What is ahead for U.S. businesses in an economic environment pillared on rising borrowing costs, failing financial institutions, and inflation? So far, 2023 is proving to have one of the highest bankruptcy filings rates in over a decade. Commercial bankruptcy filings increased 24% in March as compared to March 2022. According to the American Bankruptcy Institute Executive Director, Amy Quackenboss, “The increase in bankruptcy filings in the first quarter of the year demonstrates the growing debt burdens of both consumers and businesses.” In just the last week of April, we saw a 12% hike in Chapter 7 filings as compared to the same period in the prior year.
Chapter 7 bankruptcy cases: Evaluating a secured creditor's position
If you’re a transactional practitioner, you may find yourself representing a secured party in Chapter 7 and Chapter 11 bankruptcy cases or working as part of or alongside the bankruptcy group that is representing a debtor or a bankruptcy trustee.
In this article, we introduce the Chapter 7 process and the considerations secured creditors should keep in mind in this type of bankruptcy case.
What is Chapter 7 bankruptcy?
Chapter 7 of Title 11 of the United States Code (the “Bankruptcy Code”) is a process used to wind down a business that cannot meet its obligations as they become due (while Chapter 7 also applies to individual debtors, for purposes of this article we will focus on business bankruptcies). To that end, a bankruptcy trustee is appointed to administer the debtor’s estate and reduce its assets to cash. Proceeds are then distributed to creditors in line with the priorities set forth in the Bankruptcy Code. Secured creditors generally get priority, while unsecured creditors are paid pro-rata on their claims.
The intent of Chapter 7 is to give the debtor a “fresh start” and for the creditors to recover as much as they otherwise would’ve been able to under non-bankruptcy law.
Chapter 7 chronology
A Chapter 7 case commences with the filing of a petition for relief under Chapter 7 of the Bankruptcy Code. Chapter 7 petitions may commence in one of three ways:
- Voluntary petition — This occurs when the debtor is looking for relief from debt and usually would have liquidated large portions of the estate prior to filing. Voluntary petitions make up most cases.
- Involuntary petition — Initiated by creditors, typically in response to creditors believing that the debtor is not acting fairly.
- Conversion from a Chapter 11 or 13 — Generally occurs after the business closes, and often involves substantial portions of unencumbered and non-exempt assets.
Once the case has commenced, the debtor surrenders all its property to the Chapter 7 Trustee and the automatic stay goes into effect. Creditors may not continue any collection efforts after the petition has been filed without first seeking permission from the bankruptcy court.
The Trustee then liquidates the Debtor’s equity in the property. This means that all the debtor’s title to any assets is reduced to cash. Estate property is typically sold at auction following specific procedures.
If there are any secured creditors, they will get priority ahead of any distributions to unsecured creditors. In some instances, secured creditors may seek to foreclose on their collateral by filing a motion for relief from the automatic stay.
Once the property is reduced to cash, the Trustee distributes proceeds of the sales to the unsecured creditors pro-rata in accordance with the priorities set in the Bankruptcy Code. The remainder of the unsecured debt is then discharged.
While this is a general overview of the process, it should be noted that under the Bankruptcy Code certain creditors get special priority (creditors who hold “administrative claims,” such as the trustee’s professionals, the debtor’s employees, and other priority claims), and certain debts are not be discharged at all.
Recovery under Chapter 7 bankruptcy
If you represent a secured creditor in bankruptcy, you want to know how to recover in a Chapter 7. There are two basic principles that are seemingly at odds with each other:
- Entitlement to full recovery — To the extent that the creditor is secured, they are entitled to 100% of the outstanding debt, including interest and attorney’s fees. This means that your client may even recover any fees that are owed for your services.
However, there are some exceptions whereby the Trustee may be able to avoid certain liens, such as fraudulent transfers or liens subject to equitable subordination.
- Avoid injury to the debtor and other creditors — A secured creditor cannot recover their collateral until they can do so without injury to the debtor or other creditors unless delay would create a serious risk of loss. For example, if the collateral is perishable goods, such as produce, and its value can only be maximized before it spoils, the court may decide that allowing the creditor to liquidate outweighs any delays.
Therefore, when representing a secured creditor in a Chapter 7 bankruptcy, it is important to carefully evaluate your client’s position to strike the perfect balance between these principles.
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Evaluating the secured creditor’s position under Chapter 7
Some questions and considerations to bear in mind when evaluating a secured creditor’s position include:
- Is the security interest valid and perfected? A sure way to confirm this is to run lien searches to determine your client’s status.
- If the secured creditor holds a secondary position, investigate whether the first position lienholder is perfected. In the event the first position lienholder did not properly perfect their lien, this can be a good way to help your client get ahead in line.
- Is the secured creditor vulnerable to a preference action? One way to determine this is to ask additional questions — when was the lien perfected? If it was perfected during the 90-day period before the petition date, your client may be subject to a preference action. Again, this can be confirmed by running a lien search. What is the relationship between the debtor and the secured creditor? If the secured creditor is an “insider” of the debtor, then the lookback period is extended to one year before the petition. It’s advisable to consider the different types of preferences and ask your client as many questions as possible to ensure that if there is a vulnerability, you have a proper defense.
- What is the value of the collateral? Sometimes expert opinions may be required to make that determination. Alongside assessment of the value, investigate any underlying risks to the value of the collateral in the event you would need to file a motion for relief from the automatic stay.
- If your client is not entitled to foreclose on the collateral, then you should seek that your client receives “adequate protection.” This may be in the form of interest payments, insurance, or additional collateral.
Proof of Claim — to file or not to file?
Once you’ve determined your client’s position, you then need to decide whether to file a Proof of Claim (POC).
A POC is a claim document that creditors typically file to register their claims in the bankruptcy case. At this point they indicate how much they are owed. While a secured creditor is not required to file a POC, they are permitted to do so.
There are several risks for not filing a POC:
- If you don’t file a POC and are unable to foreclose on your collateral, you risk not having an allowed claim as determined by the bankruptcy court. The court will approve payouts to creditors based on their allowed claims.
- In the event your client’s secured claim is later deemed to be partially unsecured — meaning, the value of the collateral is less than the amount your client is owed — a POC is required to participate in the distribution allotted for unsecured creditors. If you don’t file a POC then you risk not receiving distributions on account of the unsecured portion of your claim.
- When the debtor files its petition, included therein are schedules listing known creditors and what they are owed. It is not uncommon for the debtor’s records and the creditor’s records to differ. For example, the debtor would not include any attorney’s fees that the creditor is incurring in connection with collecting on the claim. If what your client is owed exceeds the amount listed in the debtor’s schedules, a POC is a sure way to register the correct amount owed as it will supersede the debtor’s schedules. If you don’t file a POC, then you risk having the debtor’s schedules control your client’s claim amount.
- In the event the Trustee gets permission to sell the underlying collateral, the secured creditor can bid on the asset in the amount of its claim. But if a POC wasn’t filed, then this would not be allowed.
The takeaway is that it is generally a best practice to file a POC even if you represent a secured creditor. It should be noted that by filing a POC, you submit to the jurisdiction of the Bankruptcy Court and waive your client’s right to a trial by jury — in certain circumstances parties may not wish to waive this right.
Filing a Proof of Claim
When filing a Proof of Claim (POC), here are some important points to remember:
- The POC document is governed by Bankruptcy Rules 3001 and 3002.
- The form must conform substantially to Official Form 10.
- Attach substantiating documentation (statement of account, security agreement, evidence of the lien, etc.).
- The POC is prima facie evidence of the validity of the claim.
- The POC must be signed by an authorized person, but counsel should use caution when considering to sign on behalf of the client as some courts have held that this waives the attorney-client privilege.
- The POC must be filed by the bar date, which in voluntary cases is set to be no later than 70 days after the bankruptcy filing.
You are also required to include total amounts for pre-petition and post-petition attorney fees and interest.
Finally, consider whether the creditor holds any property against which it has a right of setoff. These setoff rights are generally provided for under state or federal law outside of the Bankruptcy Code. Section 553 of the Bankruptcy Code provides further guidance on setoffs.
A Reaffirmation Agreement is a helpful tool that may be available to the secured creditor to maximize payout on their claim. It is a contract between the debtor and the creditor where the debtor promises to continue owing to the creditor after the bankruptcy case closes.
Some reasons why a debtor would want to sign a Reaffirmation Agreement may include a desire to keep the property that secures the secured creditor’s debt or to avoid having the secured creditor pursue the guarantor.
The secured creditor, on the other hand, can benefit significantly. The debtor would continue making payments after the bankruptcy case closes, the underlying security interest remains in place, and the secured creditor’s overall chances for recovery are improved (especially if the secured creditor were under-secured in bankruptcy).
When representing secured creditors in Chapter 7 bankruptcy, it is important to understand your client’s position as a secured creditor, ensure your client’s claim is properly recorded, evaluate the collateral and assess any possible threats, and ensure that your client receives adequate treatment in the bankruptcy case. In addition, if your client faces any potential preference actions, it’s important to understand all available defenses.
Proper due diligence underpins this process — such as running lien searches and accurately reviewing your client’s status of perfection. This will help improve your client’s ability to maximize recovery.
For questions pertaining to representing a secured party in Chapter 7 and Chapter 11 bankruptcy cases, contact your contact a CT Corporation Specialist or call 844-878-1800.
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