The Insolvent Customer
The methods of handling the affairs of financially distressed or insolvent business debtors may be divided into two classes: those designed to keep the debtor in business and restore the business to profitability; and those designed to put the debtor out of business, realize the assets, and distribute the proceeds among creditors.
Insolvency as defined by the Bankruptcy Code is based on the traditional balance sheet test in which debts exceed assets, at fair valuation, exclusive of property exempted or fraudulently transferred. However, a potential debtor, if otherwise eligible, does not have to show insolvency to be granted relief under the Bankruptcy Code. Indeed, creditors need not prove insolvency to file an involuntary petition in bankruptcy against the debtor. They need only demonstrate that the debtor is not paying its debts as they generally come due.
The Uniform Commercial Code dictates the principle of commercial transactions dealing with the contract of sale, the giving of a check for part of the purchase price, and the acceptance of some form of security for the balance. The UCC defines insolvency as in a case where a debtor’s liabilities exceed its assets or, it is generally not paying its debts as they become due.
Reasons for Business Distress
It could be argued that creditors often willingly, but probably unknowingly, cooperated in permitting the debtor to become distressed. Frequently, lax credit analysis and poor collection follow-up contribute to the bad business habits of many customers, and foster distress. There are three broad groups of potential reasons for business distress:
- A large number of businesses are under-capitalized and consequently rely on their creditors’ capital to pull them through.
- Those who have losses that are incurred because of style changes, seasonal demand, or technology changes that have not been updated.
- The most troublesome is the customer that is poorly managed, and an inefficient or fraudulent operator.
Handling Distressed Debtors
The methods and means of handling the affairs of insolvent or financially distressed business debtors will be determined by the debtor’s alternatives that may be divided into a simple matrix as in Exhibits 1 and 2:
|Reorganize the financial affairs|
|Liquidate the business|
Creditors usually prefer to rehabilitate or work with a distressed debtor through voluntary, out-of-court settlements. When rehabilitation is not possible however, they may liquidate assets outside of bankruptcy proceedings through a general assignment for the benefit of creditors or, an agreement to liquidate between creditors and the debtor. The credit executive who is familiar with both of these methods, their requirements, advantages and disadvantages, will be able to participate effectively and intelligently in whatever action is taken when a customer becomes insolvent.
Voluntary settlements between debtors and creditors are the preferred answer to a financial problem. They are generally known as general compositions and extension agreements. Composition agreements are usually those by which the debtor pays less than 100% of what is due. An extension agreement is one in which the amount due is not paid at the due date. Usually an agreement includes both a composition and an extension, and provides for rehabilitation of the debtor and for its continuance in business. Additionally, the general composition requires agreement of approximately 90% of the creditors.
Expressed in another way, a voluntary settlement is simply a contract between the debtor and creditors that settles their claims to maximize the return for the creditors, while minimizing the financial distress of the debtor. It keeps the customer in business and avoids unnecessary court costs. The creditors may take a temporary loss, but expect the debtor to emerge stable and solvent, as a prospective “born again” customer.
The Out-Of-Court Settlement Advantages:
- Less negative publicity in the legal and business community.
- Less time consuming and usually less expensive than a formal bankruptcy proceeding.
- Less interruption in the conduct of the debtor’s business.
- Greater certainty of control by the debtor of business operations.
- Less risk in losing a management team and skilled labor.
- Greater flexibility for cash flow control.
- Avoidance of triggering default clauses in leases and security agreements.
- Better atmosphere for refinancing, capital infusion or new borrowing.
- Sale or lease of assets is less cumbersome particularly those out of the ordinary course of business.
- Less possibility of reduction in salary and other benefits paid to key employees.
- Greater protection of confidential business matters.
The Out-Of-Court Settlement Disadvantages:
- No protection against secured parties or judicial or statutory lien creditors seeking to enforce their rights pursuant to written agreements with the debtor.
- No ability to halt action by taxing authority.
- Inability to stay state or federal court proceedings pending against debtor or which may be initiated against the debtor after the agreement is initiated.
- Inability to reject collective bargaining agreements with employees.
- Inability to sell or transfer assets, free and clear of liens and encumbrances, with the exception of the agreements with all lien claimants.
- Inability to reject leases and other burdensome executory contracts.
- Unavailability of bankruptcy “cramdown” provisions to deal with undersecured creditors’ claims.
- Unavailability of a forum for prompt resolution of disputes affecting the debtor.
- Difficult mechanism for allowance of attorney’s fees for the counsel of various parties or a forum for resolution of disputes regarding payment of professionals.
- No mechanism to attack preferential transfers, fraudulent conveyances or attachments, etc. of the debtor’s property.
- No legal way to compel dissenting creditors to cooperate with settlement.
The substantial utilization of the out-of-court settlement is ample proof of its wide acceptance by sophisticated creditors and attorneys who specialize in the law of insolvency. The benefits derived from the out-of-court settlement have been recognized in the Bankruptcy Code by the enactment of section 305, which permits the Bankruptcy Court to abstain an involuntary petition in bankruptcy filed against a debtor if the dismissal would better serve the interest of the creditors and the debtor. A well-constructed out-of-court settlement agreement between a debtor and a representative body of its creditors stands an excellent chance of serving its purpose.
A Meeting of Creditors
If the decision has been made to attempt an out-of-court settlement, usually the debtor’s counsel may analyze the list of the twenty (or other suitable, representative number) largest creditors with an eye towards identifying those creditors who might be helpful as well as those who might be a stumbling block to working out an agreement. The first meeting of the creditors can be a confused affair or it can be well organized depending on the preparation of the debtors and the creditors. Ideally, the debtor will come to the meeting accompanied by both its counsel and accountant. The debtor will have current financial statements, be prepared to give the entire financial history of the business as well as the reasons for its distressed condition, and be able to answer creditors’ questions.
At this first meeting of creditors, consideration should be given to electing a creditors’ committee designed to be representative of all the creditors with whom the debtor will negotiate an agreement. Furthermore, this committee may become the creditors’ committee in the event a Chapter 11 proceeding is instituted.
The committee should be formed based on the creditors who are willing to participate, holding non-contingent, unsecured claims. After the committee has been formed, it should retain a secretary to keep minutes of the meeting, furnish the creditors with status reports of the committees’ deliberations at regular intervals, provide for the distribution of the agreement to the creditors and undertake the solicitation of their consent to the agreement. The committee should also retain counsel in the formation and preparation of the agreement with the debtor. When facts and circumstances warrant, the committee should retain an accountant other than the one employed by the debtor to conduct an independent investigation of the debtor’s financial affairs and review, if not audit, its books and records.
The Composition Agreement
With this type of pro rata settlement, the debtor proposes to settle with creditors for less than the full amounts owed. The debtor pays in cash to its creditors a uniform percentage of its obligations to be accepted in full settlement. The percentage depends upon what the debtor’s assets are, what the debtor is able to pay, and what the creditors are able to negotiate in the bargaining proceedings. Possibly, the debtor may obtain third party financing to make an attractive settlement with creditors.
The most important criterion in determining a fair settlement is to compare the proposal to an estimated settlement in bankruptcy or liquidation. A pro rata voluntary settlement should provide a larger dividend than would result in bankruptcy proceedings or liquidation. It is often advisable to provide creditors of small claims (relative to the situation) with payment in full to reduce the number of creditors and eliminate the nuisance those small claims can cause. Furthermore, it may be wise to provide that creditors agreeing to reduce their claims to a specified amount will receive 100% of their adjusted claims.
Perhaps the least drastic method of dealing with a distressed debtor who cannot pay its bills is by means of an extension agreement. By means of extension, the time for payment of accounts is legally postponed to some future date mutually agreed upon by debtor and creditors.
When to support an Extension Agreement:
- The most important consideration on the part of creditors is the honesty of the debtor, and
- Determination of whether the extension will accomplish its purpose
- does the debtor have sufficient financial strength available
- is the debtor competent.
It should be noted that creditors are not compelled to sign a composition or extension agreement, and creditors who do not sign it, are not bound by it.
The Combination Settlement
Combination settlements usually call for a pro rata cash payment combined with an extension of time. For example, the settlement may provide a cash payment of 20 percent and three future installments of five percent each, for a total of 35% in full settlement. The installment payments, usually evidenced by notes, may be payable at 3, 6, 9, or 12 month intervals. The disbursements are usually made by an attorney for the creditors rather than by the debtor.
Assignment for the Benefit of Creditors
While the creditors’ efforts are ordinarily directed toward rehabilitating the distressed debtor, some debtors are so hopelessly insolvent and lacking in prospects that they cannot be rehabilitated. In those cases, the debtor may be asked to execute a general assignment for the benefit of creditors, a liquidation technique by which the debtor goes out of business. The assignment is a device whereby a debtor transfers title to all assets to a third party, designated as assignee or trustee, with instructions to liquidate the assets and distribute the proceeds among creditors on a pro rata basis. The assignment may be made by a debtor without prior consultation with the creditors, or it may be executed after meetings with creditors or a creditors’ committee when it becomes obvious that a voluntary settlement cannot be made. As a creditor, you must file a claim as stipulated by the assignee. In most cases, that is the only way a creditor will be paid. One caveat must be considered in an assignment, that is the assets to be assigned, must be unencumbered. With lenders and some vendors taking a more secured position in recent years, the assignment has diminished in popularity.
Liquidation can also be undertaken by a consenting agreement between the distressed debtor and the creditors to convert the assets of the business and distribute the proceeds according to the agreement, among the creditors. Creditors should be supported by an attorney who can act as a point-person to represent all creditors, and can (on the consent of the creditors’ committee), prepare all documentation to ensure an equitable distribution.
Receivership Proceedings (a non-bankruptcy, court proceeding)
Unlike compositions and assignments for the benefit of creditors, receivership proceedings are rarely voluntary. In most states, receivership proceedings can only be instituted by the commencement of an adversary-type proceeding, and the receivership is instituted only after the court has made the determination that it is necessary and proper.
Each state can have different rules governing receivership administration, therefore careful attention should be paid by creditors to all communication received in the case so that they can maximize their return. If creditors feel that the state is not looking out for their best interest, it is possible to consider filing an involuntary bankruptcy case against the debtor to control the situation in either a Chapter 7 or 11.
Bankruptcy–the formal proceeding
An overall understanding of formal proceedings is essential for the credit professional so that as the situation arises, you can be conversant and knowledgeable of some things you can and cannot do while your customer is under the jurisdiction of the Bankruptcy Court. The Bankruptcy Code is the aggregate law that dictates the actions of all parties involved in the case.
As a commercial credit grantor, you may encounter the following major chapters or types of action filed in the Bankruptcy Court. Debtors can voluntarily file any one of these, but creditors can file an involuntary petition against a debtor only under Chapter 7 or Chapter 11.
The United States Bankruptcy Code is the formal name of the section of the United States Code (Title 11). The Code was enacted on October 1, 1979, and replaced the prior Bankruptcy Act of 1898. Chapters 1, 3, and 5 of the US Code generally apply to all bankruptcy matters. Chapters 7, 9, 11, 12 and 13 contain particular provisions for the several forms of bankruptcy relief (liquidation and reorganizations).
Perhaps the most significant section of Chapter 1 is section 101 that contains definitions of terms and phrases used throughout the Code. Examples of these specialized meanings include:
- Claim–any right to payment whether liquidated, unliquidated, fixed, contingent, matured, unmatured, disputed or undisputed and includes an equitable right to performance even if that right did not give rise to payment.
- Farmer–expanded to include partnerships and corporations–in 1986 a new category entitled “family farmer” was created.
- Insolvent–the condition in which debts exceed assets, at fair valuation, exclusive of property exempted or fraudulently transferred. This is the traditional bankruptcy balance sheet test of insolvency, although exempt property is not included among the debtor’s assets.
- After notice and hearing–construed to mean that an actual hearing may not be required in every situation, provided certain other conditions are met.
Chapter 1 also governs the interrelationship of the various Chapters including: statute of limitations, bankruptcy court powers and who may be a debtor eligible for relief under Chapters 7, 9, 11 or 13.
Chapter 3 covers the commencement of a bankruptcy case (voluntary, involuntary, joint, or ancillary to a foreign proceeding); the qualification, appointment, compensation, capacity and role of trustees and professionals and the administration of a case (creditors’ meetings; notice; examination; immunity; taxation; unclaimed property conversion; adequate protection; automatic stays; use, sale, and lease of property; executory contracts; and utility services).
Some of the important provisions of Chapter 3:
- A voluntary case is commenced when the debtor files a petition, and this filing constitutes an “order for relief.”
- Relief may be given in an involuntary case only if the debtor fails to pay debts as they become due, or if a custodian was appointed for or took possession of the debtor’s assets during the 120-day period preceding the filing of the petition.
- Creditors’ meetings must be held within a reasonable time after the order for relief, and the judge is not permitted to attend or preside at the first meeting of creditors. The United States Trustee is designated to preside at the first meeting of creditors.
- Special tax provisions deal with the method of taxing bankruptcy estates.
- The trustee may sell, use or lease property without notice or hearing if it is in the ordinary course of business, but notice and hearing is required when such actions do not arise out of the ordinary course of business. Cash collateral is separately treated and is not so freely available to the trustee.
- The trustee or debtor-in-possession is required to give adequate protection to secured creditors when the creditor or other party with an interest in property of the estate objects to the continuation of the stay for cause or when the trustee or debtor-in-possession proposes the use, sale or lease of such property or attempts to obtain credit. Adequate protection may be provided by replacement security to the extent of the objecting entity’s interest in the property, or by granting the objector the so-called “indubitable equivalent” of the objecting entity’s interest in the property.
Chapter 5 contains the definition of property of the estate and the provision for the proof and allowance of claims. It also sets out priorities among unsecured creditors, sets parameters for non-dischargeability of debts, and contains the elaborate scheme of bankruptcy exemptions.
Some important provision of Chapter 5:
- The preference period is ninety days generally and during that period the debtor will be presumed to have been insolvent at the time of a transfer on account of an antecedent debt. In the case of a transfer to an insider as defined in Title 11 ยง 101, however, the preference period is extended to one year prior to bankruptcy.
- Certain business transactions are excepted from preference avoidance. For example, transfers intended as, and that in fact are, contemporaneous exchanges for new value given the debtor, as well as certain ordinary course of business transfers of the debtor may be deemed to be non-preferential.
- Likewise, the much-debated status of the “floating lien” is clarified by the code. Lenders are safe from preference actions under the Code to the extent that such security interests are perfected and so long as no improvement in the position of the secured party to the detriment of unsecured creditors occurred during the preference period.
- Reasonable and necessary expenses incurred by members of an official unsecured creditors’ committee in the performance of duties for the committee may be reimbursed by the estate as an expense of administration.
Chapter 7 contains the framework for an ordinary liquidation proceeding. It is the “straight bankruptcy” chapter and provides for appointment of an interim trustee; election and duties of a trustee; election of a creditors’ committee; the collection, liquidation and distribution of the assets of the estate; and the discharge of the debtor.
This action petitions the court for immediate liquidation, and the business closes its door. The business assets are inventoried, appraised and liquidated; the proceeds are distributed first to secured creditors, and then on a pro rata basis to unsecured creditors after administrative expenses and other priority claims including taxes, etc. are paid. In most cases, other than filing a claim with the court, there is little else for a commercial credit grantor to do. The amount unsecured creditors receive, if anything, is usually very small. In most cases, even the secured creditors do not realize 100% on their claims. On rare occasions, Chapter 7 cases may be converted to Chapter 11, if the court agrees that creditors may receive a higher payout if the business attempts reorganization. It should be noted that a debtor could convert an involuntary Chapter 7 at will.
This is reserved for the public sector, such as cities, counties, school districts, tunnel, bridge, port and highway authorities. Its objective is similar to a Chapter 11, in that the debtor continues to operate while it restructures its finances and looks for ways to pay off its debt. A creditors’ committee is appointed, but has less influence in Chapter 9 than in Chapter 11 in instituting controls on the debtors’ management, operations, income and expenditures. Chapter 9 was fairly rare until late 1994 and 1995 when some of these governmental agencies suffered heavy losses on investment in derivatives.
Chapter 11 contains the reorganization provisions of the previous Code. It represents one of the most significant reforms in the Code consolidating Chapters VIII, X, XI and XII of the original 1898 Bankruptcy Act. The primary purpose of this Chapter is to promote the rehabilitation and the continued viability of the debtor. A Chapter 11 plan may, however, provide for the orderly liquidation of the debtor.
Under this chapter, proprietorships, partnerships and corporations attempt to gain breathing space, while they work with creditors to reorganize their finances and arrange a payment plan to which creditors will agree. This is called a Plan of Reorganization, allowing the debtor to be in possession of its assets (DIP). A major difference between this and Chapter 7 is that the business intends to continue to operate after the Chapter 11 proceedings have concluded.
The filing of a Chapter 11 is usually preceded by events such as an actual or threatened foreclosure on fixed assets or inventory by a secured creditor, a large number of suits filed by unsecured creditors, the refusal of a lender to continue a line of credit, or the falling apart of an out-of-court settlement.
Once the court accepts the petition, it prohibits all creditors, even those secured or with judgments, from taking any additional collection or legal action. This restriction, known as the “automatic stay,” continues until the court rules otherwise. The court sends notices to all known creditors, and schedules a first meeting of creditors known as a 341 meeting (Section 341 of the Bankruptcy Code). A creditors’ committee which normally includes the seven largest unsecured creditors and others which the court may appoint, is formed to help investigate, review, and analyze all pertinent financial and operating information. It helps the court determine if the debtor has given an honest and full financial disclosure, if the continuance of the business appears feasible, and it helps to devise or recommend a plan of arrangement offered by the debtor. If a very large company whose finances are heavily involved with many classes of creditors files a petition, the court may appoint more than one creditors’ committee.
Shortly after the first meeting of creditors, the court may appoint a trustee approved by the creditors to oversee the operations of the debtor and the overall proceedings when improprieties may be suspected. As part of this process, frequent detailed reports must be filed by the debtor, so the trustee can determine that company’s management is operating the company prudently, not further dissipating assets, and is abiding by any court-ordered restrictions.
While the debtor has the sole right to propose a plan of arrangement for the 120 days after the filing of the petition, more often than not this period is extended by the court for several months. After the 120-day period (or extensions), the creditors may put forth their own plan.
While negotiations are going on, the court, in addition to tending to legal matters of the case, processes all the claims filed by unsecured creditors. There is a deadline for filing claims. This is sometimes referred to as the “bar date,” and is usually included in the filing notice sent to creditors.
The debtor may file an action to expunge or reduce a creditor’s claim through its attorney. Failure to object to the debtor’s motion will cause a creditor’s claim to be expunged or reduced as motioned by the debtor. Accordingly, action should be taken immediately to object to the debtor’s motion with supporting documents verifying the creditor’s claim attached thereto.
After the creditors’ committee approves the plan of arrangement, copies are sent to creditors for their review. Prior to, or accompanying the plan a “disclosure statement” which contains sufficient background and financial information to allow the creditors to make an informed decision about the plan, is submitted to the creditors. If more than 50% of the number of unsecured creditors whose claims collectively represent two-thirds of the dollar amount of unsecured claims vote for the plan, the plan is confirmed.
After confirmation, the debtor is “discharged” from bankruptcy, which for practical purposes means that management takes back the operations of the company as long as the terms of the plan of arrangement are met.
If the creditors do not approve a plan of arrangement, the court may still approve it, if the bankruptcy judge believes it is in the best interest of all parties. This is known as the “cramdown” feature.
If a plan is not approved; or if at anytime during the Chapter 11 the court believes the best interests of creditors are not served by the debtor staying in business, the action can be converted to Chapter 7 and the business liquidated.
Small Business Chapter 11
Under the Bankruptcy Reform Act of 1994, a “small business” provision was adopted to permit an accelerated Chapter 11 for commercial or business debtors with less than $2,000,000 in debt. Debtors whose primary assets and operations relate to real estate are not eligible. In a “Small Business” case, the court may order that no creditors’ committee be appointed, thereby saving expenses, but potentially minimizing the ability of creditors to have a meaningful influence in the case. Only the debtor may file a Chapter 11 plan and disclosure statement in the first 100 days. However, a plan must be filed by 160 days after the petition is filed. The court may combine the hearings on the disclosure statement and plan. Generally, the intent of the small business provision is to accelerate and streamline the Chapter 11 process in small cases.
Similar in intent to Chapter 11, it is reserved for family farmers. The 1986 Amendments to the Bankruptcy Code provided a new rehabilitation section designed to provide family farmers facing bankruptcy a fighting chance to reorganize their debts and keep their property. This Chapter was closely modeled after existing Chapter 13, but altered certain provisions that were inappropriate for farmers, such as the requirement that plan payments commence within thirty days of plan confirmation.
Although Chapter 13 is derived from Chapter XIII of the original 1898 Bankruptcy Act, it contains significant reforms and is designed to assist individuals in effectively resolving their financial difficulties by rehabilitation rather than liquidation. This Chapter can only be used on a voluntary basis. While the Chapter was previously known as a “wage earner” case, it is now known as Adjustments of Debts of an Individual With Regular Income.
Some of the important provisions of Chapter 13:
- Eligible debtors include not only wage earners but also any debtor with regular income, including small business proprietors with unsecured debts of less than $250,000 and secured debts of less than $750,000.
- Use of a standing Chapter 13 trustee.
- Increased flexibility is provided in the development of the plan, as there are fewer statutory requirements regarding its contents.
- The debtor has a right to convert to a liquidation at any time, and the Court has the power, for cause, to convert the case to Chapter 7 or 11 or, in the alternative, to dismiss it without the debtor’s consent unless the debtor is a farmer.
- If a Chapter 13 plan is confirmed, the trustee must distribute payments under the plan as soon as practicable.
- The Chapter 13 trustee is required to ensure that the debtor commences making timely payments. Failure of the debtor to do so provides grounds for conversion or dismissal.
Types of Petitions for Bankruptcy
The Voluntary Petition
Voluntary proceedings are commenced by filing a petition under an applicable chapter of the Code as previously mentioned, by a party which may be a debtor under that chapter. The petition is merely a brief written statement by the debtor, executed under oath.
The Involuntary Petition
An involuntary petition may be filed only against debtors actively engaged in business. They may be proprietorships, partnerships, or corporations; excluded are farmers and not-for-profit businesses. Likewise, involuntary relief is not available against municipalities under Chapter 9. It would simply be bad policy to allow a small number of creditors to control the fate of a municipality governed by popularly elected officials. Involuntary cases can only be commenced under Chapter 7 or Chapter 11 of the Bankruptcy Code under the following condition:
- If the debtor has less than twelve unsecured creditors, a single creditor holding at least $10,000.00 in unsecured claims can file or,
- The debtor has more than twelve unsecured creditors of which three or more hold unsecured claims aggregating at least $10,000.00.
The Joint Petition
A joint case commences when an individual debtor and spouse file a single petition. A joint petition must be voluntary on the part of both parties; it is not possible for a debtor to drag his or her spouse into bankruptcy without the knowledge or consent of the latter. It must bear a sworn statement of both spouses that the petition is true.
The filing of a joint petition does not result in the automatic pooling of the assets and liabilities of the joint debtors. Rather, when presented with a joint petition, the court must determine the extent, if any, to which the debtor’s estates should be consolidated.
Proof of Claims in Bankruptcy
When to File
In Chapter 11 cases, it is no longer required that the creditor file a Proof of Claim if the creditor recognizes its claim, listed in an indisputable amount, on the schedule of liabilities filed by the debtor. If however, there is any question or dispute about the amount listed (or if the creditor is not listed at all), the creditor must file a Proof of Claim in order to realize any settlement. To be safe, always file a Proof of Claim in any bankruptcy proceeding.
In a Chapter 7, 12 and 13 all Proof of Claims must be filed within 90 days after the first date set for the ยง 341 meeting and will not be extended if the ยง 341 meeting is continued. If the 90th day falls on a weekend or holiday, the next business day is the deadline. In Chapter 11 bankruptcies, the bankruptcy court determines the deadline for filing the Proof of Claim.
Priority of Claims in a Bankruptcy Settlement
Secured claimholders are entitled to payment prior to general claimholders to the extent of their secured interest. A creditor whose claim is greater than the value of the property securing its claim will have that claim broken down into two parts:
- A secured claim to the extent of the value of the collateral (the value is to be determined by the creditor and the trustee or debtor in possession, and if they can not agree, by the court).
- An unsecured claim for the balance.
The failure of a secured creditor to follow Proof of Claim is not grounds for the avoidance of the secured creditor’s lien.
The following claims have priority, in the order listed, over other unsecured claims:
- All costs of administration, including all necessary expenses of preserving the estate, including wages, salaries, or commissions for services rendered after the commencement of the case
- any tax incurred by the estate
- the expenses of creditors in recovering property for the benefit of the estate
- reasonable compensation for services of accountants and attorneys.
- In an involuntary case, unsecured claims arising out of the debtor’s business after the commencement of the case, but before the appointment of the trustee.
- Wage claims up to $4,000 for each employee, including vacation, severance, and sick leave, earned in the 90 days before the earlier of the filing of the petition or the end of the debtor’s business.
- Contributions to employee benefit plans.
- Unsecured consumer claims for deposits before the commencement of the case, in connection with the purchase, lease, or rental of property.
- Income taxes for which a return is due within three years of the commencement of the case, property taxes for one year, unemployment, withholding.
Two Important Insolvency Concepts Dealing with Bankruptcy
In bankruptcy, there are two concepts dealing with the matter of insolvency in which creditors may become involved, Preferential Transfers and Fraudulent Conveyances.
In order to ensure an equitable distribution of the unencumbered assets among the unsecured creditors, the court must find the existence of five conditions in order to permit the trustee to avoid a transfer:
- The transfer must be to or for the benefit of the creditor.
- The transfer must be for or on account of an antecedent debt.
- The transfer must have been made when the debtor was insolvent.
- The transfer must have been made during the 90 days immediately preceding the commencement of the case.
- The transfer must enable the creditor to receive more than the creditor would have received if the debtor were liquidated.
With respect to preferential transfers, the Code defines inventory, new value, and receivables in order to make their meaning unmistakable.
The Fraudulent Conveyance
The Code contains specific provisions that are substantially similar to the Uniform Fraudulent Conveyances Act. The Code (section 548) empowers the trustee to avoid any transfer of property by the debtor or any obligation incurred by the debtor that was made or incurred within one year prior to the commencement of the case with actual intent to hinder, delay or defraud any existing or future creditors or which was made for less than a reasonably equivalent value if the debtor:
- Was insolvent or became insolvent on the date of the transfer,
- Was engaged in business and that an unreasonably small amount of capital remained after the transfer was completed, or
- Intended to incur or believes that it would incur debts beyond its ability to pay them.
The Code specifically defines a fraudulent transfer so as to prevent a debtor from simply giving away assets on the eve of filing bankruptcy–provided the debtor was insolvent.
The Path to Distress
Generally speaking, companies do not fail suddenly. To the contrary, they can often be seen moving down a well-defined path of failure that is many years in duration. This path can be illustrated into three classic phases.
Often in the first phase of distress, it is possible to observe defects in the structure of the top management of the company. Imbalance of skills or knowledge of the executive team; or a lack of managerial skill or talent just below the senior level is frequently a source of deterioration in the operation. Other signs of problems are improper cash flow planning, inadequate budgetary control systems and inaccurate cost projections. Another serious defect visible in the early stages of distress, is a deficient response to change. Outdated products, low research and development budget, aging manufacturing facilities, antiquated methods of selling–these are the sort of signs that suggest that the management’s attitude has become ossified and that they are unable to keep pace with at least some aspects of the rapidly changing world.
If one of the above problems prevails, it is usually a matter of time before a company displays the second phase which is represented in any one of the following classic errors. Overtrading occurs when a company’s sales turnover increases over time faster than its profits, so that eventually it becomes unable to obtain the extra capital required to finance the expansion.
Secondly, a company allows the proportion of non-equity finance compared with equity finance to increase by taking up larger loans, overdrafts, leases and so on until it reaches the point when, should its trading profits dip downwards for any reason, it will no be able to service the interest payments.
The third mistake is a little more subtle but still very common; it consists of launching a project that is so large in relation to the company’s available resources that if something goes wrong, it cripples the company. Generally, companies not exhibiting the kinds of management defects mentioned above do not make this sort of error or are able to manage themselves out of it.
The Symptoms Appear–The Dive Begins
The distressed company moves into the third phase of its journey when the following symptoms occur. There are non-financial symptoms such as a declining market share, a fall in product or service quality, the postponement of maintenance in a factory and/or office, management not responding to phone calls, negative reports in the press, or layoffs due to sales a decline.
There are financial symptoms such as the rise in overdrafts, slowdown in payables, the deterioration of many of the liquidity, profitability, leverage, efficiency, activity or turnover ratios and the unambiguous messages from such failure-predicting equations as Altman’s Z-Score. (Refer to the yellow tab section of the Technical Reference Manual: Ratios or Formulas).
The third group of symptoms comes under the heading “creative accounting”‘ which seems to be inseparable from the phenomenon of distress and ultimate failure. A Chief Financial Officer is generally the first person to realize that their company is running into trouble and will often try to hide this fact from outsiders, colleagues, and most importantly refusing to accept the company’s distressed condition themselves.
Finally, the company passes into the period where it becomes more obvious to others that it is lost, all of the symptoms appear in ever increasing profusion, and it is in distress. Often an extremely chaotic scramble for cash occurs and finally the business falls into the control of its creditors.