Where you file bankruptcy is not supposed to make a difference, but it does. A client’s distance from the courthouse, comfort with an attorney, applicable law, practice and custom all differ from one district to the next.
The rules concerning the venue of a bankruptcy case offer debtors a variety of choices in where to file. Venue of a case is proper:
(1) in which the domicile, residence, principal place of business in the United States, or principal assets in the United States, of the person or entity that is the subject of such case have been located for the one hundred and eighty days immediately preceding such commencement, or for a longer portion of such one-hundred-and-eighty-day period than the domicile, residence, or principal place of business, in the United States, or principal assets in the United States, of such person were located in any other district; or
(2) in which there is pending a case under title 11 concerning such person’s affiliate, general partner, or partnership.
This language can be interpreted to permit a bankruptcy case to be filed where the debtor:
Lives
Intends to live permanently
Works
Has most of their property
Has a related person or entity that has already filed for bankruptcy
Under this language, a creative attorney may be able to file a bankruptcy case in multiple places, without too much stretching of the facts. The more careful principles are the timing elements.
The venue rules require that the debtor satisfy one of the bullet points above for the 180 days before the bankruptcy case is filed or for a longer period during that 180 days than any other period. This language means that during a period of a client’s transition, for ninety-one days venue will still be available in a desired jurisdiction.
An excellent example of this would be a client who has just done a short sale of her home in Maryland, goes to school and lives in Pennsylvania, has a job in Delaware but intends to join her husband after graduation in California. For 89 days after her short sale closes she can file a bankruptcy case in either Maryland (principal assets), Pennsylvania (residence) or Delaware (principal place of business). She may also argue that because she intends to permanently reside in California with her husband, that she can file her bankruptcy case there (domicile).
Once the 90th day after her short sale passes, she may no longer qualify to file in Maryland if her principal assets were not in Maryland for a longer period of the last 180 days than any other district.
Why does any of this matter? The place where a debtor may claim exemptions seems to be of greater substance than the place of filing, but many other factors come into play too. Sometimes a debtor wants to be away from his creditors, other times a debtor may want to be close to them. A debtor’s primary attorney may favor one jurisdiction over another, or a debtor will want to be closer to a financing source. Depending upon the type of case, a business debtor may want to be in a jurisdiction that is known for favoring complex cases while others may want to be where the employees reside. Some clients avoid certain venues out of fear that they will randomly be assigned a judge they perceive to be hostile to their company or industry.
Whatever the choice, the place of filing is another factor to consider in moving forward with a well planned bankruptcy.
Chapter 7 of the Bankruptcy Code offers extraordinary relief: a fast track to walk away from all dischargeable debts. My clients are often stunned by the scope and the speed of the Chapter 7 process, because most cases are successfully closed, with discharge entered, less than 120 days after filing.
There is a bar to this relief however: the means test. If your income is above the median for your state and you don’t meet the statutory threshold even after filling out “the long form”, the door to Chapter 7 will be shut to you.
An important exception to this rule is that debtors who owe mainly non-consumer debt don’t have to fill out the long form, even if their income is way over median. The Bankruptcy Code tells us that if your debts aren’t primarily consumer debts there will be no “presumption of abuse” that the debtor will need to overcome to enjoy the benefits of Chapter 7. The definition of consumer debt is:
Debt incurred by an individual primarily for a personal, family, or household purpose.
Taxes, real estate investments gone bad and business debt are all non-consumer debts. So if you’re filing bankruptcy to get out from under defaulted real estate loans when the property is worth way less than what’s owed on the mortgage, and you don’t owe as much on credit cards or your home loan, then you won’t have to fill out the long form.
But that’s not necessarily the end of the story. Every bankruptcy case requires the debtor to file in good faith. If the bankruptcy judge finds that a case isn’t filed in good faith, that case can be dismissed.
The phrases “good faith” and “bad faith” aren’t defined in the Bankruptcy Code but courts have long repulsed debtors who flaunt their wealth:
The ability to repay debts, living an expansive lifestyle beyond one’s means, and singling out a major creditor for nonpayment are factors that merit dismissal for bad faith.
Courts may find a lack of good faith when a debtor fails to make candid and full disclosure.
A number of courts have dismissed Chapter 7 cases when it appears that a debtor is living a lavish lifestyle while making no legitimate efforts to repay their debts.
Evidence of a lavish lifestyle may be maintaining a vacation home, driving a luxury vehicle, making substantial retirement fund withdrawals, or even sending children to expensive private schools. When debtors are attempting to discharge hundreds of thousands or even millions of dollars in business debt, a bankruptcy court will, if asked, consider whether those debtors are making any legitimate effort to pare down their lifestyle.
If the court finds that the debtor has failed to make that effort, the result may be that a debtor is forced into Chapter 13 or, if their debt exceeds the statutory limit, Chapter 11. Filing a Chapter 11 case may be a disaster for individuals, because the administrative costs (filing and attorneys’ fes) are much higher and creditors have a greater voice in the treatment of their claims.
The trend in bankruptcy courts across the country is that if a debtor is going to ask creditors to suffer due to nonpayment of their debts, the debtor will also need to share that pain. Refusal to take on that burden may very well lead to denial of Chapter 7 relief.
The mortgage and foreclosure crisis that continues to sweep our country has been national news for almost five years. Media accounts tell different sides of the suffering and the attempts to alleviate the suffering. Neighborhoods, towns and even cities are threatened with long-lasting blight and devastation as homes become vacant and vandalized. Legislators draft emergency laws to force mortgage servicers to become more accountable to homeowners seeking modifications. States’ Attorneys General sued the major servicers, Bank of America, Wells Fargo, Citi, Chase and GMAC, and settled for $25 billion, apparently with mixed success.
Anecdotal horror stories abound, with homeowner after homeowner describing their nightmare experiences from within the loan modification labyrinth. The President of the United States has announced several programs trying to help the problem. Bank of America conducted a national moratorium on foreclosures. Courts around the country attempted to interpose mandatory mediation before a foreclosure case could proceed. Short sales of underwater homes have become commonplace.
While all of these views through the prism of this national disaster describe our collective efforts to lessen the pain of the ordeal, few voices have been heard trying to describe what our country will look like after we emerge from the crisis. What flaws in our culture lead to this catastrophe and what needs to change in the way Americans buy homes, develop property, and raise our families?
Early in the crisis, the Museum of Modern Art in association with The Temple Hoyne Buell Center for the Study of American Architecture, Columbia University, New York, recognized that daring and visionary minds needed to scrutinize the underlying assumptions of success and self image that cause the phrase “The American Dream” to automatically translate into a tableau of a detached single family home in a residential subdivision with a lawn, a driveway and a white picket fence. MOMA assembled a series of teams to study the foreclosure rates and the problems besetting five diverse “inner ring” suburbs: Cicero Illinois; Orange New Jersey; Rialto California; Temple Terrace, Florida; and Keizer, Oregon. This study resulted in en epic exhibit that displayed at MOMA through the summer of 2012 and a 182 page companion volume entitled Foreclosed: Rehousing the American Dream. The companion book explains that before long, the MOMA teams discovered that
[T]here is scarcely such a thing as a typical suburb anywhere but in the American imagination. This imagination is in a state of shock and anxiety brought on by the collapse of the model of economic growth and abundance that has fueled the American suburban dream for the last sixty-five+ years – by scenes of houses boarded up even in formerly affluent areas, of neighbors in foreclosure, of houses worth less than the outstanding sums on their mortgages.
[The exhibit] sets out to address this complex national emergency, at once a cause and a symptom of the mortgage-default crisis, on which the project seizes as a rare chance for fresh thinking. While architects, urban and landscape designers, and infrastructure engineers can do little directly about the problem of foreclosed mortgages and households “under water” (that being a crisis of the financial architecture of America), they can address the risks of a downward spiral of disinvestment in suburbs.
Foreclosed, page 12. The teams’ vision of these reinterpreted suburbs is breathtaking:
New Jersey: The Oranges
Despite Orange’s accessibility – commuting time to New York averages twenty-five minutes by car or forty minutes by train – there is a significant rate of foreclosure there, and a high rate of unemployment. The Foreclosed team noted that some 15% of the land within a half mile radius of the Orange train station is publicly owned, either as municipal property, in buildings such as schools, or as vacant lots. In addition, some 22 percent of the site is occupied by public streets and sidewalks, laid out in a traditional gridded town plan. Having calculated that annual maintenance expenses for infrastructure exceeds $640,000, the team proposed eliminating many streets and replacing them with new, three story high, mixed use structures offering a mixture of commercial, office, and residential spaces. The proposal is intended to reduce the tax burden on an economically challenged city and to redevelop the street as a new economic engine.
Florida: Temple Terrace
Temple Terrace, located near Tampa, is a town of 22,653 that has been following a development model focusing on the creation of a “downtown” through a public/private partnership to redevelop 225 acres around a major intersection near the city’s southwestern border with neighboring Tampa. The town is a classic low-density city/suburb of primarily single-family houses, and has been hit hard with a foreclosure rate approaching 7.4%, with 30% of homeowners paying more than 30% of income on housing, the normal upward limit for the housing expense in a family budget.
The MOMA team sought to reinterpret the 225 acres by reconfiguring a two-mile-long commercial site that would increase population by more than 10,000 people, adding a new, linear town center designed to ease a daily life led with recourse to cars.
Illinois: Cicero
Cicero is an aging inner-ring suburb set on the edge of metropolitan Chicago, and along freight rail lines predicted to increase in capacity. It has lately become an arrival point for new immigrants to the region, the great majority of them Mexican and Central American. Cicero has experienced a high rate of foreclosure.
The MOMA team, Studio Gang Architects, believed that
“The American Dream has always been about the freedom to remake oneself. America used to support that goal, but now impediments have been put into place. Our project is trying to remove those impediments. The American Dream for new arrivals is not about escaping the city for a rural refuge, it is rather a dream of opportunity, education, starting a business, helping one’s children succeed.”
The team set out to create new housing types able to mix families and generations living and working, in ways that are generally prohibited under existing zoning codes.
Oregon: Keizer
Keizer is a suburb of Portland that lies between Eugene, Oregon and Seattle, Washington. The key characteristics of Keizer, Oregon, the site selected in the Pacific Northwest, include a significant poverty rate and a relatively diverse racial makeup.
WORKac, the MOMA team exploring solutions for Keizer asked “what if we could live sustainably and close to nature?” They discovered that cities in Oregon are required by law to establish an urban growth boundary to protect open land outside city borders. This encourages densification within existing boundaries and retains otherwise highly desirable forest or farmland.
WORKac proposed reversing the 2010 sale of 28 acres for development with a series of big box stores and instead designed a model to bring higher density and more sustainable living to the metropolitan edge. This vision of suburban living combines the density generally associated with large cities with a direct connection to nature.
California: Rialto
Rialto, in San Bernardino County, is emblematic of the California housing crisis, where years of rapid increase of housing prices was followed by the implosion of value and a torrent of foreclosures. In this community of nearly 100,000, the foreclosure rate is 11.4% and 48% of their population is paying more than 30% of their income towards housing.
A conspicuous symbol of the housing failure is Rosena Ranch, a large residential subdivision under planning and construction since 2004. Since 2008 work has ground nearly to a standstill. At one end of the site, only 10% built, nearly identical large-scale houses stand right on top of each other. At the other end snake acres of terraced but unbuilt lots.
The MOMA Rialto team, Zago Architecture, set out to “relax the boundaries” of suburbs as found, creating a richer mix of uses, housing types, living situations and landscapes than the “serial repetition” of individual homes with a driveway and a patch of lawn.
Two Sides, Same Coin
Lawyers, judges, mediators and bankers constitute the “financial architecture” of America trying to work our way through this crisis. As we labor through, we should not lose sight of the vision from Foreclosed: Rehousing the American Dream of the architects, urban and landscape designers, and infrastructure engineers who are attempting to rethink our suburbs and free the American Dream of its bonds to single family detached homes.
The answer to this question will depend on your home state. Some states are judicial foreclosure states, some states are non-judicial foreclosure states, and some states like Maryland are quasi-judicial foreclosure states.
Judicial foreclosure: Delaware, Pennsylvania. In a judicial foreclosure state, the lender will file a complaint seeking a money judgment and mortgage foreclosure. This is very much like a conventional lawsuit. The homeowner has the opportunity to file an Answer to the complaint and assert any possible defenses.
Most of these cases are resolved by entry of a default judgment (if the homeowner doesn’t answer) or summary judgment (if the homeowner does file an answer but there are no legitimate defenses to the foreclosure). Once the lender has a judgment they need to enlist the sheriff to schedule a sale. The sheriff’s sale is usually done at the sheriff’s office in a large public room. That process can take about six to ten months from start to finish.
Some states require a lead time before the lender can actually file the complaint. In Pennsylvania the lender is required to give 33 days. In states like Delaware, the lender actually has to have a mandatory mediation to give the homeowner a chance to negotiate a loan modification. The mediation can add 60 days or more to the process. This time is added to the six to ten months that will run before a homeowner will lose the right to stay in the home after default.
Non-judicial foreclosure: Virginia. In an non-judicial foreclosure state, like Virginia, foreclosure and eviction can happen very quickly because the courts do not get involved in the process. Many mortgages in Virginia require lenders to give homeowners a 30-day notice and right to cure before beginning the process. Failing a cure, and depending upon the language in the mortgage or deed of trust document, the creditor can schedule a foreclosure sale and have the sale after publishing in a local newspaper after two, three or four weeks. A commissioner reviews the sale and expenses and a deed can be transferred approximately thirty days after sale.
Quasi-judicial foreclosure: Maryland. In Maryland there are more complex rules. A lender can’t file a complaint (called an Order to Docket) before the later of (a) 90 days after default or (b) 45 days after sending the homeowner a Notice of Intent to Foreclose. The lender must wait another 45 days after service of the Order to Docket on the homeowner (if the lender can’t serve the homeowners after attempts on two different dates, the lender can post the Order to Docket on the home). Just as in Delaware there’s an opportunity for mediation in Maryland, but unlike Delaware the process is not mandatory; the homeowner must ask for a stay of the foreclosure sale to allow mediation to proceed if the lender does not agree.
Under some timelines, up to 270 days must pass before there’s going to actually be a Maryland foreclosure, and even then a court must ratify the sale, the buyer needs to go to settlement and, if the homeowner refuses to leave, obtain a court order to evict the homeowner from the house. It is not surprising in Maryland for a homeowner to be able to remain in a home for a year or more after default.
In all of these jurisdictions a homeowner may file a Chapter 13 bankruptcy case to stop the foreclosure sale and attempt to cure the default over 60 months so they can keep their home. Many people file that bankruptcy right on the eve of the foreclosure sale so that, even if the bankruptcy ultimately fails, they can maximize the time they can stay in their home.
Don’t Panic: Bare Legal Title May Keep Property Out Of Bankruptcy
Sometimes it’s convenient to add the name of a parent, child or sibling to property or a bank account. Usually done for estate planning purposes, co-ownership of property allows title of the asset to pass seamlessly from one person to the other upon death, or allows a younger person in the family to manage cash or securities for the benefit of an elderly parent or grandparent.
Under the U.S. Bankruptcy Code, a trustee has the right to liquidate all the debtor’s assets for the benefit of creditors. Frequently when planning a bankruptcy, clients want to know whether they should take someone’s name off property or a bank account before filing, and that answer will depend upon the specific circumstances of the case. More often, however, clients don’t realize that they are in title to an account or a home, and questions come up when filling out the schedules (or getting ready to meet with the trustee) about how to deal with this property. This property is likely (though not always) saved from liquidation by the trustee under the principal of “bare legal title.”
Bare legal title occurs when someone has a purely legal, but not equitable, ownership interest in an asset. If a person holds title in their name but has done nothing to contribute to the value of the asset, that person may be found to hold no equity in the asset. (Of course, assets obtained by gift or inheritance don’t count, because the person was intended by the donor or by operation of law to have all rights and privileges with respect to that asset, either now or in the future. ) It’s usually clear that if a child has never made any deposit into a parent’s bank account and has never withdrawn any funds for their own use, that child only holds bare legal title to the account and the trustee won’t be entitled to seize that money in the child’s bankruptcy. Similarly, if a child deposits the down payment on a house and makes all the mortgage payments, if the child keeps the parent’s name on the house for convenience purposes then the trustee in the parent’s bankruptcy shouldn’t be able to sell the house and pay the parent’s creditors.
On the other hand, sometimes the holder of legal title does help the “real owner” of the asset obtain or improve the asset, and when that happens the “bare legal title” defense will fail. A common example occurs when a parent agrees to co-sign a loan for the child to buy a house or a car. The child puts up the down payment, makes all the loan payments, pays all maintenance and is in sole possession of the vehicle. This seems to be a good case for the parent to claim that her title of the vehicle is legal only. When the parent files for bankruptcy she will argue that the trustee should not be allowed to sell the car. This argument is likely to fail because the parent exposed her credit in order to allow the child to obtain the vehicle. Although the parent has not contributed any cash, use of the parent’s credit is enough to defeat a claim for bare legal title to the vehicle.
Recognizing that an asset is protected under the bare legal title doctrine may prevent a debtor from taking potentially damaging action in preparation for bankruptcy. Transferring property out of a debtor’s name on the eve of bankruptcy may draw scrutiny as to a debtor’s good faith and thereby lead to litigation seeking to deny a discharge. Losing a discharge because of a pre-bankruptcy transfer of property of no value to a debtor would be a disastrous result. Even if the debtor is victorious, defending that lawsuit will cause the debtor to waste needless time, money and stress.
A better solution would be for the debtor’s attorney to carefully analyze whether the bare legal title doctrine is applicable and if so, disclose the asset in the debtor’s schedules with a statement that the property is held in bare legal title. Usually, the trustee will leave that property alone. On the other hand, if the doctrine does not apply, the debtor may need to delay filing the bankruptcy, file a different chapter than they initially planned, or else try to settle with their creditors.
Learning the truth about a bankrupt debtor’s finances can sometimes become a daunting task. Even if debtors don’t hide their assets or conceal their transfers, the complexity of even fairly simple economic transactions frequently require a deep study of a debtor’s books and records. For this reason, the federal bankruptcy laws provide for a number of ways to discover and, if necessary, expose a debtor’s financial life.
First Source of Information: Debtor’s Required Submissions
The first method is the debtor’s fundamental obligation to disclose assets, liabilities, income, expenses and other financial information in the Schedules and Statement of Financial Affairs. The schedules form the initial basis into any examination of the debtor’s financial condition. The schedules need to be filed with or within fifteen days of commencing the bankruptcy case, but the bankruptcy court will regularly grant extensions provided that the schedules are filed at least a few days before the regularly scheduled meeting with the trustee (also called the First Meeting of Creditors or the 341 meeting). Typically, the Schedules and Statement of Financial Affairs offer all the information most creditors need to close their files.
Meeting of Creditors: More “Free Discovery”
Creditors will have the opportunity for more “free discovery” at the meeting with the trustee, where the debtor will have to answer questions under oath. Because the proceedings are open to the public and usually involve several cases being scheduled for examination at the same time, in chapter 7 or 13 cases the trustee may limit creditor questioning, or else move the case to the end of the docket. The debtor’s testimony is recorded on an electronic digital recorder and is available in an mp3 audio format.
Rule 2004 Exam: Fishing Expedition
When parties seek more comprehensive information, or when information is sought from non-debtors, the best technique is to ask the bankruptcy court for permission to take an intensive deposition under Bankruptcy Rule 2004 (for this reason, these examinations are generally called 2004 Exams). When requesting a 2004 Exam the party seeking information may ask the Bankruptcy Court to order production of documents, testimony under oath or both.
Courts routinely issue orders authorizing highly intrusive 2004 Exams of debtors. This makes sense, because Rule 2004 itself states that the scope of a 2004 Exam “may relate only to the acts, conduct, or property or to the liabilities and financial condition of the debtor, or to any matter which may affect the administration of the debtor’s estate, or to the debtor’s right to a discharge.” An expansive review of the debtor’s financial condtion could include review of the following documents, at least:
bank statements for all accounts and canceled checks; check registers; tax returns; any financial reports, profit and loss reports, cash flow reports or general ledgers; payroll records; documents evidencing any loans given or received; paystubs; accountant notes or correspondence; credit card statements; documents evidencing incorporation or any amendment to a charter or similar authority to conduct business as an entity; promotional materials, including brochures, flyers, websites, emails or any other item that may appear in either printed or electronic medium that was created or disseminated to assist in the promotion of a business
In question 18 of the Statement of Financial Affairs the debtor needs to disclose information pertaining to businesses that the debtor has owned or managed within the six years prior to filing the bankruptcy case. As a result, an examining creditor may seek document production beginning six years prior to the petition date.
Debtors may complain that a creditor’s examination is nothing more than a “fishing expedition”, but in truth this kind of open ended inquiry is precisely the point of the examination. Debtors frequently lose sight of the truth that the opportunity permitted by the Bankruptcy Code to restructure or discharge debt is extraordinary. Part of the price that debtors pay for that opportunity is complete, accurate and, if necessary, exhaustive disclosure. In all of the relief chapters of the Bankruptcy Code: Chapters 7, 9, 11, 12 and 13, debtors have an inherent obligation to file their cases in good faith. In chapter 7 especially, the chapter of the Bankruptcy Code that offers debtors the greatest possible relief, debtors have a heightened obligation to provide information. Debtors, for example, cannot receive a discharge under Chapter 7 if they have “failed to explain satisfactorily, before determination of denial of discharge under this paragraph, any loss of assets or deficiency of assets to meet the debtor’s liabilities.” This penalty applies whether or not the debtor has acted maliciously or fraudulently. In exchange for receiving the benefits of bankruptcy debtors must be prepared for a deeply detailed examination of documents and a deposition under oath.
The real power of a Rule 2004 Exam, however, is the right of debtors or other parties in interest to examine non-debtors. Although these examinations are limited in scope and must be authorized by the bankruptcy judge, they provide an extraordinary opportunity to obtain documents and depose any person or entity that is related to the debtor. A perfect example of this power is the right of a debtor/minority shareholder to compel production of documents for the ostensible purpose of valuing the debtor’s shares. Under state law, a minority shareholder would have to file a lawsuit to compel an accounting to discover information about the corporation. In bankruptcy, on the other hand, the trustee or debtor may simply file a brief motion with the bankruptcy court to obtain as much if not more information than would be available in the state courts.
Landlords, banks, credit card companies, spouses, CPAs and others with information relative to the debtor’s financial condition are all vulnerable to being heralded before the bankruptcy court to disclose that information, even without a lawsuit pending. Under the bankruptcy rules, in addition to obtaining a court order these non-debtors must be personally served with a subpoena in order for the bankruptcy court to obtain jurisdiction to compel the production. Failure to honor the subpoena will open the door for sanctions and contempt of court.
The Rule 2004 procedure puts real teeth into bankruptcy court discovery. However, when there are actual contested matters, adversary proceedings or other lawsuits pending in the bankruptcy court the parties must resort to the normal discovery rules permitted under the Federal Rules of Bankruptcy Procedure such as interrogatories, requests for production of documents, requests for admission, depositions, etc. In these matters the normal scope of discovery relevance applies, that is the information may lead to the discovery of admissible evidence. This scope may coincide with the scope of a 2004 examination, but that Rule 2004 procedure is not available.
To Examine Or Not To Examine, That Is The Question
Filing bankruptcy is usually the end of the road for most collection efforts, but creditors can’t know that for certain unless they take steps to learn more about the debtor. Nobody wants to throw good money after bad, but if there’s enough money at stake and the creditor has the means, deposing the debtor under Rule 2004 may provide an unexpected return on investment.
The vast majority of bankruptcy cases begin when a debtor files a petition seeking relief from creditors. This document is known as a “Voluntary Petition” and usually results in the bankruptcy court assuming jurisdiction over a debtor’s assets and, in the case of an individual, entry of an order discharging pre-bankruptcy debts.
Debtors are not the only parties who have the power to enlist help from the bankruptcy courts. Under the right circumstances, creditors can file an Involuntary Petition and force the debtor to address issues of insolvency and the dissipation of assets. The following are the main threshold requirements to initiate an involuntary bankruptcy case:
If the debtor has more than eleven creditors, three creditors can join together to file an involuntary bankruptcy petition. These creditors are known as the “petitioning creditors.” If the debtor has eleven or fewer creditors, only one creditor is required. In practice, between normal utility, cell phone, credit card, employee, mortgage and other claims most debtors will have more than eleven creditors.
The debtor is generally not paying its debts as they become due, unless such debts are the subject of a bona fide dispute as to liability or amount. A bankruptcy court will examine the debtor’s overall financial health. If the debtor simply cannot keep up with its bills the court will be much more likely to approve an involuntary bankruptcy than if the petitioning creditors are disgruntled claimholders with whom the debtor is in litigation. .
The three creditors must have noncontingent debts. These debts must not be personal guaranties or other claims that will not mature until some other event occurs to trigger liability.
The debts of the petitioning creditors must not be subject to a bona fide dispute. Creditors cannot use the involuntary bankruptcy procedure as a litigation tactic.
The aggregate amount of the unsecured claims of the petitioning creditors must be more than $14,425. Involuntary bankruptcy is a remedy for unsecured creditors, not secured creditors who may foreclose on or seize collateral to obtain repayment of their claims.
Creditors most commonly use the involuntary bankruptcy procedure when the debtor has transferred, or is likely to transfer, assets that will diminish the creditors’ likelihood of being paid. For example, if the Debtor has made substantial transfers to insiders without adequate consideration, a bankruptcy trustee may recover those transfers for up to four years, depending upon the law of the applicable state. Similarly, if a debtor has repaid creditors substantial sums within the prior 90 days, a trustee can recover those payments as preferences.
On the other hand, sometimes creditors have concerns that a debtor will transfer significant assets, or even the debtor’s entire business operation. If a creditor obtains this kind of information the creditor may seek similarly situated creditors and commence an involuntary bankruptcy case by filing a petition with the bankruptcy court.
Filing an involuntary petition is similar to filing a federal court complaint. The debtor has thirty days after service to contest the validity of the filing. As shown from the list above, debtors may have many grounds to resist the bankruptcy filing. However, if the creditors prevail at a trial on their petition, the court will enter an order for relief and appoint a Chapter 7 trustee to begin the process of administering the debtor’s assets. At that point, the debtor has the right to convert its case to Chapter 11 (or 13, if the debtor is an individual) in order to reorganize its affairs.
The filing of an involuntary petition is often a double edged sword for creditors. On the one hand, the filing creates an automatic stay that prevents creditors from taking any steps to collect on their claims. Thus no foreclosure, lawsuit or asset seizure may occur after filing an involuntary case.
On the other hand, until the bankruptcy court enters the order for relief the debtor’s activities are not restricted. Thus the debtor can continue to buy and sell assets and even transfer assets without consideration. However, if the court views these activities as severely prejudicial to creditors’ rights, or even if the petitioning creditors can establish that the debtor has committed fraud or other abusive acts, the court has the power to appoint an interim trustee even without entering an order for relief. Under those circumstances, the debtor will lose control of its assets.
It is not surprising that the filing of an involuntary bankruptcy may have disastrous effects on the debtor’s business. The adverse publicity of a bankruptcy case, along with the cost of contesting an involuntary petition, may cause significant damage to the debtor. In light of these potentially dire results, the bankruptcy code provides significant remedies for debtors who ultimately prevail against an involuntary petition. If the petition is dismissed debtors may obtain costs or a reasonable attorneys’ fee. If the court rules that the involuntary petition was filed in bad faith, the court may award the debtor any damages caused by the filing or punitive damages.
Under the right circumstances, when the debtor’s actions are causing creditors to lose significant value to repay their claims, the filing of an involuntary bankruptcy may result in a significant recovery and prevent years of costly and futile litigation. However, the prospect that a debtor may receive an award of its attorneys’ fees even against petitioning creditors who act in good faith should cause creditors to carefully analyze all the elements and likely defenses before filing that simple two page involuntary petition.
Towards the beginning and towards the end of a Chapter 11 case the debtor must summarize its financial condition for creditors and the court. In the beginning, the debtor files schedules of assets and liabilities and a statement of financial affairs. These documents are often creditors’ first look at the debtor’s inner workings and are designed to give creditors insight into the prospect of, and possible sources for, repayment for their claims.
The disclosure statement appears towards the finale of the Chapter 11 case and has a different flavor than the schedules and statement of financial affairs. While the earlier documents are intended to be objective, black and white expressions of facts, a disclosure statement frequently provides the debtor’s point of view regarding how it fell into bankruptcy and why the creditors should approve the debtor’s exit plan of reorganization.
The filing of a plan of reorganization is an important milestone event in the life of a Chapter 11 case. The business (or the individual with a complex or sophisticated financial situation) is offering creditors the first view of how much the debtor intends to pay and over what period of time. The debtor may propose to restructure secured debt and pay considerably less than the face amount of unsecured claims. A plan of reorganization may also contain provisions for non-economic measures such as providing an injunction against the enforcement of creditor’s rights against third parties, such as officers or other guarantors.
If a plan of reorganization proposes to impair a class of creditors, those creditors have the right to vote to accept or reject the plan. The Bankruptcy Code does not contemplate that these creditors will need to fly blind in making this decision: the debtor is required to furnish those creditors with information concerning the debtor’s past, present and future. The debtor must compile this information within a disclosure statement.
The disclosure statement must contain adequate information to enable a typical voting creditor to make an informed decision whether to accept or reject a plan of reorganization. It is a vital part of a bankruptcy court’s function in a Chapter 11 case to make a determination whether the debtor’s proposed disclosure statement satisfies this threshold. The minimum requirements will generally be:
A balance sheet
An income statement
A pre-bankruptcy history of the debtor’s operations
Reasons for filing the Chapter 11
Post-bankruptcy events, including litigation
A description of the debtor’s officers and management, with their compensation
Projections of the debtor’s anticipated post-Chapter 11 performance
Alternatives to the plan
A disclosure statement therefore becomes a much more living document than the debtor’s schedules and statement of financial affairs. The disclosure statement offers the debtor the opportunity to explain why the business faltered and why creditors should trust debtor’s management to fix the problems. The disclosure statement also allows the debtor to tell its side of the story, to a point, regarding any significant litigation that may have occurred during the Chapter 11 case.
Most importantly, the disclosure statement explains the debtor’s view of alternatives to the plan. The primary alternatives are typically dismissal of the bankruptcy and conversion of the case to Chapter 7. In most cases, the debtor can make a persuasive case that both of these alternatives will spell disaster for creditors.
Certainly, the debtor will explain that dismissal of the Chapter 11 case will allow creditors unrestricted ability to dismember the debtor by foreclosure on secured claims or execution on judgments obtained (or expected to be obtained). While this result may be appealing to the aggressive creditors who may have motivated the Chapter 11 filing by their enforcement actions the debtor should expect that the majority of its creditors will be concerned that such actions would leave nothing to satisfy the bulk of the debtor’s existing claims.
On the other hand, the debtor’s task in comparing the plan to a Chapter 7 liquidation may prove more complex. For this alternative, the debtor will need to convince creditors that the value of the debtor’s promise to make a stream of post-Chapter 11 payments is more valuable than the liquidation value of its assets. When these assets are fully encumbered by a secured bank or finance company (or the IRS) this task is relatively easy: in a Chapter 7 case the lender will almost certainly be able to obtain relief from the stay in bankruptcy and foreclose on its collateral, leaving unsecured creditors with nothing. Under that circumstance, unsecured creditors should be expected to fully support the debtor’s plan.
However, when no such secured debt exists and the assets are freely available to unsecured creditors, the debtor’s task becomes more challenging. In that case, the debtor will need to bolster its proposed stream of payments to in effect buy back from the creditors the equity in its assets, as well as pay a premium. This premium is necessary because the debtor is, in effect, gambling that its post-Chapter 11 performance is more valuable to creditors than straight liquidation.
The creditors, however, are really the players at risk because they may suffer the decrease in the value of the debtor’s asset base as the debtor labors to satisfy a stream of payments that frequently extends for several years. In this circumstance, the debtor must explain in the disclosure statement that it is likely to be able to maintain the payments, and that the payments are much more valuable than the liquidation value of its assets.
The bankruptcy court will closely monitor these elements of the disclosure statement. The standard for approval is fairly high. The debtor may not file a plan of reorganization and disclosure statement for many months or even years after commencing the Chapter 11 case; creditors may well have written off the debts. In that case, a creditor may be expected to believe that any recovery is better than no recovery, and therefore simply send in its ballot accepting the plan without much analysis. Courts will require that debtors include substantial financial information in the disclosure statement to make sure that the creditors are reasonably informed in casting their ballot.
Once the court approves a disclosure statement the debtor will send each creditor a packet including the plan of reorganization, the disclosure statement, a ballot, notice of the hearing to consider confirmation of the plan and deadlines for submitting their ballots or filing objections to the plan. This is an exciting time for the debtor as it seeks to successfully emerge from Chapter 11, made possible only by expending the time and effort needed to compile its information-rich disclosure statement.
Chapter 11 is a powerful tool to help businesses and high income individuals restructure their debt. The ability to modify secured claims, reject burdensome leases and negotiate steep creditor discounts create unparalleled opportunities to give new life to struggling debtors. However, the right to reorganize is not absolute: debtors need to be able to prove that they can identify sufficient profits to make some meaningful distribution to their creditors. Most Chapter 11 cases fail, for one of the following reasons:
Losing Money. Turning distressed companies profitable is the primary goal of Chapter 11. The central reorganizing philosophy is that if a business has breathing room from creditors and can focus on its core business lines, it has the best chance to make more money than it spends. Once a company shows a track record of profitability in Chapter 11 it can propose a plan of reorganization detailing its proposed repayment of creditors.
Unfortunately, many companies never achieve profitability. Instead, high operating expenses, low margins and cash flow crises result in prolonged losses. Debtors need to report these losses in monthly operating reports filed with the Bankruptcy Court. Once these losses are spotted by a bank, a creditors committee or the Office of the United States Trustee (a division of the US Department of Justice charged with overseeing the entire bankruptcy system) the debtor should expect to soon face a motion to convert the Chapter 11 case to Chapter 7. If a debtor has significant assets, continuing losses will erode that asset base and reduce the recovery available to creditors if those assets need to be sold. Of course, a debtor’s management wants to remain in control with its assets intact; otherwise, the business must close. Therefore the debtor is more than willing to sustain losses in the hope that the business will turn itself around. However, keeping the doors of a business open while liabilities continue to mount means that the company is gambling with creditors’ money. Neither creditors nor the Court will permit a reorganization to go on for very long when business losses threaten to obliterate the debtor’s asset base.
Fraud or Mismanagement. Chapter 11 and the bankruptcy system as a whole are based largely on the honor system. A debtor sets out its assets, liabilities, and statement of financial affairs under penalty of perjury. The bankruptcy world tends to take most of these representations on faith because it would be prohibitively expensive to verify each and every financial statement a debtor makes in the bankruptcy case. In Chapter 11 specifically, debtor’s management remains in place once the bankruptcy case is filed. Management assumes the role of “debtor in possession” with all the powers of a trustee. As a fiduciary, the debtor’s management owes the highest duty of care and honesty to its creditors.
At the same time, debtors face constant anxiety that their shaky finances will collapse and they will lose the protections from creditors. Moreover, debtors frequently want to retain as many assets as possible while paying as little as they can to creditors. This imbalance of goals and allegiances frequently cause debtors to compromise their integrity. However, once the trust is gone the debtor’s control over its assets will quickly follow. If a creditor can prove that the debtor has mislead creditors or the court a bankruptcy judge will not hesitate to convert the reorganization case to a Chapter 7 liquidation (although sometimes, if the debtor retains significant valuable assets, creditors will request that the debtor be liquidated under the supervision of a trustee in Chapter 11 instead of Chapter 7).
A Powerful Enemy. In Chapter 11, creditors have the right to vote to accept or reject their treatment under a plan of reorganization. Although the debtor may force some of its rejecting creditors to accept proposed treatment, frequently the configuration of creditors and claims will vest in a single large creditor the right to control whether a plan is approved by the bankruptcy court. Such a creditor may be a bank with a large unsecured deficiency claim or a litigation adversary who has (or is likely to get) a large judgment. If this powerful creditor is hostile to the debtor it may become impossible for the debtor to obtain approval of a Chapter 11 plan. In that event a bankruptcy judge will likely find that cause exists to convert the Chapter 11 case to Chapter 7.
For most businesses, conversion to Chapter 7 is a death sentence. A trustee will be appointed and will be looking to quickly liquidate the debtor’s assets for cash. The debtor’s management will lose control of the business. Sometimes, if the trustee believes that the officers have been dishonest he will sue the officers for recovery of compensation or for errors and omissions. In any event, conversion to Chapter 7 will generally signal the end of a debtor’s hopes to save the company.
Most debtors believe that once they receive a discharge in bankruptcy and their case is closed they can put their troubles behind them. While that’s true almost all the time the bankruptcy code does leave the door open for creditors to complain that the discharge was obtained as a result of fraud. Like many other provisions of the bankruptcy code the timeframe for bringing these actions is somewhat compressed.
The procedure for debtors obtaining a discharge in bankruptcy is fairly straightforward. At the beginning of the bankruptcy case the debtor submits schedules of assets and liabilities and a statement of financial affairs. These documents attempt to accurately and completely portray the debtor’s financial condition. The debtor signs these documents under penalty of perjury and they become open to the public.
Approximately 30 to 40 days after filing a case the debtor meets with a Chapter 7 trustee. (Although this meeting is technically called the “first meeting of creditors” creditors almost never attend.) Creditors and the trustee then have 60 days after the first meeting of creditors to complain to the bankruptcy court that the debtor should not receive a discharge or that individual claims should not be discharged and should survive the bankruptcy case. This 60 day period is strictly enforced and if no complaints are filed during that time the bankruptcy court will promptly award the debtor a discharge.
Almost every chapter 7 case results in the debtor receiving a discharge. At the same time, almost every chapter 7 case is a “no asset case” where the trustee does not identify any assets to be liquidated to cash for distribution to creditors. If the case is a “no asset” case, the bankruptcy will be closed promptly after the debtor receives a discharge. However, this is not always the end of the story.
Within one year after entry of the discharge the trustee, a creditor, or the United States trustee may request a revocation of that discharge “if it was obtained through the fraud of the debtor, and the requesting party did not know of the fraud until after the granting of such discharge.” In those situations, the objecting creditor will likely need to ask the bankruptcy court to reopen the case and at the same time file a motion to revoke the debtor’s discharge.
Other grounds to cause the revocation of the debtor’s discharge also address the debtor who is dishonest or refuses to cooperate in the bankruptcy process. For example, a debtor may obtain property by inheritance within 180 days after filing a bankruptcy case. When that happens, the debtor is supposed to report that inheritance to the Chapter 7 trustee, even if the bankruptcy case has been closed. If the debtor “knowingly and fraudulently” fails to report this inheritance then the trustee or other creditor may file a motion to revoke the discharge. The timeframe for bringing this action is one year after the later of closing the case or entry of the discharge order. If the trustee identifies assets for distribution then the debtor’s exposure to a discharge revocation could be considerably longer then one year after the discharge: trustees frequently keep a Chapter 7 case open for several years as they identify assets for liquidation and distribution to creditors. This longer timeframe also applies if the grounds for the motion to revoke the discharge are that a debtor has refused to obey an lawful order of the court or to respond to a material question approved by the court or otherwise to testify as to a material fact in the bankruptcy case.
Finally, grounds to revoke a debtor’s discharge may arise when a debtor fails to cooperate during an audit conducted by the United States trustee. Although these audits are rare, the United States trustee does have the right to conduct audits of debtors, their assets, debts, income and expenses. These audits serve the function of policing the “honor system” that is at the heart of the bankruptcy disclosure process. Specifically, the bankruptcy code provides the United States trustee with the right to ask for revocation of discharge if the debtor “fails to explain satisfactorily a material misstatement” or “make available for inspection all necessary accounts, papers, documents, financial records, file and all other papers, things, or property belonging to the debtor that are requested for an audit.”
The bankruptcy code is silent as to the timeframe for the United States trustee to ask a bankruptcy court to revoke the debtor’s discharge upon the debtor’s misbehavior during an audit. While the United States trustee should not have an unlimited amount of time to bring this action a debtor should expect that a bankruptcy court will grant the United States trustee longer than the one year after discharge imposed upon other creditors.
Creditors almost never file motions to revoke a debtor’s discharge. Nevertheless, the threat exists that a dishonest debtor may have his ill-gotten fresh start taken away. This “escape hatch” for creditors is an important component to preserve the integrity of the bankruptcy system.
