tenant to cure nonmonetary defaults in order to assume a lease, if it is impossible to cure the default at the time of assumption.{footnote}11 USC §365(c).{/footnote}

Utility Services

Debtors continuing in business after bankruptcy almost always want to continue utility services such as electricity. The bankruptcy code has always required "assurance of payment"to a utility serving a debtor. Some courts had previously considered whether the debtor had a good payment history to the utility and consider security deposits held by the utility to determine there was an adequate assurance of payment. It seems that these will no longer be adequate assurance. Some courts had also held that the administrative expense claim in the bankruptcy was assurance of payment, but the reform act affirmatively prohibits this.

The reform act now requires assurance of payment 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.{footnote}11 USC §366(c)(1)(A).{/footnote} 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 now need to post a cash deposit or prepay.

Under the reform act, 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.

Foreign Bankruptcies and Creditors

The Reform Act generally adopts the Model Law on Cross-Border Insolvency from the United Nations Commission on International Trade Law. The old bankruptcy code §304(Cases Ancillary to Foreign Proceedings) is replaced by a whole new Chapter 15 (ANCILIARY AND OTHER CROSS-BORDER CASES), with the objectives of: 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.{footnote}11 USC §1504; 28 USC §1410.{/footnote} 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."{footnote}11 USC §1520.{/footnote} 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.{footnote}11 USC §1519 and §1520.{/footnote} This is a significant change from prior law and creditors must now 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."{footnote}11 USC §1513 (a).{/footnote} They are entitled to the same notices given to creditors generally.{footnote}11 USC §1514.{/footnote}

Procedural Changes

Small Business Provisions

The Reform Act attempts to streamline the Chapter 11 reorganization process for "small business debtors," with debts of less than Two Million Dollars. Some procedural rules have been 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.{footnote}11 USC §1125.{/footnote} This may help small businesses get out of bankruptcy faster and successfully reorganize.

Other new rules regarding the automatic stay are applicable only to small business cases.

Automatic Stay

Generally when a debtor files bankruptcy, creditors are automatically prohibited from taking action against the debtor or the debtor's property.{footnote}See section below the Bankruptcy Filing, Automatic Stay.{/footnote}This is referred to as the "automatic stay." The Reform Act limits that automatic stay in some instances of "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 under the Reform Act, the automatic stay will simply 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.{footnote}11 USC §362(n).{/footnote}

Lessees of personal property, including rental equipment, have always had to 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.{footnote}11 USC §365(d).{/footnote} The Reform Act now states that the automatic stay automatically terminates if the debtor does not assume the lease within this time deadline.{footnote}11 USC §365(p).{/footnote} This will make 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.

Debtors would sometimes repeatedly file bankruptcy in order to stop imminent foreclosures. Mortgage lenders in such cases would often obtain bankruptcy court relief from the stay, debtors would allow their bankruptcy to be dismissed, only to file the bankruptcy again on the next eve of foreclosure. The automatic stay will 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{footnote}11 USC §362(b)(20).{/footnote} The bankruptcy court can also enter an order prohibiting a debtor from filing any further bankruptcies, in which case the automatic stay will not apply if the debtor does file again.{footnote}11 USC §362(b)(21).{/footnote}

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.{footnote}11 USC §522(n).{/footnote}

Bankruptcy Notices

It has been a common problem that creditors never receive notice of bankruptcy or that subsequent notices during the bankruptcy process are sent to a bad address. Under the Reform Act, 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.{footnote}11 USC §342.{/footnote} It is not clear how these notice requirements will be enforced.

It is also now possible for any creditor to file a notice of address with any bankruptcy court that has to be used by any bankruptcy court in any chapter 7 or 13 bankruptcy.{footnote}11 USC §342(f).{/footnote} 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.

Creditors Committees

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

Under the Reform Act, the court has greater 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.{footnote}11 USC §1102(a).{/footnote}

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 will also now have greater responsibility to provide information to creditors not on the committee. Committee must now provide access to information and must solicit and receive comments from general unsecured creditors not on the committee.

Discharge Under Individual Reorganization Plan

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. Under the Reform Act, in an individual Chapter 11, debts are not discharged until all payments are made under a reorganization plan.{footnote}11 USC §1141.{/footnote} Chapter 11 bankruptcy is sometimes filed by wealthy individuals with complex business affairs.

Debtor Exclusive Right to Submit Reorganization Plan

The debtor has always had the exclusive right for some period of time to submit a plan in a Chapter 11 reorganization case. Courts would often extend this deadline, frustrating creditors who felt that the debtor was mismanaging the reorganization. Under the Reform Act, the debtor has the exclusive right to file a plan for only 18 months. This deadline cannot be further extended by the court.{footnote}11 USC §1121(d).{/footnote}

In a small business reorganization, the debtor has an exclusive right to file a plan 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.{footnote}11 USC §21(e).{/footnote} 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.

Consumer and Individual Bankrupcies

Means Testing

The new Means Testing was 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." {footnote}11 USC §707(b).{/footnote} 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.{footnote}11 USC §109.{/footnote} 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.{footnote}11 USC §727(a)(11) and 11 USC §1328(g).{/footnote}

Discharge every Eight (8) Years

Creditors have commonly believed that a debtor was only allowed to file bankruptcy every 7 years. This has never been exactly true. The rule was actually that a debtor could obtain a discharge every 6 years. Under the Reform Act there must be eight (8) years between discharges under Chapter 7 or Chapter 11.{footnote}11 USC §772(a)(8).{/footnote} 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.{footnote}11 USC §1328(f).{/footnote}

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 now complicated provisions restricting abusive use of Homestead Exemptions. The Reform Act restricts the Homestead Exemption, regardless of state law, to $125,000 if the debtor bought their residence less than 40 months before the bankruptcy filing.{footnote}11 USC §522(p).{/footnote} 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.{footnote}11 USC §522(o).{/footnote} Assets protected from creditors in individual retirement accounts are also now generally limited to one million dollars.{footnote}11 USC §522(n).{/footnote}


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