© 2010

Bankruptcy Basics for the Non-Bankruptcy Lawyer

Presentation by:

Manuel D. Leal, Victor A. Vilaplana, Yolanda C. Garcia, James P.S. Leshaw, Omar J. Alaniz

2

Overview of Today's Program

General Bankruptcy Principles

The Players

The Claims Process

Bankruptcy Court Jurisdiction

Adversary Proceedings vs Contested Matters

Preferences

Fraudulent Transfers

The Confirmation Process

3

General Bankruptcy Principles

4

General Bankruptcy Principles: Chapter 7 vs Chapter 11

Chapter 7 Trustee appointed - supplants debtor's

management and liquidates estate property; powers also include avoidance actions (e.g., preference, fraudulent transfer actions)

Cessation of all business operations

Expeditious liquidation of assets and prompt distribution of proceeds to creditors under court supervision

No restructuring obligations

Provides a formulaic payment distribution scheme

Chapter 11 Debtor remains in possession of company

and management (Debtor-in-Possession); has all rights, duties, and obligations of trustee

Designed to preserve "going concern value" of business (though liquidation is possible)

Orderly, court-supervised process that allows entity or individual to reorganize

Reorganized company (if not liquidated) emerges after court confirms the Chapter 11 Plan (examples: Texaco, GM, Chrysler, United Airlines)

Chapter 7 distribution scheme serves as a baseline; chapter 11 provides a forum for negotiation

5

General Bankruptcy Principles: Automatic Stay

A statutory injunction that is automatic at the instant of the bankruptcy filing

The following are prohibited: Demand letters or emails to the debtor

Phone calls to the debtor demanding payment

Acceleration of debt or notices of default

Dilution or squeeze out remedies affecting a debtor's interest in a joint venture, partnership or corporation

Filing lawsuits against the debtor or continuing prosecution of lawsuits that were already filed - this includes private arbitration

Posting property for foreclosure or conducting foreclosure sales

Perfection of security interest in collateral by filing UCCs or by filing deeds of trust

Taking possession of collateral

Setting off any debt owing to the debtor against any claims against the debtor

6

General Bankruptcy Principles: Automatic Stay

The stay does not prevent actions against guarantors, non-debtors, and non-estate property

The stay is inapplicable to causes of action by the bankrupt debtor

The stay can be lifted on motion to the Court

There are exceptions to the automatic stay For example, police powers of governmental entities and

safe harbor provisions

7

General Bankruptcy Principles: Anticipation of a Bankruptcy Filing

Automatic Stay

20-day Administrative Priority Claim

Reclamation Rights

Other Non-bankruptcy Law Rights

Critical Vendor Payments

Postpetition Trade Term Agreements

Executory Contracts

Setoff Rights

Asserting Prepetition and Postpetition Claims

Selling Your Claims

8

The Players

9

The Players: Debtor-in-Possession

Debtor's management and board stay in possession and operate and oversee the business

This is what is colloquially referred to as the "Debtor"

All references to "Trustee" in the Bankruptcy Code apply to the Debtor-in-Possession if a Chapter 11 Trustee is not appointed (discussed later)

10

The Players: Statutory Committees

Intended to provide a unified voice to similarly situated stakeholders (especially those that can't afford their own counsel)

Unsecured creditors' committee is appointed by the U.S. Trustee and has a broad creditor profile

Additional committees may be appointed (e.g., producer's committee, asbestos committee, equity committee)

Members owe fiduciary duty to constituents and commonly assert that the Debtor's plan improperly favors one group over another or does not maximize value (although maximizing value not always required)

Fees/expenses of committee professionals (including experts and lawyers) are paid by the Debtor

11

The Players: U.S. Trustee vs Chapter 11 Trustee

United States Trustee Often referred to as the "Police" in the bankruptcy case (though the

court is not obligated to rule in the U.S. Trustee's favor

Division of U.S. Department of Justice

May be heard on any issue in chapter 11 case

Chapter 11 Trustee Replaces debtor's management and board, runs debtor's business,

manages chapter 11 case, and can hire its own professionals (including lawyers)

Extreme remedy, which requires a showing of case (e.g., fraud, dishonesty, incompetence, or gross mismanagement either before or after commencement of case)

12

The Players: Repeat Players

There are Many Repeat Players

Law firms

Lawyers

Banks/Secured Creditors

Landlords

Employees/Unions

Distressed debt firms who oppose/support the plan

Financial advisors

Representatives of asbestos claimants

Representatives of environmental claimants

Representatives of tort/products liability claimants

13

The Claims Process

14

The Claims Process: General Principles

In Chapter 11, the court will set a bar date, and all claims must be filed before the date

In Chapter 11, check the Debtor's Schedules to determine if your claim is scheduled.

If claim is scheduled, creditor need not file claim unless (i) creditor disagrees with the scheduled amount or (ii) the claim is listed as disputed, contingent, or unliquidated.

Filing a claim does not guarantee a recovery, but not filing a claim typically ensures no recovery

15

The Claims Process: Allowance and Payment

A timely filed claim is "allowed" until there is an objection

If an objection to a claim is filed, the claim is "allowed" only after resolution

Basis for claim objection may be state law or bankruptcy law (see 11 U.S.C. § 502(b)).

For large creditors, negotiations will often occur with the debtor, and a deal may be reached to resolve the claim before confirmation

Unless the debtor is solvent, the claimant will not recover 100% of the allowed claim value but will, instead, recover a pro rata distribution once the assets available to pay creditors are determined

In some instances, claimants may be out of the money entirely

16

Bankruptcy Court Jurisdiction

17

Bankruptcy Court Jurisdiction

28 USC § 1334 – statutory jurisdiction to hear cases “arising in,” “arising under” or “related to” cases under title 11

Statutory authorization to hear and determine core matters and to make proposed findings of fact and conclusions of law on non-core matters

Supreme Court limited jurisdiction in Stern v. Marshall

18

Adversary Proceedings vs Contested Matters

19

Adversary Proceedings

Related to but separate from the bankruptcy

Assigned a different case number and separate docket is maintained

Most of the federal rules of evidence and civil procedure apply (though they are not strictly followed)

They are essentially their own trials stemming from the bankruptcy

Most often heard by the bankruptcy judge unless the "reference" is withdrawn, in which case, the district court hears the adversary proceeding

20

Adversary Proceedings

Rule 7001 defines causes of action that must be brought in an Adversary Proceeding

(1) recovery of money or property

(2) determining the validity, priority, or extent of a lien

(3) obtaining approval for the sale of both the interest of the estate and of a co-owner in property

(4) objection to or revoke a discharge

(5) revoking a confirmation order

(6) determining the dischargeability of a debt

(7) obtaining an injunction

(8) subordinating any allowed claim or interest

(9) obtaining a declaratory judgment relating to any of the foregoing, or

(10) determining a removed claim or cause of action

21

Contested Matters

Occur within the main bankruptcy case

More akin to motion practice and are often resolved on dispositive motions without a trial

However, contested matters can become complicated and hotly contested

Hearing setting default is approx. 20-25 days after filing of motion but court has flexibility to expedite setting or set the hearing for a date certain

If discovery is needed, parties can agree on a schedule and court approves

Some Federal Rules of Civil Procedure apply (see Rule 9014)

22

Contested Matters

Examples of Contested Matters

Motions to Lift the Automatic Stay

Claim Objections

Motions to Assume, Reject, or Assign Unexpired Leases or Executory Contracts

Motions to Sell Property of the Estate

Confirmation of a Plan of Reorganization

23

Preferences

24

Preference - Two Typical Scenarios

Debtor is experiencing financial hardship so he/she chooses to pay the car, cell phone, and electric bill, but not his/her student loans, credit cards, or a promissory note. Debtor has “preferred” the creditors whose collection action

are most likely to interrupt the debtor’s lifestyle.

Sophisticated creditor is aware of a company’s deepening insolvency and intensifies collection effort, extracts a payment, or files a lawsuit. Creditor is attempting to obtain as much of the shrinking pie

before other creditors do. Sophisticated creditors have an advantage.

25

Preference - General

Preference law is entirely a creature of bankruptcy law.

Preference (and fraudulent transfer) law enables the trustee or DIP to pull back property into the bankruptcy estate and redistribute that property to creditors according to the Bankruptcy Code’s priority scheme (including to the parties whose transfers were avoided).

Preference law is intended to prevent the race to the courthouse and to rebalance fair distribution among creditors who undertake disparate collection action.

26

Preference - Hypothetical

Prior to a bankruptcy filing, debtor has four creditors with the following unpaid claims: A - $100; B - $200; C - $500; D - $200. Assume total assets = $500.

Debtor pays off D ($200) and 2 months later decides to file bankruptcy.

Without preference law, remaining $300 is shared pro rata among unpaid creditors. Total claim pool is $800. Creditors receive 37.5% recovery: A - $37.50; B - $175; C - $187.50. D was paid $200 prior to filing.

Utilizing preference law, trustee/DIP sues D for $200; bankruptcy estate increases to $500. Total claim pool is $1,000. Creditors receive 50% recovery: A - $50; B - $100; C - $250; D - $100.

27

Preference - Elements

A preference is only “voidable” if it meets all seven elements, and affirmative defenses often apply (discussed below).

Seven elements of a voidable preference: a transfer of an interest in the debtor’s property on account of an antecedent debt made within the preference period (90 days before the bankruptcy

filing for non-insiders; 1 year for insiders) while the debtor was insolvent to or for the benefit of the creditor that permits the creditor to receive more than it would under chapter

7 (liquidation) had the transfer not been made

Notably absent: intent or state-of-mind

28

Preference - Affirmative defenses

Examples of Affirmative Defenses:

Substantially contemporaneous exchanges for new value

Ordinary course (can be ordinary course between parties or ordinary course in the industry)

Purchase Money Security Interests

Safe Harbor Provisions (protections for financial contracts such as derivatives, swap agreements, etc.)

29

Fraudulent Transfer

30

Fraudulent Transfer - General

Fraudulent transfer law exists outside the bankruptcy context

The Bankruptcy Code includes a fraudulent transfer statute, but the trustee or DIP may sue under a state fraudulent transfer law in addition to or instead of the bankruptcy law.

Fraudulent transfer (like preference) law enables the trustee or DIP to pull back property into the bankruptcy estate and redistribute it to creditors according to the Bankruptcy Code’s priority scheme (including to the parties whose transfers were avoided).

31

Fraudulent Transfer

Three types:

Actual Fraud: 11 U.S.C. § 548(a)(1)(A)

Constructive Fraud: 11 U.S.C. § 548(a)(1)(B)

Partnership Transfers: 11 U.S.C. § 548(b) [not covered]

32

Fraudulent Transfer - Actual Fraud

Must prove an actual intent to delay, defraud, or hinder payment to creditors.

Must show that the debtor had an intent to interfere with creditors' normal collection processes or with other affiliated creditor rights for personal or malign ends.

No requirement of insolvency.

Presumption of actual fraud in Ponzi schemes

33

Fraudulent Transfer - Actual Fraud

Badges of Fraud

the lack or inadequacy of consideration

the family, friendship, or close associate relationship between the parties

the retention of possession, benefit or use of the property in question

the financial condition of the party sought to be charged both before and after the transaction in question

the existence or cumulative effect of the pattern or series of transactions or course of conduct after the incurring of debt, onset of financial difficulties, or pendency or threat of suits by creditors

the general chronology of events and transactions under injury

34

Fraudulent Transfer - Constructive Fraud

Must show that (i) the debtor received less than reasonably equivalent value of

the asset and (ii)

(a) the transfer was made while the company was insolvent,

(b) the company was left with unreasonably small capital, or

(c) the company believed that it would incur debts that would be beyond its ability to repay as the debts matured.

No state-of-mind requirement

Transfers for the benefit of insiders or obligations such as employment contracts during company's insolvency also satisfy the second prong

35

The Plan Process

36

The Plan Process

Debtor formulates its "plan" to emerge from bankruptcy Stand alone plan Obtain exit financing Sell some or substantially all assets Merge/consolidate entities

Debtor negotiates with key stakeholders to arrive at a consensual plan of reorganization

Debtor drafts plan that will classify creditors and interest holders and sets forth distribution and payment terms

Once debtor formulates plan (with or without agreement from key constituents), debtor will seek approval of a disclosure statement and distributes plan and disclosure for voting

Creditors and interest holders may vote on the plan (unless they are not affected by the bankruptcy or they receive no property under the plan)

37

The Plan Process: Confirmation

Confirmation is the court's approval of the plan of reorganization or liquidation

To confirm a plan, one must meet the statutory obligations under 1129 (15 tests for business cases) plan filed in good faith creditors receive at least as much as they would have in a chapter 7 unless the

agree otherwise confirmation is not likely to be following by another bankruptcy or further

restructuring voting thresholds are met

Often, the court will consider only the Debtor's plan

But if the Debtor's exclusivity is terminated, the court may consider multiple plans but can only confirm one

Many aspects of litigation may come before confirmation (and may continue after)