Georgia Law
Georgia Bankruptcy & Workout Law
- Bankruptcy & Workout Law
Bankruptcy & Workout Law
Every year, for many businesses in America, the answer to financial problems is to declare bankruptcy, a legal proceeding in federal court that allows a business to be released from the obligation of paying some or all of its debts. It is often said that bankruptcy gives a debtor a fresh start, but filing bankruptcy is not a panacea for all financial problems. Declaring bankruptcy can seriously damage a company's credit rating, making it difficult to establish credit or take out loans. Without good credit, some companies simply cannot operate. Many companies can work themselves out of even very serious debt without ever going near a bankruptcy court, so declaring bankruptcy should not be an automatic first step for a business experiencing financial problems. This chapter discusses bankruptcy options available for businesses. For information on personal bankruptcy, see the Bankruptcy Law Chapter.
Background
Bankruptcy law is almost entirely federal law. The United States Constitution grants to the federal government the exclusive right to make bankruptcy laws. Pursuant to this authority, the federal government created the Bankruptcy Code, Bankruptcy Rules of Procedure, and a system of bankruptcy courts to handle bankruptcies throughout the country. This is not to say that bankruptcy law is uniform throughout the nation, however. Although the federal government has final authority to make all bankruptcy laws, in some instances the Bankruptcy Code grants to individual states the power to deviate from or to supplement federal law in very limited circumstances. For instance, the Bankruptcy Code allows a debtor to keep certain assets, known as exempt assets, that creditors cannot reach to satisfy debts. The Bankruptcy Code gives individual states the authority to expand the categories of exempt assets if they choose. Thus, although bankruptcy law is federal law rather than state law, the amount and type of assets that are beyond the reach of creditors differ depending upon the state in which the debtor files for bankruptcy. Attorneys experienced in handling business bankruptcies can advise a business on where best to file for bankruptcy to receive the most favorable treatment from the local bankruptcy court.
The Most Common Business Bankruptcies
The Bankruptcy Code creates different categories of bankruptcy, known as chapters, that are appropriate for different debtors. The most common forms of business bankruptcy are Chapter 7 and Chapter 11.
Chapter 7
The vast majority of bankruptcy cases filed are Chapter 7 cases. Chapter 7, often called "liquidation bankruptcy," is commonly used by individuals who simply want to walk away from their debts, but it may also be used by businesses that want to terminate their operations and liquidate their assets. When a debtor files Chapter 7, the bankruptcy court appoints a person to administer the case. This person, called the trustee, is a private citizen, not an employee of the court. The debtor turns over some or all of his or her debts and assets to the trustee, and the trustee then liquidates the property by selling it off and dividing the resulting cash among the creditors. The trustee can sue and be sued on behalf of the estate.
Petition and Schedules
A Chapter 7 case begins when the debtor files a petition with the bankruptcy court. Any individual, partnership, or corporation can file Chapter 7 regardless of the amount of debt or whether the debtor is solvent or insolvent. The petition should be filed with the court serving the area where the debtor lives or where his or her principal place of business or assets are located.
Along with the petition, or shortly thereafter, the debtor files with the court several schedules listing current income and expenditures, a statement of financial affairs, all executory contracts, existing or potential lawsuits by or against the debtor, and any recent transfers of assets. If a debtor does not reveal a debt in these schedules, the bankruptcy court cannot discharge or cancel that debt. Any debt omitted from these schedules is called a non-scheduled debt and is not affected by the bankruptcy.
Stay
Filing the petition automatically stays (stops) all of the listed creditors from trying to collect the money owed them. The stay arises automatically, without any judicial action, although the court usually notifies creditors of the filing of the petition. The stay is effective from the time of filing, even if the creditors do not receive notice until much later. As long as the stay is in effect, creditors generally may not start or continue actions against the debtor to collect on the debt. Lawsuits, garnishment actions, and even telephone calls to the debtor must cease.
Creditors Meeting
After the debtor files a Chapter 7 petition, the court-appointed trustee administers the case and liquidates assets. The trustee usually calls a meeting of the debtor, the debtor's attorney, and the creditors. The debtor must attend this meeting. Creditors may attend in order to ask questions and examine documents concerning the debtor's financial affairs and property. In most Chapter 7 bankruptcies, all of the debtor's assets are either exempt or subject to valid liens, so there are no assets for creditors to pursue. In these cases, known as "no asset" cases, it is likely that no creditors will attend the creditors meeting. If it appears that a case will have assets to pursue, creditors usually will attend this meeting to gather information about the case, because they plan to ask the bankruptcy judge to declare some of the debts non-dischargeable, they plan to challenge the exempt status of some asset, or they plan to file claims. After the creditors meeting, the creditors may file a claim against the debtor with the court. If the debtor has non-exempt assets free of security interests, these are used to satisfy valid claims.
Liquidation, Discharge, and Reaffirmation
A Chapter 7 bankruptcy concludes when the trustee sells the debtor's property, distributes the cash to the creditors, and discharges the remaining debt. The trustee's primary role is to sell off the debtor's non-exempt assets in a way that maximizes the amount the creditors receive for their claims. Revenues from assets subject to security interests, such as property subject to a mortgage, are used to satisfy the debt on the particular asset. The discharge extinguishes the debtor's remaining liability on the debt. Certain items are non-dischargeable and thus are unaffected by the bankruptcy. Non-dischargeable assets include most tax obligations, liability for damages resulting from willful or malicious acts, debts incurred by giving false financial information, or debts incurred for luxury goods or services just before bankruptcy.
Creditors may ask the court to deny an individual debtor a discharge. The grounds for denial of discharge are extremely narrow and requests for denial are rarely granted. Grounds for denial include failing to adequately explain the loss of assets, perjury, failing to obey lawful orders of the court, and fraudulently transferring, concealing, or destroying property that should be in the estate.
Because a secured creditor has rights that permit him or her to seize pledged property, a debtor may want to reaffirm a debt even after it has been discharged if the debtor wants to keep the property. A reaffirmation is an agreement between the debtor and the secured creditor that the creditor will not exercise his or her right to take back the asset so long as the debtor makes payments. A debtor must wait six years before filing for Chapter 7 again.
Chapter 11
Chapter 11 is frequently referred to as "reorganization bankruptcy." Individuals are permitted to file for Chapter 11, but it is generally used by businesses. Under this chapter of the Bankruptcy Code, a debtor is given time to satisfy its debts while still continuing to operate its business. The major justification for Chapter 11 is that the value of a business as an operating entity is almost always greater than it would be if the business were forced to cease operations and have its assets sold. In a Chapter 11 reorganization the debtor is given "breathing room" to restructure its debt while continuing to provide jobs for its employees, pay creditors, and produce a return for investors. During the repayment period, the company usually is allowed to continue operating under the current owner unless the creditors show that the management is unfit to run the company.
Petition
Chapter 11 usually commences when the debtor business voluntarily files a bankruptcy petition. (Involuntary petitions are discussed below.) The voluntary petition should follow the official form, which is available from legal stationery stores. In the petition, the business includes its name, its place of operation, the location of principal assets, a debtor's plan or notice of intent to file a plan, and a request for relief. By filing for Chapter 11, the business automatically becomes a "debtor in possession," meaning a debtor that possesses and controls its assets even though undergoing reorganization under Chapter 11. Unlike Chapter 7 bankruptcy cases, a trustee is not automatically appointed. Instead, in Chapter 11 cases the bankruptcy judge has discretion to decide whether it is necessary to appoint a trustee. Generally, a trustee is not appointed; but if appointed, the trustee assumes control of the business that filed for Chapter 11.
Stay
Filing the petition automatically stays all of the listed creditors from trying to collect the money owed them. As in a Chapter 7 bankruptcy, the stay arises automatically, without any judicial action, and the court usually notifies creditors of the filing of the petition. The stay is effective from the time of filing, even if the creditors do not receive notice until much later. As long as the stay is in effect, generally creditors may not start or continue actions against the debtor to collect on the debt. Lawsuits, garnishment actions, and telephone calls to the debtor must cease. In some cases, such as when a creditor has clear title to a particular property and the property is not necessary to the reorganization, a secured creditor may petition the court for relief from the automatic stay to recover the property.
Plan
The debtor also files a written disclosure statement and plan of reorganization with the court. For 120 days after the filing, the debtor has an exclusive right to file a plan. After the exclusive-right period expires, a creditor or the case trustee may file a competing plan. Chapter 11 cases can drag on in court for years, but the creditors' right to file a competing plan acts as an incentive for the debtor to file a plan within the exclusive-right period. The disclosure statement contains detailed information about the debtor's assets and liabilities and is meant to be used by the creditors to evaluate the debtor's plan of reorganization. The plan must classify outstanding claims and detail how each class of claims will be treated. The plan also must show that the creditors will receive more money if the business is allowed to continue operation than they would if the assets of the company were liquidated. All creditors whose contractual rights will be modified or who will be paid less than they are owed are given a right to vote on the plan. In order for it to be accepted by the creditors, each class of creditors must approve the plan with a majority vote. The plan also must be approved by the court. If the court approves the plan, but some of the creditors do not, the court can force the reluctant creditors to accept it. If a plan is not approved, the company may be liquidated.
Common Bankruptcy Issues
A number of issues are common in both Chapter 7 and Chapter 11 bankruptcies.
Involuntary Bankruptcy
Unlike the situations described above, in which the debtor decides whether to file bankruptcy, in an involuntary bankruptcy creditors force the debtor into bankruptcy. Under certain conditions, creditors may petition the bankruptcy court to initiate a Chapter 7 or Chapter 11 bankruptcy against a debtor. The court will only accept such a petition if it is signed by at least three creditors who are owed a total of at least $5000 in unsecured debt. If a debtor has fewer than 12 unsecured creditors, however, just one unsecured creditor owed at least $5000 may file an involuntary bankruptcy petition.
Involuntary bankruptcy is rare, but if someone does file a petition against a debtor in bankruptcy court, the debtor has an opportunity to file an answer to the petition and refute any charges made against it in the petition. If the judge sides with the debtor, the court dismisses the petition and the creditors may be liable for reasonable attorney's fees and any money the debtor loses in defending the case. In addition, if the judge decides that the petition was filed in bad faith, the court may order the creditors to pay punitive damages to the debtor.
Conversion, Dismissal, and Suspension
The petitioner's original choice of bankruptcy chapter is not permanent. Once begun, a case may be voluntarily or involuntarily converted to a new chapter. Requirements for conversion vary, but once converted, a case may not be converted back to its original chapter.
The bankruptcy court has authority to suspend or dismiss a case. The court can suspend or dismiss a case "for cause," for failure to pay filing fees, or "if the interests of creditors and the debtor would be better served by such dismissal or suspension."
Transfers to Avoid Losing an Asset in Bankruptcy
Some transfers that are valid in regular business relationships are invalid when one party is in or approaching bankruptcy. The Bankruptcy Code empowers a bankruptcy trustee to invalidate a number of transfers made prior to a bankruptcy filing.
Fraudulent Conveyances
The Uniform Fraudulent Transfer Act is designed to remove any temptation a debtor may have to hide property before declaring bankruptcy, for example, by giving it to a relative. Any transfer of the debtor's assets made within 90 days of filing for bankruptcy, or within one year if a relative or business associate is involved, is carefully scrutinized by the bankruptcy court. If the court determines that the debtor was attempting to defraud creditors by selling property at a below-market price, the court may order the property or other assets be given over to the trustee. Anything that was sold at a reasonable market value before a bankruptcy filing, however, cannot be recovered by the court under the rules of the Uniform Fraudulent Transfer Act.
Preferences
A preference occurs when a debtor treats one creditor more favorably than another creditor similarly situated. For instance, suppose a debtor with only $100 owes creditors A and B $100 each. If the debtor pays the $100 to A, leaving nothing for B, A has received a preference and B has been harmed by the preference. Bankruptcy condemns preferences if the following conditions exist:
- Transfer is for the benefit of a creditor
- Transfer is made for debt owed prior to the initiation of bankruptcy
- The debtor is insolvent at the time of transfer
- Transfer is made either 90 days before filing of the bankruptcy or one year before filing if made to an insider such as a relative or director of a corporate debtor
- Transfer lets a creditor receive more than it would have in a hypothetical Chapter 7 liquidation of the debtor's estate
Creditors receiving preferences can be forced to "disgorge" them by returning the assets to the debtor's estate so that other creditors can share them equally.
Effects of Declaring Bankruptcy
The old adage that it is better to know how to swim before jumping into deep water applies to any business considering filing bankruptcy. One of the most obvious effects of declaring bankruptcy is possible serious damage to one's business credit rating. Because a bad credit rating follows a business for a long time, even relatively simple bankruptcies are not painless.
Another drawback to bankruptcy is public exposure. One of the first events in many bankruptcies is a meeting between the debtor and all its creditors. At this meeting, the creditors and a court-appointed trustee are allowed to examine all the debtor's financial records--such as bank statements and loan documents--and to ask questions about how money has been spent. For a business with anything unsavory to hide, a bankruptcy proceeding can be incriminating. For some businesses, the public exposure of bankruptcy may permit competitors to get an inside look at how the business is run.
Finally, bankruptcy can be expensive. Understandably, bankruptcy attorneys are very careful about a client's ability to pay legal bills. Most bankruptcy attorneys collect enough money in advance from their near-bankrupt clients to handle a typical bankruptcy filing. Any contest with creditors will push fees higher, to a level that many businesses may be unable to pay. In addition, the trustee in charge of a bankruptcy case is paid by commission, based on a percentage of the money that he or she distributes to pay creditors.
Alternatives to Bankruptcy
Informal Payment Plans
Any business in financial trouble undoubtedly receives many letters from creditors demanding payment on debts owed. Even a very demanding creditor may have a change of heart once a debtor mentions the possibility of filing bankruptcy, because creditors know that bankruptcy means that they may only get a fraction of what is owed them. If a businessperson is confident that the business' financial problems are only temporary, he or she may want to consider asking major creditors to accept reduced payments for a short period or asking for a short delay in making payments. Provided that the debtor has not already given creditors reason to doubt its sincerity, such as by completely ignoring their letters or by consistently breaking promises, chances are good that creditors will agree on one of these plans.
As mentioned above, creditors know that bankruptcy means they will probably get just a small fraction of the total sum owed them. Creditors also know that if they sue to collect their money, they will face the hassle of seeking a court order to force the debtor to pay. This is time consuming and costly. All these factors make it more likely that a creditor will agree to a repayment plan.
Workouts
The term "workout" is used to describe a somewhat nebulous process in which a business and its creditors get together to realign their financial expectations of each other. Workouts can be traumatic and all parties involved typically come away with less than they had going into the process, but a successful workout can be better for all involved than bankruptcy. If a business' financial prospects worsen dramatically, creditors may need to accept a lower rate of interest or payments drawn out over a longer period of time, or they risk seeing the business collapse entirely. Creditors, shareholders, labor unions, management, and suppliers need to realize that diminished returns from a financially troubled company may be preferable to the returns from a defunct company. The primary advantages over bankruptcy are that the workout gives the parties greater control over the process (there is no interference from the bankruptcy court) and it can dramatically cut legal fees.
Workouts sometimes commence voluntarily when far-sighted management, realizing that commitments will not be met, approaches creditors to obtain more favorable terms. Dramatic events, such as litigation losses, environmental catastrophes, and changes in business or economic conditions, also may trigger the need for workout.
Workout and bankruptcy proceedings are often interrelated. For example, the threat of filing for bankruptcy may provide needed impetus for recalcitrant parties to agree to a workout plan. Similarly, if a business is able to agree to a plan of workout with most, but not all, of its creditors and investors, then a Chapter 11 petition may be used as a tool to force the remaining creditors to go along with the terms of the workout.
To the uninitiated, workout may seem like a game with no rules or a trip without a map. In part, this is true. The parties have a great deal of flexibility to come to new terms between themselves. Theoretically, they can do whatever they want. Realistically, however, the possibility of filing for Chapter 11 creates a set of "pseudo-rules" for workouts that establish parameters for negotiations. Parties know that if they refuse to go along with a plan similar to what would be approved in a hypothetical Chapter 11 case, bankruptcy proceedings may be initiated, and a plan enforced against their will. Similarly, if a debtor and one creditor come to a workout agreement that unfairly disadvantages other creditors, the remaining creditors might initiate involuntary bankruptcy proceedings and have the workout plan invalidated as a preference.
The biggest concern for lenders going into workout negotiations is potential lender liability. A creditor always needs to resist the temptation to take control of the business, because if a creditor becomes so involved in the debtor's business that it controls the business the creditor may become liable for any damages incurred. The creditor's involvement is particularly risky because the definition of when a creditor "controls a debtor" is hazy. There is no simple formula to apply and courts look to all the creditor's actions in the broadest context. Financial management of a debtor's business is especially risky in environmental matters. In one notorious case (the Fleet Factors decision), a court ruled that a lender could be held liable for Superfund cleanup costs of the debtor's facility if the lender "had the ability to influence the hazardous waste decisions of its borrower" even though the lender had never actually participated in the decision-making process. Mere ability to influence can equal lender liability.
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