Take a few moments to review this overview of the ramifications

Transcription

1 BANKRUPTCY PRIMER The Last Resort: What Happens When Your Borrower Files Bankruptcy? by J. Tol Broome Jr. Take a few moments to review this overview of the ramifications of bankruptcy, the procedures to follow, and the lender s rights and remedies. The author cautions that this article in no way is intended to be an all-inclusive discussion of bankruptcy and urges bankers to consult an attorney and/or the institution s bankruptcy department when a borrower files. Bankruptcy. The mere mention of the word makes you cringe, doesn t it? Yet the act itself has become commonplace. Whereas consumers and businesses alike once dreaded the lasting stigma attached to bankruptcy making it a last resort only after all other remedies had failed the rate of filings has increased dramatically over the past 20 years and the stigma has disappeared rather quickly. According to the American Bankruptcy Institute, in 1983 there were only 348,880 filings in the U.S. By 1996 new filings had tripled and exceeded the million mark for the first time reaching 1,178,555 bankruptcies. And in 2002 a new high was reached with 1,577,601 total filings. While some economists will tell us to take heart in a diminishing rate of increase, others tell us we could be in for a brand-new round. Either way, we must be prepared. The Federal Bankruptcy Code If not for the Bankruptcy Code, each state would be left to make its own laws and to conduct its own proceedings. However, the Code supersedes all state laws when a bankruptcy is involved. First and foremost of numerous provisions is that all creditors must cease direct U.S. Bankruptcy Filings Year Bankruptcies Business Consumer ,880 62, , ,521 64, , ,510 71, , ,438 81, , ,999 82, , ,46 563, , ,461 63, , ,960 64, , ,987 71, , ,517 70, , ,202 62, , ,829 52, , ,601 51, , ,178,555 53,549 1,125, ,404,145 54,027 1,350, ,442,549 44,367 1,398, ,319,465 37,884 1,281, ,253,444 35,472 1,217, ,492,129 40,099 1,452, ,577,651 38,540 1,539,111 Source: American Bankruptcy Institute 2003 by RMA. J. Tol Broome is senior loan administrator at BB&T, Winston-Salem, North Carolina. 78 The RMA Journal September 2003

2 contact with the debtor once a bankruptcy petition has been filed. In most cases, once the petition is filed, a trustee is appointed who becomes the liaison between the debtor and its creditors. The sections of the Bankruptcy Code most frequently used by individuals and small business owners are Chapter 7, Chapter 11, and Chapter 13. A Chapter 7 is a full liquidation of all nonexempt assets. A Chapter 11 is a reorganization, whereby a business attempts to repay as many debts as possible while continuing to function. In a Chapter 11, the business owner operates the business as debtor-in-possession without a trustee. A Chapter 13 is for individuals and proprietorships and is similar to a Chapter 11 in that the debtor makes an effort to repay as many creditors as possible, but uses personal cash flow rather than liquidation of assets. Chapter 7 A Chapter 7 bankruptcy is the quickest of the three and usually is fully resolved within about six months. However, a Chapter 7 should be filed only if the business owner sees no way to stay in business or if the individual cannot meet monthly obligations, even on a partial-pay basis. If your borrower files a Chapter 7, you will likely receive nothing if you are an unsecured creditor. Even if secured, you might not receive full payment of the debt owed. There is a seven-step process for a Chapter 7 bankruptcy: 1. Petition filed by debtor. Creditors are given an automatic stay, which means they cannot contact the debtor; taxes, child support, and alimony are not stayed; an interim trustee is appointed; and the first meeting of the creditors is scheduled. 2. Financial disclosure. At the time of filing or shortly thereafter, the debtor must provide a complete list of assets, debts, sources of income, and expenses meeting. The first meeting of the creditors, known as the 341 meeting, usually is held within 30 days of the bankruptcy filing; a permanent trustee is elected by the creditors. 4. Proof of claim. Creditors have approximately 180 days to file a proof of claim, which provides details to the trustee regarding the debt owed. A proof of claim must be filed for the creditor to collect anything from the liquidation of assets. 5. Exemptions. The debtor provides a list of exempted assets (those that will not be sold) to the trustee. 6. Order of claims. The trustee approves the order in which claims will be paid, ranging from the best secured to unsecured. Secured claims are to be paid from the liquidation of the specific collateral pledged for that debt; deficiencies on secured claims and unsecured claims are paid from what is left over usually little or nothing. 7. Sale of assets. The trustee sells all nonexempt assets and pays claims in order of priority. Exempt property in a Chapter 7. As mentioned, the debtor is allowed to exempt certain property from a Chapter 7 liquidation. This provision keeps 79

3 debtors from becoming completely destitute after a bankruptcy is filed. Exempt property claims are one area in which each state is allowed its own laws and amounts. You should consult an attorney or an up-to-date bankruptcy exempt property list in your home state to find out what assets and amounts are exempt in Chapter 7. Federal law also provides for exemptions in Section 522(d). There is a provision that allows states to opt out of the federal exemptions and establish their own. The federal exemptions are: Equity in a primary residence of up to $17,425 (known as the Homestead Exemption). Equity in a motor vehicle of up to $2,775. Your Borrower Has Filed for Bankruptcy: Now What? It is vital that you follow the right course of action once your borrower files bankruptcy. Here are 16 tips for you to follow when one of your borrowers (or any other debtor of yours) files bankruptcy: 1. Always file a proof of claim, particularly if you are a secured creditor. 2. Consult an attorney for any sizable claims ($1,000 or higher). Otherwise, you can file a proof of claim yourself. 3. As soon as you receive notice of filing or even suspect that your borrower will file bankruptcy, have your documents reviewed to ensure that your collateral position is sound. Many a bank has been blindsided by documentation deficiencies that cause a secured claim to become unsecured. 4. If the borrower is a business and still has funds in a deposit account, you can exercise your right of offset. The debtor s attorney will likely advise your borrower to move all of the deposit accounts soon after filing bankruptcy. So, you should consider offsetting while you have the chance, particularly if the borrower is filing a Chapter 7, or you think the business will likely wind up in liquidation. 5. Don t call the borrower for payment after you receive notice of the filing. You can be held in contempt of court and even jailed if you pursue a debtor after bankruptcy has been filed. If your borrower files a Chapter 13, you also can t call any joint creditors such as a spouse. 6. If your borrower is a business and is filing a Chapter 11, the debtor s attorney will require a retainer ($20,000 to $150,000 or higher, depending on the size and complexity of the company) before taking the case. In order to pay this retainer, the borrower either will build a war chest before filing or he will petition to pay the fee out of operating capital (translation: your collateral if you are secured by A/R) generated by the company post-filing. 7. If your borrower is a business, look for preferential payments to insiders, such as the owner(s) and family members. The bankruptcy court may require these payments to be returned if they occurred within 90 days before the filing. 8. In a Chapter 11 proceeding, you will become familiar with the term adequate protection. Part of the Bankruptcy Code is to provide adequate protection for secured creditors, protecting them from having their collateral position deteriorate post-filing. If your collateral position appears to be weakening as time passes, petition the court for adequate protection. 9. Have the collateral reappraised if your claim is significant. It will help to know the current market value of your collateral, which may have changed significantly since the loan was made. It is advisable to have your attorney order the appraisal so that it can t be used against the bank during discovery. 10. Inspect your collateral. If you are secured by real estate, go and tour the property. If your collateral is inventory, have a physical count done. You may find that the value on the books is substantially different from what is actually there. 11. If you are secured, you might be better off if the debtor files a Chapter 7. Sometimes it is better to liquidate now and take your lumps rather than to wait until the collateral value has deteriorated further. 12. After the plan is started, pay attention to notices. If the debt is discharged, you will receive no more payments. But if the case is dismissed, you can go after the debtor for the full amount owed. 13. If you are secured, you can file for a relief from stay to get your property out of the bankruptcy. This is particularly advisable if you are confident that the liquidation of the collateral will be sufficient to pay off your loan(s). 14. If you suspect fraud of any kind, report it to the bankruptcy court immediately. 15. Be careful what you put in file memos and s, particularly pertaining to collateral values. Your own conservative valuation of your collateral position might be used against you as the court decides how much of your claim the borrower will be required to repay. 16. Think twice before extending credit to anyone or any business that has filed bankruptcy in the past. 80 The RMA Journal September 2003

4 Books, tools, and equipment used for business of up to $1,750. Personal jewelry of up to $1,150. Other personal property (other than jewelry), such as furniture, clothes, appliances, and books of up to $9,300, but with no one item valued higher than $450. Other personal property up to $925, with an additional amount of up to $8,725 allowed to be used for debtors who do not use the homestead exemption. Prescribed health aids, such as eyeglasses, dentures, and hearing aids. Equity in a life insurance contract that has not matured of up to $9,300. Federal and state benefits, such as Social Security and other entitlements. Right to receive crime victim award payments, dependent payments from life insurance contracts, wrongful death payments, and personal injury payouts of up to $17,425. Certain pension plan payments that support the debtor or dependents. Order of claims in a Chapter 7. The trustee establishes the order of claims to be paid in a Chapter 7 filing. There generally are eight classes of claims, listed in order of priority: 1. Secured claims, which are paid from the liquidation of the assets securing those debts. 2. Administration and collection expenses, such as court fees and attorney fees. 3. Claims arising in the normal course of business after the debtor files but before a final trustee has been appointed. 4. Employee wages and salaries, with a $4,650 maximum per employee for wages earned within 90 days of filing by the debtor for whom the employees worked. 5. Payments into employee benefit plans, up to $4,650 per employee, made within 180 days of the filing. 6. Claims arising from deposits, up to $2,100 per consumer, made by individuals for goods not delivered or services not performed by the debtor. 7. Taxes and penalties due up to three years before the bankruptcy filing date. 8. All other unsecured claims for which proofs of claim have been filed. Chapter 11 A Chapter 11 bankruptcy normally is filed by a business entity. It can be done voluntarily by the business, but it also can arise from an involuntary filing brought about by unpaid creditors. An involuntary filing typically occurs when a creditor feels a debtor is taking an action that will impair its ability to repay or that will impair the value of the collateral that secures loans to the creditor(s). Chapter 11 reorganization plans often are quite drawn out in time and expense. The three key parties involved debtor, court, and creditors must ultimately come to an agreement over how the debtor will attempt to repay the creditors. There are five steps in any Chapter 11 procedure: 1. Order of relief. The bankruptcy court issues an order of relief, which essentially means that the Chapter 11 filing becomes official. The order of relief is automatic in a voluntary filing. However, in an involuntary filing, the debtor is allowed time to offer objections to the need for a Chapter Creditor committee. A committee of creditors is appointed by the bankruptcy court. 3. Reorganization plan. The debtor is given an exclusive period of 120 days to file a plan of reorganization. Extensions are often given, so this process can take even longer. The basic premise of any plan of reorganization is to get as many creditors as possible to agree as quickly as possible to a repayment plan. The creditors also may file a separate plan, or they may choose to accept the debtor s plan or suggest revisions to the debtor s plan. 4. Agreement to plan. The debtor, bankruptcy court, and creditors normally attempt to agree to the plan of reorganization. There are circumstances in which the court can approve a plan even if a creditor or group of creditors does not agree (this is sometimes called a cram down). 5. The plan of reorganization is put into action. One of three results will follow: 1) 81

5 the plan is followed and creditors are paid as stipulated therein; 2) the plan must be modified with agreement by the debtor, bankruptcy court, and creditors; or 3) the debtor is unable to comply with the plan and the bankruptcy is converted to a Chapter 7. The trustee and court monitor the plan to ensure compliance by all parties. Chapter 13 Chapter 13 of the Bankruptcy Code covers bankruptcy for individuals with regular income. A Chapter 13 petition can be filed only in cases where there is less than $290,525 in unsecured debt and less than $871,550 in secured debt. If the business is set up as a sole proprietorship and it becomes unable to pay all of its creditors, a Chapter 13 filing will become likely. It is less costly and less time consuming than a Chapter 11, which is why this option is often taken. Even if the borrower is a corporate entity, it may become necessary for the owner to file a Chapter 13 or Chapter 7 bankruptcy if the business files a Chapter 11. If the owner has run up a lot of personal debt to support the business, filing a Chapter 11 will likely decrease the salary level out of the business. Consequently, business owners often find themselves between a rock (the Chapter 11 proceedings) and a hard place (the personal creditors) and unable to pay all of the bills. As with any bankruptcy filing, creditors may not contact the debtor once a Chapter 13 filing has been taken. Secured debts generally are paid in full, unless the value of the asset was less than the amount owed at the time of filing. Unsecured creditors normally receive only a percentage of what is owed (anywhere from 5% to 90%). There are five steps in a Chapter 13 filing: 1. Debtor filing. There are no involuntary Chapter 13 filings. 2. Plan of debt adjustment. This plan includes a list of debts owed, with a proposal from the debtor, to repay all or part of these obligations. 3. Trustee appointment. The trustee ensures there is no fraud and serves as the liaison between the debtor and creditors. 4. Hearing. The debtor, trustee, and creditors come together before the bankruptcy judge to discuss the plan of debt adjustment. The judge places a great deal of credence in the input of the trustee. The judge usually approves the plan. 5. Plan implementation. The plan is followed, with creditors paid as agreed, or the debtor becomes unable to comply with the provisions of the plan and it is either modified or converted to a Chapter 7. A Chapter 13 usually takes from three to five years to carry out. Finding the Right Attorney It s vital to find the right attorney to help you through the difficult process of dealing with a borrower s bankruptcy. While any attorney can represent you in a bankruptcy proceeding, you will be well advised to find a lawyer who specializes in bankruptcy as a creditor s attorney. A bankruptcy specialist will fully understand the complicated process and the roles of and restrictions placed on the different parties involved. A bankruptcy specialist also will know the trustees, judges, and creditor attorneys, which should help the process run more smoothly. How do you find the right bankruptcy attorney for your situation? Check with other bankers in the area for references. A CPA also might be able to recommend a good bankruptcy specialist. If all else fails, call one of the larger law firms in your community and ask to speak with a bankruptcy attorney, preferably a creditor specialist. Silver Linings It is never good news to learn that one of your borrowers has filed bankruptcy. But for some well-meaning debtors, bankruptcy can be an effective last resort in an attempt to repay as many creditors as possible. If you follow the right course of action when a borrower files bankruptcy, you will maximize your chances of recovering some or all of the amount you are owed. Contact Broome at tbroome@bbandt.com. 82 The RMA Journal September 2003