In-house attorneys will notice an increase in bankruptcy filings if the economy goes into recession. Some will be forced to witness bankruptcy up close as they represent the debtor who is filing for bankruptcy. In-house lawyers should have a good understanding of bankruptcy so they can give some advice to their business if a filing is a possibility. This article will cover the basic information that in-house attorneys need to understand about bankruptcy from a creditor’s perspective.

Bankruptcy Law

Bankruptcy laws in the U.S. are part of a clearly defined legal process outlined in the U.S. Bankruptcy Code, Title 11 of the U.S. Code, and the special rules for bankruptcy procedures (and Local rules span Data-Contrast=”auto “>),), which preempt state law and rely upon it. Bankruptcies in the United States are filed before federal bankruptcy judges and then decided by those courts. There are many different bankruptcy chapters, each covering various debtors or situations. The most common ones are Chapter 7, Chapter 11, and Chapter 13.

Chapter 7: This type of bankruptcy is also called “liquidation bankruptcy” and involves the sale by a trustee of non-exempt assets to pay creditors. Any remaining debts that are eligible are then discharged. This type of bankruptcy is usually suitable for companies with no realistic reorganization prospects.

Chapter 11: Chapter 11 bankruptcy allows businesses to restructure their debts while continuing operations, known as debtors-in-possession (yes, the people who managed the company into bankruptcy are put back in charge). This involves creating a plan of reorganization that details how the debtor is going to repay creditors over time.

Chapter 13: Designed primarily for individuals but can be used by sole proprietorships. The debtor creates a plan of repayment to pay back their debts within a certain period.

The Bankruptcy Process

A company can be declared “insolvent” if its debts exceed its assets. Many companies work hard to balance their debts with investments; bankruptcy is the last option. If bankruptcy is the best (or only) option, the company will hire bankruptcy counsel to guide them. This is important because bankruptcy is a complex process. It is essential to understand that bankruptcy is intended to get the company back into the business or to ensure an orderly liquidation. The process ensures that similar creditors will be treated equally, regardless of whether the bankruptcy is filed to reorganize the company or to sell the assets.

Several things happen automatically when a bankruptcy petition is filed

Automatic Stay: A stay is automatically imposed without the debtor needing further action. The stay stops all creditor collection activities, such as lawsuits, foreclosures, and collection calls. Creditors who violate the stay face steep penalties. The visit allows the debtor to reorganize their business without worrying about creditor lawsuits and other actions.

Priority of Debts. Bankruptcy laws establish a hierarchy of debts. Priority is given to secured debts (such as those guaranteed by an Article 9 UCC filing), followed by other priority debts, such as employee wages and tax obligations. Unsecured obligations, like those owed to company vendors, can be paid in full if sufficient funds or assets are available before discharge or liquidation.

Executory contracts: Under Chapter 11, the debtor can accept or reject specific contracts. They are called executory leases or contracts where parties have obligations to perform. Creditors must continue performing under contracts until the debtor accepts or rejects them. The contract is terminated if the debtor refuses to act. The priority of the debts determines the payment due to the creditor. If the debtor assumes a contract, it must correct any default (pre- and post-filing bankruptcy). If the debtor does not do this, the creditor’s claim will be higher in bankruptcy than the unsecured claims.

Preferences: In order to ensure that creditors are treated equally and fairly, bankruptcy law prohibits debtors from favoring one creditor over another shortly before filing bankruptcy. They are known as “preferences.” In order to qualify, there must be (a) a transfer of debtor property, whether money or assets, (b) to a specific creditor, (c) in payment of existing debt, (d) within a specified period of time before bankruptcy filing (usually 90 days), and (e) allow the creditor more than what they would receive through the bankruptcy distribution.

If a transfer is determined to meet these criteria and to be preferred, the debtor, or the trustee in bankruptcy, can avoid or recover the transfer and reclaim assets to distribute more fairly among creditors. Note that creditors and the bankruptcy court will be vigilant in ensuring the debtor does not make fraudulent conveyances. This includes trying to conceal assets from creditors or court.

In Chapter 11, it is the debtor-in-possession’s responsibility to manage the business’s day-to-day operations, make business decisions, obtain financing, and seek opportunities to maximize the value for creditors. Court approval may be required for major decisions such as selling assets or entering new contracts. The debtor will need to submit a reorganization plan outlining how they plan to repay their creditors and restore financial stability. The project must be accepted by creditors and approved by the bankruptcy court. The bankruptcy court and creditors must receive regular financial reports from the debtor.