Ten Key Terms to Understand Regarding Chapter 11 Bankruptcy Proceedings

Ten Terms that are key to understand Chapter 11 Bankruptcy Proceedings.  Chapter 11 Bankruptcy terminology can be a confusing lexicon for the uninitiated.   Here are the 10 Key terms you will need to understand as you navigate Chapter 11 Bankruptcy.

  1. Adequate Protection

Adequate protection refers to the protection offered to creditors of a failing business to ensure payment to a creditor through the use of business assets, essentially as collateral. Specifically, section 361 of the Bankruptcy Code defines adequate protection as cash payments, replacement or additional liens, or administrative expense claims or the indubitable equivalent. Each type of adequate protection must be sufficient to compensate the secured lender for the loss of value to its cash collateral caused by its use by the debtor.

Because of the automatic stay provision of the Bankruptcy Code, creditors may not enforce collection efforts after the filing of a bankruptcy petition by a business. Thus, the only protection a creditor has during the pendency of the bankruptcy is adequate protection. The assets of the debtor’s business become items which creditors have a legal claim to take in the instance where the business fails. Creditors must be given adequate protection that those assets will not be sold or destroyed. Therefore, to protect the interests of the creditors, a business owner cannot sell, lease, or otherwise dispose of his business assets after filing a chapter 11 petition.

  1. Adversary Proceeding

An adversary proceeding is essentially a lawsuit within a bankruptcy case and is initiated through the filing of a complaint by the debtor, a creditor, or the trustee. Adversary proceedings are governed by Rule 7001 of the Federal Rules of Bankruptcy Procedure, which lists ten different types of adversary proceedings, with some exceptions.

Creditors often file an adversary proceeding to determine the dischargeability of a debt of the debtor. An example of an adversary proceeding that may be filed by a trustee includes an attempt to collect money back from a creditor who received funds or property from the debtor. A trustee may also file an adversary proceeding in an attempt to convert the debtor’s case from a chapter 7 to a chapter 13 proceeding, for example. Motions to dismiss are also appropriate subjects of adversary proceedings. Finally, a debtor may file an adversary against a creditor to, for example, recover damages for a creditor’s action in violation of the automatic stay.

  1. Automatic Stay

The automatic stay acts as a temporary injunction against all creditors to prevent them from taking action against a debtor or the property of the debtor’s estate. Automatic stays are governed by Section 362 of the Bankruptcy Code. An automatic stay provides the debtor an opportunity to attempt a repayment or reorganization plan while relieving the debtor from pressure from creditors. The automatic stay becomes effective immediately, without further action, upon the filing of the bankruptcy petition.

It is important to note that the automatic stay only prevents a creditor from taking action against the debtor. It does not prevent action against other entities such as a co-debtor (except in the chapter 13 context), a guarantor, or an insurer, for example. Furthermore, the automatic stay is subject to certain exceptions and will not stop such actions including, but not limited to, criminal proceedings and actions for family support. Anybody who intentionally violates the automatic stay will be liable for actual damages incurred by the violation.

The automatic stay is temporary and will terminate upon the occurrence of events specified in 11 U.S.C. § 362(c). However, where the debtor obtains a discharge of his debts, the automatic stay is replaced by a permanent injunction with respect to those discharged debts.

  1. Bifurcation of an Allowed Claim

Section 506 of the Bankruptcy Code Bankruptcy Code section divides, or bifurcates, an allowed claim into two parts. The claim will be a secured claim to the extent it is supported by collateral of a certain value. The remainder of the claim will be an unsecured claim to the extent that the value of the collateral is less than the amount of the allowed claim. For example, if a creditor holds an allowed claim of $1000 and the claim is secured by collateral worth $800, the claim will be bifurcated into: (1) a secured claim in the amount of $800, and (2) an unsecured claim in the amount of $200.

  1. Claims and Proofs of Claim

A claim, as defined in section 101(5) of the Bankruptcy Code, is a right to payment, whether or not reduced to judgment, liquidated or unliquidated, fixed or contingent, matured or unmatured, disputed or undisputed, legal or equitable, secured or unsecured. In turn, a debt is defined in section 101(12) as a debtor’s liability on a claim. The definition of a claim is to be interpreted broadly.

In considering whether a claim exists under the Bankruptcy Code, it is necessary to consider when a claim arises for bankruptcy purposes. The Code does not clearly establish when a right to payment arises. Case law has held that a claim “arises” when all transactions or acts necessary for liability have occurred.

In order to receive distributions in a bankruptcy case, a creditor must file a proof of claim. An exception to this rule is when a claim is scheduled by the debtor in a Chapter 11 case. Secured creditors, i.e. those creditors whose claim is secured by collateral, do not have to file a proof of claim. If a proof of claim is timely filed, it is deemed allowed unless another party objects to it. Once a proof of claim is filed, the claim is presumed to be valid and any objecting party has the burden of demonstrating that the proof of claim is not valid.

  1. Cramdown

In a Chapter 11 case, cramdown occurs when a court confirms the plan over an objection of creditors. In a cramdown case, creditors who reject the plan or accept less than they are owed are referred to as “impaired creditors.” The plan may not unfairly discriminate against these impaired creditors. The debtor must also show that the plan is fair and equitable to the impaired class.

To confirm the plan over the objection of a secured creditor, the claim holder must receive the lesser of the full value of the property securing the claim or the entire value of the claim. To confirm the plan over the objection of an unsecured creditor, the creditors must either accept the plan or the owners of the corporation must not receive any property under the plan. Finally, a plan cannot be confirmed if each claim holder does not receive at least as much as he would have received under a chapter 7 liquidation unless those receiving less vote to accept the plan.

  1. Fraudulent Transfer

A fraudulent transfer, or fraudulent conveyance, is the transfer of a debtor’s assets to a third party with the purpose of preventing creditors from accessing such property to satisfy their claims. Section 548 of the Bankruptcy Code governs fraudulent transfers. The purpose of law prohibiting fraudulent transfers is to preserve for creditors the assets of the debtor’s estate. Claims of fraudulent transfer can be asserted for transfers within one year of the filing of the bankruptcy petition.

Fraudulent conveyances can be either actual or constructive. In an actual fraudulent conveyance, the transfer of property is made “with actual intent to hinder or defraud any entity to which the debtor was or became . . . indebted.” 11 U.S.C. § 548(a)(1)(A). To prove the debtor’s fraudulent intent, courts consider certain “badges of fraud.” In a constructive fraudulent conveyance, the debtor’s intent is irrelevant. Instead, constructive fraudulent transfers require two things. First, the debtor must receive less than the reasonably equivalent value of the property for the transfer. Second, the debtor must have been insolvent at the time such transfer was made or must have become insolvent because of such transfer. Whether a transfer of property is a constructive fraudulent conveyance turns on the reasonably equivalent value of such property. Courts will took to such factors as the fair market value of the property and whether the transfer was made in good faith in the ordinary course of business.

  1. Motion for Relief from Stay

To seek relief from the automatic stay provision of the Bankruptcy Code (§ 362), a creditor may file a motion for relief from stay. Motions for relief from stay require notice and a hearing, where the creditor can attempt to demonstrate cause for the granting of such relief. For example, a motion for relief from stay may be filed by a secured creditor to foreclose on real estate. When a motion for relief from stay is granted, it simply lifts the automatic stay and restores the parties’ state court rights. The creditor can then enforce those rights to the extent the order granting the relief from stay permits. A motion for relief from stay does not remove property from the bankruptcy estate or grant a creditor ownership of property.

  1. Preferences and Preference Actions

Preferences are defined in section 547 of the Bankruptcy Code as payment on previously incurred debt made while the debtor was insolvent to a non-insider creditor, within 90 days of the bankruptcy filing, that allows the creditor to receive more on its claim than it would have had the payment not been made and the claim paid through the bankruptcy proceeding. Section 550 of the Bankruptcy Code permits the trustee to avoid and recover any preference payments by filing a lawsuit against the creditor. The policy behind these code sections is to prevent aggressive collection activities that often result in forcing the debtor into bankruptcy. Three common defenses to preference actions include the ordinary course of business defense, the contemporaneous exchange for new goods or services defense, and the new value defense. The creditor has the burden to prove each defense.

  1. Priority Claims

Priority claims are the claims of unsecured creditor that take “priority” over other unsecured claims. There are 10 categories of priority claims, as listed in section 507(a)(1)-(10) of the Bankruptcy Code. The priority of these claims cannot be modified; however, it is the burden of the creditor to demonstrate that his claim meets the requirements of a priority. Each priority claim must be paid in full before general unsecured creditors are paid. The priority rules apply to all chapters of bankruptcy under title 11.

Generally, the categories of priority, subject to certain restrictions, are: domestic support obligations, administrative expenses, claims arising in an involuntary bankruptcy petition under chapter 7 or 11 that arose between the filing of the petition by creditors and the order of relief issued by the court, employee wages up to $10,950 for each worker for the 180 day period prior to the bankruptcy proceeding, unpaid contributions to employee benefit plans, claims for grain from a grain producer or fish from a fisherman, consumer layaway deposits, prepetition taxes, commitments by the debtor to a federal depository institution, and death or personal injury claims.

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