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Operation of the Bankruptcy System

before the House Judiciary Committee
Subcommittee on Commercial Law

April 16, 1997

I am Charles Tatelbaum, a shareholder and chair of the Creditors Rights/Bankruptcy Department in the Tampa/Clearwater law firm of Johnson, Blakely, Pope, Bokor, Ruppel & Burns, P.A. I am appearing on behalf of the American Bankruptcy Institute, presently serving as its Vice President of Research. The ABI is the nation's largest multi-disciplinary organization devoted to research and education on issues related to insolvency. We have over 5,500 members, including attorneys, accountants, judges, bankers, credit managers, trustees, academics and financial service professionals. The ABI is non-profit and non-partisan and we generally take no advocacy positions before Congress, although we regularly appear to assist Congress' understanding of our nation's bankruptcy laws. We are honored to be here this morning to help increase the Committee's awareness of current issues affecting bankruptcy. The following is a summary of important but essential elements of bankruptcy practice and law, which serve to highlight the significant issues that will be brought before Congress in the near future.

General Overview

Bankruptcy is booming in America like never before. In 1996, a record 1,178,555 new bankruptcy petitions were filed by both business and consumers. This was a 27.2 percent increase over total bankruptcy filings in 1995.

Consumer bankruptcy filings continue to drive the increase, as more than 95 percent of all cases (1,125,006) were by individuals and households, up 28.6 percent from 1995. Consumer filings have been rising in the wake of a sharp increase in the debt load carried by individuals and households. Consumer debt service as a percentage of disposable personal income has grown steadily since late 1993.

Moreover, the trend suggests that filings in 1997 may set another record: the fourth quarter of 1996 marked the highest three month total ever and the second consecutive quarter that total filings averaged over 100,000 per month.

Although business bankruptcy cases have been relatively flat by contrast (only a 3 percent increase in 1996, to 53,549 total filings) these cases frequently involve the redistribution of billions of dollars in assets. The life and death of companies are at stake in every sector of the economy and every state in the union. The 10 largest cases filed in 1996, for example, covered sectors as diverse as retailing, high technology, financial services, health care, energy, manufacturing, children’s entertainment and brewing [ FN: Fox Meyer Health Corp., Anchor Glass Container, G. Heileman Brewing, Best Products Co., Anacomp, Inc., Morrison Knudsen Corp., Color Tile Inc., Discovery Zone, Inc., Tipbook Finance Corp., and Kenetech Windpower, Inc.] and over $8 billion in assets.

Arguably, a fundamental shift is occurring in American commercial life. Bankruptcy, once considered a likely prospect for only marginal or start-up concerns, is now something to be dealt with by all business people. Virtually all businesses have had some dealing with a bankruptcy entity, whether as a creditor or debtor. The issues being resolved in U.S. bankruptcy courts are complex and run the gamut from mass torts, underfunded pension plans, environmental disasters, financial frauds, international disputes, and more. [ FN: Warren, Business Bankruptcy , Federal Judiciary Center, 1993.]

The complexity of the business cases, and the raw volume of consumer cases, are resulting in some strain on the U.S. bankruptcy courts and administrative staff. With more individuals and businesses looking to the bankruptcy law for relief, it is important to understand the bankruptcy code’s development, purposes and principles.

History And Purposes of Bankruptcy

Our legal system for administering insolvency cases dates back to the U.S. Constitution, which, in Article 1, Section 8, Clause 4, empowers Congress "to establish…uniform laws on the subject of bankruptcies throughout the United States." Congress exercised this power by enacting bankruptcy statutes in 1800, 1841, and 1867 to deal with the effects of specific economic downturns. Viewed as temporary remedies, however, these laws were repealed once economic conditions stabilized. It was only upon the enactment of the nation’s first comprehensive bankruptcy statute, the National Bankruptcy Act of 1898, that bankruptcy became a remedy available "continuously in the United States, in good economic times and bad." [ FN: 20 Stat. 54(1898); L. LoPucki, Strategies for Creditors in Bankruptcy Proceedings.]

The National Bankruptcy Act of 1898 governed the administration of bankruptcy cases until it was repealed by the Bankruptcy Reform Act of 1978 (as amended, the "Bankruptcy Code"). [ FN: Pub. L. No. 95-598, 92 Stat. 2549 (1978).] Although the 1898 law initially contemplated only liquidation of a debtor’s non-exempt assets, amendments to this statute in 1938, known as the Chandler Act, established debtor rehabilitation as a viable alternative to liquidation. [ FN: 52 Stat. 840 (1938).]

The Bankruptcy Reform Act of 1978 is the most significant development in modern bankruptcy law. It creates a uniform procedure for business reorganization and modernizes the consumer bankruptcy provisions. It also establishes bankruptcy courts separate from the United States District Court system. The Bankruptcy Code was the product of more than a decade of drafting and debate. Spurred on by a series of very critical studies, Congress eventually enacted the Bankruptcy Code notwithstanding severe criticism from creditor groups who found its provisions too debtor-oriented. Criticism of the law continued after its enactment, culminating in the enactment of significant amendments in 1984.

The impetus for the 1984 amending legislation was the case of Northern Pipeline Co. v. Marathon Pipeline Co., 458 U.S. 50, 102 S. Ct. 2858 (1982). In Marathon, the Supreme Court declared unconstitutional the jurisdiction granted to Bankruptcy Judges under the Bankruptcy Code. In response to this decision and other pressures, Congress enacted and passed the Bankruptcy Amendments to this decision and other pressures, Congress enacted and passed the Bankruptcy Amendments and Federal Judgeship Act of 1984. While these amendments were necessary to cure the Marathon jurisdictional problem, they also made a number of changes in Bankruptcy Code provisions pertaining to consumer cases designed to tighten perceived abuses by consumer debtors in the area of exemptions and discharge under Chapter 7 and 13 of the Bankruptcy Code.

The Bankruptcy Code was further amended in 1986 with passage of the Bankruptcy Judges, United States Trustees, and Family Farmer Bankruptcy Act of 1986, legislation which made the U.S. Trustee system national in scope (with the exception of courts in North Carolina and Alabama) and enacted a new Chapter 12 to deal with the adjustment of debts of a family farmer with regular annual income; and in 1990, with certain miscellaneous amendments affecting principally commercial transactions.

Other minor amendments to the Bankruptcy Code since 1978 have addressed various subjects, including retiree benefits, international interest and exchange rate swaps, executory contracts, licensing rights to intellectual property, dischargeability of student loans and criminal restitution.

Prompted by continued, heated criticism from various groups, including creditors, and to address certain concerns that were not contemplated previously in the Bankruptcy Code, the Bankruptcy Reform Act of 1994 [ FN: Pub. L. No. 103-394 (1994).] was enacted, adopting comprehensive amendments to, among other things, improve bankruptcy administration; address commercial, consumer and governmental bankruptcy issues; and to establish the National Bankruptcy Review Commission.

The nine-person Commission is completing its two year project to study and recommend to Congress changes in the bankruptcy system in the United States. As a result of the expansive outreach of the Commission to receive input from all facets of bankruptcy related issues, it is anticipated that the Commission report will attempt to deal with the areas most in need of change. Since in most cases the Commission's report will not provide legislative drafting to implement the Commission's recommendations, it is especially important that this Committee and its staff be familiar with the underlying concepts involving the issues to be raised by the Commission report. [ FN: To assist the Commission and Congress in the identification of issues in need of reform, the ABI is conducting the Bankruptcy Reform Study Project. The Project produced dozens of analytical papers and sponsored ten symposia on a wide range of hotly debated bankruptcy issues. In December, ABI released the results of a broad-based and comprehensive empirical survey of professionals involved in the bankruptcy system. The ABI’s Report on the State of the American Bankruptcy System (attached) reflects the views of attorneys, accountants, academics, judges, trustees, lenders, credit managers, turnaround consultants and others, or topics such as abuse in the bankruptcy system, causes of bankruptcy, consumer bankruptcy, business reorganization, jurisdiction and procedural issues, and more.]

The Bankruptcy Code serves several major purposes. First, it provides an orderly process for the liquidation of assets of a debtor and the distribution of the proceeds of the liquidation of those assets in an equitable fashion to the creditors of the debtor. The Bankruptcy Code also supplies the mechanism for granting a discharge to the debtor from debts, thereby providing the debtor with a "fresh start" in life with those assets that the bankruptcy law exempts from distribution to creditors. In addition, the Bankruptcy Code provides a debtor, either corporate or individual, with the opportunity to rehabilitate or reorganize, rather than liquidate, provided the debtor pays creditors all or a portion of the obligations owed from future earnings.

Understanding Title 11 of the United States Code

Title 11 of the United States Code contains all of the substantive direct law involving bankruptcy. [ FN: Other provisions related to court jurisdiction are found in Title 28, provisions relating to bankruptcy crimes are found in Title 18 and miscellaneous other related provisions are placed throughout the U.S. Code. Procedural rules are found in the Federal Rules of Bankruptcy Procedure and in Local Rules adopted by various bankruptcy courts.]

A brief overview of the current chapters to Title 11 may provide some general assistance.

Chapter 1

This chapter is entitled "General Provisions" and provides definitions of terms used in Title 11, reviews the powers of the court and other general matters dealing with the provisions of the Bankruptcy Code. The provisions of Chapter 1 apply to all chapters of the Bankruptcy Code.

Chapter 1 contains general provisions including definitions, rules of construction, applicability of chapters and who may be a debtor. The definitions of various terms utilized in the Bankruptcy Code, found in §101, are extremely important. For example, the definition of "person" includes individuals, partnerships, corporations and, in certain enumerated circumstances, a governmental unit. The term "corporation" includes entities normally not thought of as corporations, including un-incorporated companies or associations. Section 105 is an "all writs" provision that gives the Bankruptcy Court extremely broad power to carry out the purposes and intent of the Bankruptcy Code, and is the source of the Bankruptcy Court's authority to grant injunctions and other equitable relief.

Chapter 1 also establishes criteria for who may be a debtor under each chapter of the Bankruptcy Code. For example, railroads may not be Chapter 7 debtors, and insured banks, insurance companies and specified small business investment companies may not be Chapter 7 or Chapter 11 debtors. Only family farmers with regular annual income and individual, corporate or certain partnerships owing less than $1.5 million may file under Chapter 12. Only an individual with regular income that owes non-contingent, liquidated, unsecured debts of less than $250,000 and non-contingent, liquidated, secured debts of less than $750,000 may be a debtor under Chapter 13; while couples may file joint Chapter 13 cases, these debt limits remain the same. While too much debt makes a debtor ineligible for Chapter 13, insolvency is not a condition precedent to any form of voluntary bankruptcy. A municipality may be a debtor under Chapter 9, only if it meets five specific prerequisites. Section 109 provides that no individual may be a debtor who was a debtor at any time in the preceding 180 days if his or her case was dismissed under certain circumstances. These conditions, detailed in Chapter 1, help determine the type of bankruptcy that may be filed.

Chapter 1 also creates standards and penalties pertaining to bankruptcy petition preparers.

Chapter 3

This chapter is entitled "Case Administration" and contains the provisions dealing with how cases are to be handled once filed under the Bankruptcy Code. Significant areas covered include the commencement of the case, the officers (trustees, examiners and other professionals) administration, administrative powers (including the automatic stay, sale, use or lease of property, obtaining credit in executory contracts) and related provisions. The provisions of Chapter 3 apply to all chapters of the Bankruptcy Code.

The filing of a bankruptcy petition, whether voluntary or involuntary, invokes an automatic stay, preventing essentially all actions against the debtor or property of the estate. The stay, provided by §362(a), is automatic and self- executing from the time of filing, not from the time that a creditor receives notice of the bankruptcy. No court order is required. The bankruptcy filing is notice to the world, and the stay is not dependent upon actual notice to any person. The automatic stay casts a mantle of protection over the debtor and the bankruptcy estate, and is, perhaps, the most important benefit provided to a debtor. The bankruptcy estate is defined broadly to consist of all of the debtor's property that exists at the date of the filing of the bankruptcy case plus additional property that may be recovered pursuant to the provisions of the Bankruptcy Code. The automatic stay prevents chaos among creditors seeking repayment upon the initiation of a bankruptcy case and is an effort to strike a compromise between the rights of affected parties and the opportunity of the debtor to rehabilitate or liquidate in an orderly manner. Complementing the stay are procedures to protect secured creditors whose collateral is utilized by the debtor during the bankruptcy case and provisions enabling the debtor or trustee to obtain financing on a going- forward basis.

The automatic stay affects actions directed at collecting pre-bankruptcy debts against the debtor or the bankruptcy estate. It does not, however, prohibit actions brought by the debtor or trustee. The automatic stay is applicable to party litigants, prosecutors and other parties to court and, in some instances, administrative proceedings. The automatic stay primarily stays actions to recover pre-petition claims. Typically, actions to recover post- petition claims are only stayed to the extent that a creditor attempts to execute its claim against property of the estate.

Several exceptions exist to the stay provided by the Bankruptcy Code, including the commencement or continuation of a criminal proceeding against the debtor or an action by a governmental unit to enforce its police or regulatory power for the health, safety and welfare of the community, or to establish paternity, or to establish or modify an order for alimony, maintenance or support, or to collect alimony, maintenance or support from property that is not property of the estate. Another important limitation of the stay is that it does not generally protect co-debtors from collection efforts, unless the case is filed under Chapter 12 or 13.

The stay continues in effect with respect to acts against property of the estate until it is either affirmatively lifted by the court or until the property is no longer in the estate. Property is no longer property of the estate if it is abandoned by the trustee, sold, provided to the debtor as exempt or otherwise disposed. The stay also ends when either the case is closed, the case is dismissed or a discharge is granted or denied. Termination of the stay, however, does not necessarily mean that the debtor is no longer protected. When a discharge is granted to a Chapter 7 individual debtor, for example, it operates as an injunction prohibiting certain collection actions against the debtor.

The automatic stay may be terminated, annulled, modified or conditioned by court order on the motion of a party in interest after notice and a hearing. The court may take such action if it finds "cause," including a lack of adequate protection. [ FN: 11 U.S.C. Section 362(d)(1).]

The principle of adequate protection applies only to an entity that has an interest in property of the estate, such as a secured creditor or a landlord. Adequate protection is the concept that insures that such interest in property is not diminished during the (sometimes lengthy) bankruptcy process. Adequate protection is illustrated but not defined by §361 of the Bankruptcy Code and can be established in any one of three forms:

1. providing periodic cash payments to protect against any decrease in value that may result from the stay;
2. providing an additional replacement lien; or
3. granting such other protection as will provide the protected creditor with the "indubitable equivalent" of its interest.

Lack of adequate protection usually is alleged by secured creditors to claim that their interest in their collateral is at risk. Often, the value of the collateral is deteriorating or being dissipated during the course of a bankruptcy case. Secured creditors, by virtue of due process concerns, are constitutionally entitled to the "indubitable equivalent" of their interest, if their interest has value.

A lien creditor also can obtain relief from the stay if the debtor does not have any equity in the encumbered property and the property is not necessary to an effective reorganization. [ FN: 11 U.S.C. Section 362(d)(2).] The creditor has the burden of proof on the issue of whether the debtor has any equity in the property. The debtor or trustee has the burden on all other issues.

The debtor-in-possession's ability to conduct its business and successfully reorganize often will depend upon its ability to use "cash collateral." "Cash collateral" includes the debtor's cash, deposits and the like in which a creditor has an interest, and includes proceeds, products, offspring, rents or profits of property and the fees, charges, accounts or other payments for rooms in hotels and the like. In contrast to the Code's liberal authorization of the debtor's conduct of its business in other respects, the debtor-in-possession or trustee is prohibited from using, selling or leasing cash collateral unless (i) each entity that has an interest in the cash collateral consents to such use or disposition, or (ii) the court, after notice and a hearing, authorizes such use, sale or lease. [ FN: 11 U.S.C. Section 363(c)(2).] The Code also imposes a duty upon the debtor-in-possession or trustee to segregate and account for any cash collateral. [ FN: 11 U.S.C. Section 363(c)(4).]

The most common example of cash collateral is the debtor's accounts receivable subject to a security interest. In such a case, the monies collected from the accounts constitute cash collateral and cannot be used without the secured creditor's consent or court authorization.

If the debtor continues to use cash collateral without the secured creditor's consent or court approval, the secured creditor may protect its interest in the collateral by initiating litigation in the bankruptcy court such as filing a motion for adequate protection or relief from stay, or a complaint accompanied by a motion for a temporary restraining order.

The consequences of court denial of a request to use cash collateral could be fatal to the debtor's reorganization efforts. To avoid that risk, where feasible, debtors generally first attempt to obtain the secured creditor's consent to the use of cash collateral before resorting to the court for contested relief.

Absent the secured creditor's consent, the debtor-in-possession must file a motion requesting the court to authorize the use of cash collateral. Such a motion is urgent and often requires the immediate consideration of the court. The Code recognizes this fact and expressly provides that any hearing on the use of cash collateral "shall be scheduled in accordance with the needs of the debtor" for such relief [ FN: 11 U.S.C. Section 363(c)(3).] and that the court "shall act promptly" on any such request. In exceptional circumstances, if there is not enough time for an actual hearing with proper notice, the court may authorize the use of cash collateral on an ex parte request.

In determining whether to authorize a debtor-in-possession to use cash collateral, the court should consider whether the secured creditor's interest in the debtor's property will be adequately protected. If the creditor's interest would be adequately protected under appropriate restrictions and conditions, the court may limit the debtor-in-possession's use of cash collateral by such restrictions and conditions.

The Bankruptcy Code gives the trustee the ability to assume, assign or reject executory contracts and unexpired leases subject to Bankruptcy Court approval. The terms "executory contract" and "unexpired lease" are not defined in the Bankruptcy Code. The generally accepted definition of an executory contract is a contract under which the obligations of both the debtor and the other party are so far unperformed that the failure of either to complete performance would constitute a material breach excusing the performance of the other. A contract or lease that has fully terminated prior to the filing of the bankruptcy petition or a contract under which performance remains due by only one party (such as payment) is not assumable or assignable. The question of whether a contract or lease is fully terminated pre-petition is to be determined according to state law.

Section 365 of the Bankruptcy Code provides detailed rules for determining the rights of the debtor, creditors and other parties with respect to executory contracts and unexpired leases, determining when such contracts and leases can be assumed and/or assigned by the debtor or trustee and providing protections for non-debtor contracting parties.

Chapter 5

This chapter is entitled "Creditors, the Debtor and the Estate" and covers such areas as creditors and claims, the duties and benefits of a debtor, and the estate. Significant areas include all of the avoidance powers of the officers, as well as priorities in payment, exemptions and exceptions to discharge. The provisions of Chapter 5 apply to all chapters of the Bankruptcy Code.

Section 507 governs priorities among creditors and delineates how the debtor's estate, once amassed, will be distributed to creditors.

An individual (as opposed to a corporate) debtor is allowed to exempt certain property from his or her bankruptcy estate in accordance with §522. Property exempted is not liable for any debt that arose before the bankruptcy case was commenced except debts excepted from discharge and debts secured by liens that are not avoidable. The Bankruptcy Code provides in §522 a list of federal exemptions that a debtor may choose to claim unless the law of the debtor's state prohibits the use of such federal exemptions. In that case, the debtor can rely only on the exemption scheme of that state.

Section 523 sets forth debts that are not discharged for an individual debtor under Chapter 7, 11 and 12 (as distinguished from §727, which bars the entire discharge of the Chapter 7 debtor under certain circumstances). Section 524 contains provisions enjoining third parties from interfering with the discharge of a debtor. Modeled after the trust/injunction in the Johns-Manville case, [ FN: Kane v. Johns-Manville Corp. , 68 B.R. 618 (Bankr. S.D.N.Y. 1986), aff’d in part , rev’d in part , 78 B.R. 407 (S.D.N.Y. 1987), aff’d , 843 F.2d 636 (2d Cir. 1988).] §524 also permits the Bankruptcy Court to issue an injunction when a trust is established to pay future personal injury claims against the debtor based on exposure to asbestos-containing products.

With the exception of a municipal bankruptcy under Chapter 9, the filing of a petition for relief under the Bankruptcy Code creates an estate. Section 541 of the Bankruptcy Code specifies what becomes property of the debtor's estate. The concept of property of the estate is broad in scope, encompassing all kinds of property, including tangible and intangible property, causes of action, real and personal property, the legal interest of the debtor in property held by the debtor in trust for others, and property of the debtor held by others. Property of the estate also includes certain after- acquired property and certain property that the debtor- in- possession or trustee can recover pursuant to the avoidance powers and provisions of the Bankruptcy Code.

In a Chapter 7 case, property of the estate is collected by the bankruptcy trustee and sold. The proceeds of the sale are then distributed to creditors. In a Chapter 11, 12 or 13 case, the debtor retains the property. The value of this retained property determines the minimum amount that must be offered to non-assenting general creditors in a reorganization plan.

Property acquired after the petition generally is not property of the estate, with certain exceptions, such as property acquired within 180 days after the filing of a petition by devise, bequest, inheritance, property settlement, agreement or as the beneficiary of a life insurance policy.

Although §541 provides that any interest in property that the estate acquires after the commencement of the case becomes property of the estate, it is important to note that post-petition earnings of an individual debtor in Chapter 7 or Chapter 11 do not become property of the estate.

Section 542 generally requires third parties to turn over property of the estate to the trustee or debtor-in-possession. Sections 544 through 549 grant to the trustee or debtor- in- possession certain powers to bring additional property into the estate by avoiding liens or transfers (voluntary or involuntary) of property of the debtor or obligations incurred by the debtor. Section 544 grants to the trustee or debtor- in- possession the rights of a judgment lien creditor with respect to personal property, and the rights of a bona fide purchaser with respect to real property. This permits the debtor-in-possession or trustee to avoid certain unperfected liens on such property. In addition, §544 allows the trustee or debtor- in- possession to utilize certain state law avoiding powers, including state fraudulent transfer statutes. Preferences and fraudulent transfers are covered by §§547 and 548 respectively.

Property may be abandoned under §554 if it has no value to the bankruptcy estate, if it is encumbered beyond its value, or if the retention of the property would be burdensome to the estate.

The Bankruptcy Code empowers a trustee (debtor- in- possession in Chapter 11 and debtor in Chapter 9) to recover or avoid certain transfers made or obligations incurred by a debtor within specified time periods prior to the filing of the debtor's bankruptcy petition. Unauthorized post-petition transfers also can be avoided. These powers granted to trustees or debtors- in- possession are generally referred to as "avoidance powers."

The most commonly used avoidance powers are those concerning preferential transfers contained in §547 of the Bankruptcy Code and those concerning fraudulent transfers contained in §548 of the Bankruptcy Code. Using the avoidance powers, the trustee can analyze retroactively the pre- bankruptcy activity of the debtor. If the debtor made transfers, incurred obligations or otherwise took actions inconsistent with the principle of equality of distribution, then the trustee may be able to unwind or otherwise set aside the transfer or to obtain compensation from the person who received the transfer or who benefited from it.

There are two general purposes for the avoidance powers. First, the avoidance powers discourage creditors from coercing payment of claims in the course of the debtor's slide into bankruptcy. Second, these provisions ensure equal distribution among all creditors of equal standing, the theoretical thrust of the Bankruptcy Code. Obviously, a creditor who is able to squeeze payment from a debtor shortly before the filing of a bankruptcy petition enjoys "preferential" treatment on his claim to the detriment of all other creditors in a comparable position. Similarly, a payment or advantage obtained by some fraudulent means, whether that fraud is "actual" or "constructive," may operate to provide a certain creditor with an unfair advantage.

Although common law does not condemn preferences, a preferential transfer generally is contrary to the rule of bankruptcy providing for equal distribution among all creditors of the same type. A fraudulent transfer generally goes beyond this rule and involves a personal advantage secured by one creditor by means deemed actionable under state or federal law. Both kinds of transfers are subject to bankruptcy scrutiny and, if avoidable, give rise to recoveries for the benefit of all creditors.

For a transfer to be avoided as preferential, it must be a transfer of the debtor's property, or an interest in the debtor's property, to or for the benefit of a creditor on account of an antecedent debt made at a time when the debtor was insolvent, with the result that the creditor receiving the transfer received more than it would receive in a Chapter 7 liquidation case if the payment had not been made. The transfer must have occurred within 90 days before the filing of the bankruptcy petition unless the transfer is to or for the benefit of an insider, in which case the preference period is extended to within one year before the filing of the bankruptcy petition. There are several statutory exceptions to the recovery of a preferential transfer including a transfer that is a contemporaneous exchange for new value or one made in the ordinary course of business of the parties and the industry of the transferor and transferee.

Two general categories of transfers are deemed fraudulent under the Bankruptcy Code and, thus, are avoidable if made within one year of the filing of the bankruptcy petition. Section 548 of the Bankruptcy Code provides for avoidance of transfers (1) undertaken with actual intent to hinder, delay or defraud creditors, and (2) in which the debtor receives less than reasonably equivalent value as consideration for the transfer at a time when the debtor is insolvent, does not possess adequate working capital to carry on its business, or is unable or prospectively unable to pay its debts as those debts become due. State fraud laws contain similar provisions but generally have a longer statute of limitations than the one-year reachback of the Bankruptcy Code. These fraudulent transfer laws recently have been applied to so- called leveraged buyouts and also may be applicable to foreclosure actions. Using §544(b) of the Bankruptcy Code, the trustee may avoid fraudulent transfers in accordance with applicable state law to supplement the avoiding power of §548.

Chapter 7

This is the "liquidation" chapter. Individuals, partnerships and corporations may file for relief under this chapter, and involuntary petitions may also be against them. Cases which proceed under Chapter 7 are intended to more towards a prompt liquidation of all non-exempt assets [ FN: Only individuals (as opposed to partnerships and corporations) are entitled to exemptions.] for ultimate distribution to creditors in accordance with priorities established in Chapter 5. Particular issues dealing with the Chapter 7 estate, discharge and treatment of certain claims are unique to this chapter. The provisions in this chapter apply only to Chapter 7 cases.

There are several alternatives to Chapter 7 relief. Debtors who are engaged in business, including corporations, partnerships and sole proprietorships, may wish to remain in business and avoid liquidation. Such debtors may consider a petition under Chapter 11 of the Bankruptcy Code. Individual debtors who have a regular income and sole proprietorships also may be eligible for relief under Chapter 13 where an adjustment of debts is sought. In fact, a number of courts have dismissed a Chapter 7 case for substantial abuse when the debtor has the ability to propose and fund a Chapter 13 reorganization plan. Finally, debtors should be aware that out-of- court agreements with creditors or debt counseling services may provide an alternative to a bankruptcy filing.

Chapter 7 envisions the bankruptcy trustees gathering the debtor's non-exempt assets. The individual debtor is permitted to retain certain exempt property, while the debtor's remaining assets are liquidated by a trustee and the proceeds from the sale are distributed according to priorities set by the Bankruptcy Code. Relief is available under Chapter 7 regardless of the amount of the debtor's debts, or whether the debtor is solvent or insolvent.

One of the primary purposes of bankruptcy is discharging debts to give an honest individual debtor a "fresh financial start." The discharge has the effect of extinguishing the debtor's personal liability on dischargeable debts. In Chapter 7, a discharge is available to individual debtors only. It should be noted that although the filing of an individual chapter 7 petition usually results in a discharge, an individual's right to a discharge is not absolute. In addition, a bankruptcy discharge does not extinguish a lien on property.

A Chapter 7 case begins with the filing of a petition with the Bankruptcy Court in the district of the debtor's residence or principal place of business. The debtor also is required to file schedules of assets (including a schedule of exempt property) and liabilities, a schedule of current income and expenditures, a statement of financial affairs and a schedule of executory contracts. The debtor will need to compile a list of all creditors and the amount and nature of their claims; the source, amount and frequency of the debtor's income; a list of all of the debtor's property; and, a detailed list of the debtor's monthly living expenses.

Upon the filing of the Chapter 7 petition, a trustee is appointed by the U.S. Trustee (or the court in Alabama and North Carolina) to administer the case and liquidate the debtor's non-exempt assets. Typically, most Chapter 7 cases involving individual debtors are "no asset" cases with no distribution to unsecured creditors. If the case appears to be an asset case, creditors who receive notice of the filing from the court must file a claim within 90 days after the first date set for the meeting of creditors.

The primary role of the trustee in a Chapter 7 "asset" case is to liquidate the debtor's non-exempt assets in a way that maximizes the return to the debtor's unsecured creditors. This is generally accomplished through liquidation of non-exempt property and pursuit of causes of action on claims belonging to the debtor and the trustee's own causes of action to recover money or property under the trustee's "avoiding powers."

As noted previously, a "meeting of creditors" is conducted pursuant to §341(a) of the Bankruptcy Code, and usually is held 20 to 40 days after the petition is filed. The debtor must attend this meeting where creditors may appear and ask questions regarding the debtor's financial affairs and property. The trustee generally conducts this meeting.

The distribution of the property of the estate is governed by §726 of the Bankruptcy Code, which sets forth the order of payment of all claims. There are six classes of claims, and each class must be paid in full before the next lower class is paid anything.

The bankruptcy law regarding the scope of a Chapter 7 discharge is complex. Generally, with the exclusion of cases dismissed or converted, individual debtors are discharged from further debt obligations in more than 99 percent of Chapter 7 cases. In most cases, the discharge will be granted relatively early on, that is, 60 to 90 days after the first "meeting of the creditors."

The grounds for denying an individual debtor a discharge in a Chapter 7 case are limited. Among the grounds for denying a discharge are failure to keep or produce adequate books or financial records; failure to explain any loss of assets; commission of a bankruptcy crime such as perjury; failure to obey a lawful order of the Bankruptcy Court; or fraudulent transfer, concealment or destruction of property that would have become property of the estate. In addition to the denial of a general discharge of the debtor, certain debts are non-dischargeable. Among the types of debts that are not discharged in a Chapter 7 case are alimony and support obligations, certain taxes, debts for educational loans made or guaranteed by a governmental unit, debts for death or personal injury caused by the debtor's operation of a motor vehicle while the debtor was intoxicated from alcohol or other substances, certain debts incurred by the debtor in the course of a divorce or separation or in connection with a separation agreement or court decree, consumer debts for luxury goods or services, and fees becoming due post-petition to condominiums, cooperatives and the like. These exceptions to discharge are found in §523.

The court may revoke a Chapter 7 discharge on the request of the trustee, a creditor or the U.S. Trustee if the discharge was obtained through fraud by the debtor. Depending on circumstances, a debtor wishing to keep possession of pledged property, such as an automobile, may find it advantageous to retain the property by paying the secured creditor the amount of its allowed secured claim. Subject to the §523 exceptions listed above and absent any challenge to discharge under §727, the individual debtor will emerge from bankruptcy free of his pre-petition debts. In certain circumstances, however, a debtor may wish to reaffirm a debt or debts owed to a creditor that, for example, he wishes to deal with in the future. If the debtor elects to reaffirm the debt, the reaffirmation should be accomplished prior to the granting of the discharge by a written agreement filed with the court. The debtor may repay any debt voluntarily, whether or not a reaffirmation agreement exists.

Chapter 9

This chapter is entitled "Adjustment of Debts of a Municipality", and covers any cases involving any type of municipality that must seek protection under the Bankruptcy Code. Its substantive provisions are very unique to this chapter, although many of the general principles contained in the Bankruptcy Code apply. The provisions in this chapter apply only to Chapter 9 cases.

Prior to 1933, there was no federal or state legislation governing municipal bankruptcies. The lack of legislation resulted from the inability of the federal government to violate the sovereignty of the states and, at the same time, the constitutional prohibition against states impairing the obligation of contracts. In fact, the first attempt by the federal government to create a municipal bankruptcy law was struck down as unconstitutional by the United States Supreme Court. Since that time, however, Congress has been successful in creating a legislative scheme that passes constitutional muster. The present day statute, while somewhat limited in its jurisdictional grasp, strikes a balance between federal power and state sovereignty. The 1991 filing by the City of Bridgeport, Conn., and the more recent financial problems of Orange County, Calif., have focused attention on Chapter 9.

Chapter 9 is available to those municipalities (i.e., any political subdivision, public agency or instrumentality of a state) that meet certain requirements. These requirements, in pertinent part, include that the entity must:

1. be a municipality;
2. be specifically authorized by the state or state law to file for bankruptcy relief;
3. be insolvent;
4. desire to propose and effect a plan to adjust its debts; and
5. have either negotiated a plan of adjustment with its creditors, attempted to do so unsuccessfully, or shown that attempts to negotiate with its creditors would be impracticable.

The Chapter 9 case is commenced by filing a voluntary petition alleging that the five requirements have been met. A Chapter 9 case cannot be commenced through an involuntary proceeding. Unlike the other chapters, there is no bankruptcy estate created by the filing. The municipality retains total control of its property, revenues and the use or enjoyment of any income- producing property. In no situation may a trustee or examiner be appointed. Further, the Bankruptcy Court does not have any power over the municipality's property and may not interfere with the municipality's political or governmental powers. In other words, with the exception of working out a plan of adjustment, the municipality proceeds with "business as usual." Finally, in order to avoid the infringement of a state's right to control its instrumentalities, the bankruptcy proceeding may not limit or impair this control by the state.

Chapter 9 supplements the protection afforded by the automatic stay of §362(a). The Chapter 9 stay extends to any officer or inhabitant of the municipality in any action seeking to enforce a claim against the municipality. It further precludes the enforcement of a lien on or arising out of taxes or assessments owed to the municipality.

The municipality has the exclusive right to file a plan of adjustment. There is no time limit for filing a plan; however, the Bankruptcy Court may fix a date by which the plan must be filed. Certain provisions of Chapter 11 controlling the contents of plans and the treatment of claims apply to the formulation of Chapter 9 plans. The provisions adopted by Chapter 9 leave the municipality a large amount of discretion in how it proposes to adjust its debts, including whether and to what extent such claims are to be discharged.

Chapter 11

This is the "Reorganization" chapter, the one most usually highlighted in media reports. It is available for individuals, partnerships and corporations, both on a voluntary and involuntary basis. The intent of the chapter is to provide a mechanism whereby business debtors may financially reorganize and propose a plan of reorganization to creditors which provides a greater return than would a liquidation. Many of the provisions become quite complicated because of the unusual issues that are created in the reorganization process. The provisions in this chapter apply only to Chapter 11 cases.

Chapter 11 generally allows the debtor to continue its business operations as it proceeds to the desired goal of a confirmed Plan of Reorganization, which must meet certain statutory criteria. A major rationale for business reorganizations is that the value of a business as an ongoing concern is greater than it would be if its assets were liquidated and sold. Generally, it is more economically efficient in the long run to reorganize than to liquidate, because doing so preserves jobs and assets. Cooperation among the various interests, however, is crucial to a successful reorganization.

Chapter 11 may be commenced by the filing of a voluntary petition by the debtor, or the filing of an involuntary petition by creditors that meets certain statutory requirements. As with cases under other chapters, a stay of creditor actions against the debtor automatically goes into effect when the bankruptcy petition (whether voluntary or involuntary) is filed. The automatic stay provides a breathing spell for the debtor during which negotiations can take place to try to resolve the difficulties in the debtor's financial situation and propose a reorganization plan.

Upon filing of a voluntary petition for relief under Chapter 11 (or, in an involuntary case under this chapter, the entry of an order for such relief) the debtor automatically assumes a new identity as the "debtor-in-possession." This term refers to a debtor that keeps possession and control of its assets while undergoing a reorganization under Chapter 11, without the appointment of a case trustee, prior to confirmation of a Chapter 11 plan. The appointment of a trustee occurs only in a small percentage of Chapter 11 cases where cause (e.g., fraud, mismanagement or in the interests of creditors) has been established.

The debtor- in- possession's duties include accounting for property, examining and objecting to claims, and filing monthly operating and other reports as required by the court and the U.S. Trustee. The U.S. Trustee is responsible for monitoring the debtor-in-possession's compliance with these reporting requirements. The debtor-in-possession also has many other powers including the right, with the court's approval, to employ attorneys, accountants, appraisers, auctioneers or other professional persons.

In most Chapter 11 cases, the debtor has hundreds if not thousands of creditors, making it impractical for the debtor to try to negotiate with all of them. Thus, creditors' committees can play a major role in Chapter 11 cases. The U.S. Trustee appoints the committee, which ordinarily consists of the persons who hold the seven largest unsecured claims against the debtor. The committee may consult with the debtor-in-possession on the administration of the case, investigate the conduct of the debtor and the operation of the business, and participate in the formulation of a plan. A creditors' committee can be an important safeguard to and watchdog over the management of the business by the debtor-in-possession.

There is no specific statutory time limit set for the filing of a plan; however, the debtor has a 120-day period during which it has an exclusive right to file a plan and a 180-day period to solicit acceptance of the plan. The exclusivity period may be extended (and frequently is) or shortened by the court for "cause." After the exclusive period has expired, a creditor or any other party in interest may file a competing plan. The U.S. Trustee, however, may not file a plan.

Although preparation, confirmation and implementation of a plan of reorganization are at the heart of a Chapter 11 case, the debtor often will require funds to operate its business during the case. Indeed, this is one of the first problems facing a Chapter 11 debtor.

When a Chapter 11 debtor needs operating funds, use of cash collateral may be insufficient. Post-petition financing may be obtained from a lender by giving the lender a court-approved super-priority administrative claim with priority over other unsecured creditors, by giving the lender a lien on unencumbered assets and/or by granting the lender a priming lien on encumbered assets.

The U.S. Trustee plays a major role in monitoring the progress of a Chapter 11 case and supervising its administration. The U.S. Trustee is responsible for monitoring the debtor-in-possession's operation of its business, the submission of operating reports and fees, applications for compensation and reimbursement, plans and disclosure statement and creditors' committees. The U.S. Trustee also conducts the meeting of creditors in a Chapter 11 case, and appoints the official committee of unsecured creditors (and any other appropriate committee) for each case.

Frequently, the debtor-in-possession will initiate a lawsuit, known as an adversary proceeding, to recover money or property for the estate. Adversary proceedings also may take the form of lien avoidance actions, actions to avoid preferences, actions to avoid fraudulent transfers or actions to avoid post-petition transfers. Creditors also may file adversary proceedings such as complaints to determine the priority of a lien, to revoke an order of confirmation of a plan, to determine the dischargeability of a debt, to obtain an injunction or to subordinate a claim of another creditor.

A claim is a right to payment or a right to an equitable remedy for a failure of performance. If a claim is not listed by the debtor in its schedules and statements as disputed, contingent or unliquidated and the creditor agrees with the amount of his claim as listed, then the creditor need not file a proof of claim in a Chapter 11 case. It is the responsibility of the creditor to determine whether its claim is accurately listed by the debtor in its schedule of liabilities. In all other instances, a claim needs to be filed; an Official Form has been created for this purpose. The debtor must provide notification to those creditors whose names are added and whose claims are listed as a result of an amendment to the schedules. An equity security holder the holder of an equity interest in the debtor files a proof of interest, rather than a proof of claim.

The court may convert or dismiss a Chapter 11 case upon the request of a party for "cause" when there is a continuing loss to the estate, an inability to effectuate a plan, unreasonable delay that is prejudicial to creditors, denial or revocation of confirmation, or inability to consummate a confirmed plan. A debtor in a case under Chapter 11 has a one- time absolute right to convert the Chapter 11 case to a Chapter 7 case, unless: (1) the debtor is not a debtor-in-possession; (2) the case originally was commenced as an involuntary case under Chapter 11; or (3) the case was converted to a case under Chapter 11 other than at the debtor's request. A debtor in a Chapter 11 case does not have an absolute right to have the case dismissed upon request.

During the first 120 days after the filing of the voluntary bankruptcy petition, only the debtor-in- possession may file a Plan of Reorganization. The debtor-in-possession has 180 days after the filing of the voluntary petition or, in the case of an involuntary petition, the Order for Relief, to obtain acceptances of the plan. The court may extend or reduce this exclusive period for cause. The exclusive right of the debtor-in-possession to file a plan is lost only if: (1) a trustee has been appointed in the case; (2) the debtor has not filed a plan within the 120- day exclusive period or any extension granted by the court; or (3) the debtor has not filed a plan that has been accepted by each class of claims or interests that is impaired under the plan within the 180-day period or any extensions granted by the court.

If the exclusive period expires, other parties in interest in the case, such as the creditors' committee or any creditor, may file a plan. Liquidating plans are permissible.

Acceptance or rejection of the plan cannot be solicited without prior court approval of a written disclosure statement. The disclosure statement must provide "adequate information" sufficient to enable the holder of a claim or interest to make an informed judgment about the plan. After the disclosure statement has been approved, the following items must be mailed to the U.S. Trustee and all creditors and equity security holders: (1) the plan, or a court approved summary of the plan; (2) the disclosure statement approved by the court; (3) notice of the time within which acceptances and rejections of the plan may be filed; and, (4) such other information as the court may direct, including any opinion of the court approving the disclosure statement or a court approved summary of the opinion.

Section 1123(a) of the Bankruptcy Code lists the mandatory contents of a plan, and §1123(b) lists the discretionary provisions. Section 1123(a)(1) provides that a Chapter 11 plan shall designate classes of claims and interests for treatment under the proposed reorganization. Generally, a plan will classify claim holders as secured creditors, unsecured creditors entitled to priority, general unsecured creditors and equity security holders.

When competing plans are presented and meet the requirements for confirmation, the court must consider the preferences of the creditors and equity security holders in determining which plan to confirm. Any party in interest may file an objection to confirmation of a plan. The Bankruptcy Code requires the court, after notice, to hold a hearing on confirmation of a plan. For confirmation to be granted, the court must find that (1) the plan is feasible, (2) that it is proposed in good faith and (3) that the plan and the proponent of the plan are in compliance with the Bankruptcy Code. In addition, the court must find that confirmation of the plan is not likely to be followed by liquidation or the need for further financial reorganization.

After the plan is confirmed, the debtor is required to make plan payments and is bound by the provisions of the plan of reorganization. The confirmed plan or discharge creates new contractual rights, replacing or superseding pre- bankruptcy contracts. Recent amendments require the Chapter 11 debtor to continue to make quarterly fee payments to the U.S. Trustee post-confirmation, until the case is finally closed.

At any time after confirmation and before "substantial consummation" of a plan, the proponent of a plan may modify a previously confirmed plan. This should be distinguished from pre-confirmation modification of the plan. A modified post-confirmation plan does not automatically become the plan. The court must confirm the plan as modified. A Chapter 11 trustee or debtor-in-possession has a number of responsibilities to perform after confirmation, including consummating the plan, reporting on the status of consummation and applying for a final decree, which closes the case.

A revocation of the confirmation order is an undoing or cancellation of the confirmation of the plan. A request for revocation of confirmation, if made at all, must be made by a party in interest within 180 days of confirmation. The court, after notice and a hearing, may revoke a confirmation order "if and only if the confirmation order was procured by fraud."

The final decree closing the case should be entered after an estate has been fully administered.

Chapter 12

This chapter is entitled "Adjustment of Debts of a Family Farmer with Regular Income" and was added to the Bankruptcy Code to meet the unique needs of farming operations confronted with financial difficulties. Its provisions follow the concepts contained in Chapter 11 and elsewhere in the Bankruptcy Code, but provide greater flexibility and latitude for the farm debtor than would otherwise be available if the case were in Chapter 11. The term "family farmer" is defined in Section 101(18) and is available to individuals and corporations, where aggregate debts do not exceed $1,500,000 and not less than 80% of the debts arise out of farming operations owned by such debtor. The provisions in this chapter apply only to Chapter 12 cases.

Chapter 12 of the Bankruptcy Code was enacted by Congress in 1986, specifically to meet the needs of financially distressed family farmers. A Chapter 12 filing begins in much the same way as other bankruptcies with the filing of a petition and several additional forms, schedules, financial statements and a Chapter 12 statement. Upon filing of the petition, the automatic stay goes into effect. As with all other types of bankruptcy, approximately 20 to 40 days after the petition is filed, a §341 meeting of creditors is held. The debtor must attend the meeting, where creditors and the trustee appear and ask questions of the debtor.

The debtor must file a plan of repayment with the petition or within 90 days thereafter, unless the court determines that an extension is justified. Plans, which must be approved by the court, provide for payments of fixed amounts to the trustee on a regular basis. The trustee then distributes the funds to creditors according to the terms of the plan. As in Chapter 13, the debtor's plan usually lasts three to five years. It must provide for payment in full to all priority creditors. Unsecured creditors do not have to be paid in full, as long as the debtor pays under the plan all projected "disposable income" over the three to five years that the plan is in effect, and unsecured creditors receive at least as much as they would receive if the debtor's non-exempt assets were liquidated in Chapter 7. Disposable income is defined as income that is not reasonably necessary for the maintenance or support of the debtor or his/her dependents, or for payment of expenditures necessary for the continuation, preservation and operation of the debtor's business. Secured creditors must be paid at least as much as the value of the collateral pledged for the debt. One feature of Chapter 12 is that, in certain circumstances, payments to secured creditors can continue longer than the five-year period during which the plan provides payment to unsecured and priority creditors.

Within 45 days after the filing of the plan, the Bankruptcy Judge must determine whether the plan is feasible and satisfies all requirements for confirmation at a "confirmation hearing." Creditors may attend this hearing and object to the plan or any part of the plan. Once the plan is confirmed by the Bankruptcy Judge, the trustee commences distribution of the funds received from the debtor. The Chapter 12 trustee keeps a percentage of these distributions as compensation for work performed. If the plan is not confirmed, the funds paid to the trustee are returned to the debtor after deduction of the trustee's fee. Once the court confirms the plan, it is incumbent upon the debtor to make the plan succeed. The debtor must make regular payments to the trustee. During the period of the plan, the debtor should not incur any significant credit obligations without consulting the trustee.

As is the case under Chapter 13, upon successful completion of all payments under the confirmed plan, the debtor will receive a "discharge" that extinguishes the debtor's obligations to pay any unsecured debts that were included in the plan, even though they may not have been paid in full. After the discharge has been granted, those creditors whose claims were provided for in full or in part under the plan no longer may initiate or continue any legal or other action against the debtor to collect the discharged obligations. However, as with other forms of bankruptcy, there are certain categories of debts that are not discharged. In the event that there exist circumstances for which the family farmer "should not justly be held accountable," and if other statutory criteria are met, a family farmer may be excused from completing payments under a Plan of Reorganization. If the court finds that such circumstances exist along with other criteria, the judge may award the debtor a "hardship" discharge of all unsecured debts. Injury or illness that precludes employment sufficient to fund even a modified plan may serve as the basis for a hardship discharge.

Chapter 13

This chapter is entitled "Adjustment of Debts of an Individual with Regular Income" and is available only to individuals with regular income. Additionally, to be eligible, an individual's debts (or those of a hu