The 2005 amendments to the Bankruptcy Code modified the landscape for a key defense to bankruptcy preference actions. Preference actions are when a trustee or debtor in possession sue a creditor for the return of payments made in the 90 days before a bankruptcy. The concept is that creditors that receive more than similarly situated creditors by extracting unusual pre-bankruptcy payments from the struggling debtor should have to give the money back so that it can be shared equally with their peers. This creates a disincentive to employ coercive collection techniques when a debtor is teetering on the edge of bankruptcy. However, there is a defense to a preference case that allows the recipient of the money to keep it if the transfer was “ordinary”. There are several other defenses to preference actions (some of which I discuss here), but I will be highlighting the ordinary course of business defense, and more specifically, the “ordinary business terms” prong of that defense.

Section 547(c)(2) is where the general defense is found. It says:

(c) The Trustee may not avoid under this section a transfer –
(2) to the extent that such transfer was in payment of a debt incurred by the debtor in the ordinary course of business or financial affairs of the debtor and the transferee, and such transfer was
(A) made in the ordinary course of business or financial affairs of the debtor and the transferee; or
(B) made according to ordinary business terms.

The “ordinary course of business” prong (subsection A) is known as the subjective test because it concerns the history of dealing between specific the debtor and creditor. The “ordinary business terms” prong (subsection B) is known as the objective test because it concerns what is normal in the industry in which the debtor and creditor do business.

Prior to 2005, a preference defendant had the burden of proving both prongs of the defense, but now either one will suffice. This means that a preference defendant can win by proving that a suspect payment was normal for the industry even if it was not normal in the course of dealing with the debtor. However, much of the case law on the topic is from pre-2005 bankruptcy cases. During that time, when it was necessary to prove both prongs, the objective component was often treated like an afterthought. Now that “ordinary business terms” is its own defense, the question is how will the courts interpret it–and much is still uncertain because many preference cases coming to decision now are still in base cases filed before 2005. However, it is clear that in order to carry its burden on the “ordinary business terms” prong of the defense, a defendant will have to retain a trade expert to prepare a report and testify on the standard payment timing and behavior within the industry group during the preference period. Courts will have wide discretion to assess dueling expert testimony, define what constitutes the relevant industry group, and define the range of what should be considered “ordinary” within that group. There are some obvious challenges in presenting this defense, like obtaining often proprietary trade information within an industry group. Moreover, there is always wide discretion in defining a sample group, and thus much to fight over: Whether the group of businesses in the relevant industry group is defined broadly or narrowly will dictate much, and is within the discretion of the court.
An added factor to consider is the preference defendant’s right to demand a jury trial and transfer to the District Court. It has this right when it has not filed a proof of claim in the underlying bankruptcy case (the U.S. Supreme Court’s 2011 decision, Stern v. Marshall, does not change this).

In bankruptcy there is a hierarchy in the right to get paid. Secured creditors come before unsecured creditors who, in turn, come before stockholders. Senior creditors get paid in full before their juniors get anything. In a Chapter 11 bankruptcy scenario, there is usually a tier of creditors that is only partially “in the money.” For example, if a debtor’s secured debt will be paid in full, but unsecured debt will receive 10 percent on the dollar, the unsecured debt is what is known as the fulcrum security. That is because the unsecured debt is the tier of claims that will likely end owning the reorganized debtor and that will have maximum leverage over approval of the debtor’s reorganization plan. Why is this the case?

The reason the only-partially-in-the-money group of claims end up “owning the debtor” is because of something called the absolute priority rule. That rule requires that senior creditors be paid in full before junior claims get anything. If a class of claimants is only being partially paid, then no one else is entitled to receive the stock (i.e. ownership) of the reorganized debtor unless they buy this stock with cash or all classes approve the plan. So the partially-in-the-money group of claims has a presumptive right to the stock of the reorganized debtor.

A fulcrum is a lever. A partially-in-the-money group of claims has leverage over a bankruptcy plan because they are often the only class of claims that has a vote that matters. The existence of a fulcrum security usually means that a senior class of debt is being paid in full. The approval of this senior class is automatic. Any interests junior to the fulcrum will get nothing, and so the rejection of the plan by that class of claims is presumed. Consequently, the fulcrum group is the only one with a vote that matters, and this gives it leverage over plan confirmation. No wonder the this concept has such a prominent plays a key role in distressed company investing.

Credit bidding is a right that secured creditors have in bankruptcy sales allowing them to control the sale of their collateral. When collateral that secures a lien is proposed to be sold at a bankruptcy auction, a secured creditor is allowed to bid the amount of its debt as a credit bid, i.e. not a cash bid. This means that the secured creditor can compete with cash bidders with just a pen stroke. The right to credit bid, which is found principally in Section 363 of the Bankruptcy Code, gives undersecured creditors the ability to control their collateral when it it worth less than the face amount of their claims. For example, if some real estate worth $500,000 and collateral for a bank loan of $750,000 was proposed to be sold, a debtor would find it difficult to sell the property over the objection of its mortgagee in a bankruptcy sale for its value. This is because the secured lender would have the ability to bid the full amount of its claim of $750,000 without offering any cash. Credit bidding is seen as one of the chief rights of secured creditors in bankruptcy.

Although credit bidding has traditionally been seen as available in all bankruptcy sales, this notion has been partially eroded. In the seminal case of In re Philadelphia Newspapers, LLC, 599 F. 3d 298 (3rd Cir. 2010) the influential Third Circuit Court of Appeals upheld bid procedures that barred a secured lender from credit bidding at a bankruptcy sale. The key point of this case was that the sale was a plan sale and not a Section 363 sale. Consequently, the panel held that the debtor had the right to give the lender what is known as the “indubitable equivalent” of its claim, and that there was no statutory right to credit bid under the circumstances. The panel left open the option of the lender to contest whether it had really received indubitable equivalent value at the plan confirmation stage. Philadelphia Newspapers offers an intriguing alternative to attempt a cramdown of a secured claim through a bankruptcy sale.

Section 1322 of the Bankruptcy Code allows a debtor to assume an unexpired lease, such as for an apartment or car, in their Chapter 13 case. This right is subject to the provisions of Section 365 of the Code, which provide:

If there has been a default in an executory contract or unexpired lease of the debtor, the [Chapter 13 debtor] may not assume such contract or lease unless, at the time of assumption of such contract or lease, [he]–

(A) cures, or provides adequate assurance that [he] will promptly cure, such default [other than, in general, a nonmonetary default];

(C) provides adequate assurance of future performance under such contract or lease.

I’ve edited the section to highlight the point I’m making in this article, which is that to assume a defaulted lease in Chapter 13 a debtor must cure or convince the Court that he will “promptly” cure the default. Moreover, the debtor must convince the Court that he will be able to make the regular payments going forward. The latter will usually be satisfied by evidence of post-petition payments and a feasible plan. However, the first requirement is a bit more murky.

Most Chapter 13 debtors will want to do it this way: Insert plan provision assuming their desired lease and pay out the arrears over the plan term. However, if challenged by the lessor, such a provision may not be considered a “prompt” cure within the meaning of Section 365. There has been little litigation on this issue, but some courts have examined the issue of what constitutes a prompt cure under these circumstances. For example, the court in the case of in re Reed, 226 B.R. 1 (Bankr.W.D.Ky. 1998) held that a six-month cure was required to assume a defaulted car lease and satisfy the requirement of promptness. Other courts have held that longer cures are permissible. See, e.g., in re Coors of N. Miss., 27 B.R. 918 (Bankr.N.D.Miss. 1983) (three years).

If a court is inclined to allow only a short cure period, a real problem is that in most jurisdictions (including here in Massachusetts) plan confirmation and accompanying distributions will take longer than any short cure period. There are ways to deal with this in the face of pressure from the lessor. Two approaches would be to file a motion for an interim distribution to the lessor from the trustee or to carve out direct payments to the lessor before plan confirmation in addition to regular lease payments. Either approach should work as long as the debtor has sufficient income to make the regular lease payments plus the cure payments (either via the trustee or directly) in the amount of time that the court considers “prompt.” Like many terms in bankruptcy, and the law in general, what is “prompt” is a flexible term that, in practice, vests wide discretion in the court to do what it thinks is fair under the circumstances. Since a Chapter 13 debtor usually will need a car or home in order to earn a living and make plan payments, I expect that most courts will be generous in the amount of time they allow debtors to cure lease arrears.

When it comes to payment plans for Chapter 7 cases, all fees and costs must be paid before the case is filed. At first glance, this may disappoint you, but most people it’s not a problem. The payment plan period usually overlaps with the pre-filing process. In other words, you and your lawyer need time to prepare your case for a successful filing. This work is done along side the payment plan. Once the payments are made and the work is completed, the case is filed. This usually works fine for people unless they have an unusual emergency (beyond just being subject to calls and normal debt lawsuits). In those cases, a payment plan will not work well, and it will be necessary to pay for a Chapter 7 case quickly.

Many lawyers would like to be able to file a Chapter 7 cases before cases were completed, but this is illegal. If an attorney extends a payment plan into the period after a Chapter 7 is filed, he or she is breaking the law. This is because unpaid, pre-filing fees cannot be collected after a Chapter 7 case is filed due to the automatic stay (and later the discharge injunction). Any bankruptcy lawyer who would consider offering an illegal payment plan is either ignorant about basic bankruptcy law or is playing fast and loose with the rules. In either case, you do not want to deal with someone like this. In general, the Court will not excuse you from the law just because you were following the advice of an unethical lawyer.

Chapter 13 bankruptcy is usually a good fix for someone behind on their mortgage if a loan modification outside of bankruptcy is not possible and foreclosure is looming. However, there are times when a Chapter 13 will not work. I will mention three of these and then say a few additional words about the last.

1. You generally need to be able able to afford your mortgage payment plus an additional amount to pay to the trustee to cure your arrears.

2. You need to be under the Chapter 13 debt limits ($360,475 in unsecured debt and $1,081,400 in secured debt).

3. You must be able to complete your plan in no more than five years.

This last issue is one that I’ve been confronted with recently. When a family can afford their mortgage payment but doesn’t have the additional amount needed to live and pay back mortgage arrears over five years, Chapter 13 won’t work because five years is the maximum limit of a Chapter 13 plan. This limitation does not apply in Chapter 11 cases.

Although individual Chapter 11 cases are more complex and expensive than Chapter 13 cases, sometimes they are the only way to get the job done. You could, for example, propose a plan that would cure your mortgage arrears over seven years in Chapter 13, leaving you sufficient funds to live. Although this is possible, the option does carry with it some costs.

1. Chapter 11 is far more complex and, therefore, expensive than Chapter 13 in terms of legal fees and costs.

2. Proposing a plan calling for payment over, say, seven years could be challenged on feasibility grounds. It’s hard to say what will happen seven years in the future, and this can be a negative factor affecting plan confirmation chances. However, with a stable source of income and realistic projections, plan confirmation is possible.

3. Creditors must vote on a Chapter 11 plan. Even if you are attempting what is known as a cramdown plan, you must have at least one consenting class of claims. If the mortgagee controls your secured class and opposes your plan, this can create difficulties. However, most of the time Chapter 11 prompts creditors to act in their economic interest, including preferring a cure over a foreclosure.

Tax returns can be a trap for the unwary in Chapter 13 bankruptcy. Often, bankruptcy debtors do not have their tax returns squared away and filed before filing for bankruptcy. When non-tax creditors are pursuing you, and you need quick relief, often tax returns are the last thing on your mind. However, the need to file recent tax returns is enshrined in the updates to the bankruptcy code that went into effect in 2005.

Section 1308 of the Bankruptcy Code provides:

(a) Not later than the day before the date on which the meeting of the creditors is first scheduled to be held under section 341(a), if the debtor was required to file a tax return under applicable nonbankruptcy law, the debtor shall file with appropriate tax authorities all tax returns for all taxable periods ending during the 4-year period ending on the date of the filing of the petition.

This means that you must file all of your state and federal tax returns due within the past four years before your meeting of creditors. If you can’t do this, however, the law provides some help. At her discretion, the bankruptcy trustee can hold open the meeting for a period not exceed 120 days. It is the job of your lawyer to request this if your tax returns are not filed as of the date of your meeting. If the returns are not filed, and the meeting is not held open, your case will be dismissed if someone asks the Court to dismiss it. The reason for this is Section 1307(e) of the Bankruptcy Code, which provides:

Upon the failure of the debtor to file a tax return under section 1308, on request of a party in interest or the United States trustee and after notice and a hearing, the court shall dismiss a case or convert a case under this chapter to a case under chapter 7 of this title, whichever is in the best interest of the creditors and the estate.

photo by woolennium

The L.A. Dodgers baseball franchise filed for bankruptcy protection today. After a search, I think this is the only place on the “free internet” that the Los Angeles Dodgers’ Bankruptcy Petition can be viewed in its entirety. The list of largest creditors is interesting because it includes many of the Dodger players, including former Red Sox star Manny Ramirez and Andruw Jones.

The Dodgers say they filed for bankruptcy today because of cash flow problems caused by Major League Baseball’s refusal to approve its new television deal with Fox Sports worth a purported $3 billion. As is typical in these large corporate Chapter 11 cases, the Dodgers have lined up a loan to help it operate in the beginning phase of its bankruptcy. The debt facility is $150 million and the Dodgers will seek court approval of this interim borrowing tomorrow from a Delaware bankruptcy judge. The Dodgers plan to use this money to continue normal operations while they attempt to reorganize through the Chapter 11 process.

Although two affiliated Dodger entities also filed bankruptcy today, the main case number is 11-12010 and is pending in the United States Bankruptcy Court for the District of Delaware.

I wanted to write something about what makes those who procrastinate file bankruptcy. First of all, procrastination and bankruptcy often go hand in hand. The unknown is scary and making a move during a period of insecurity is hard. Bankruptcy often feels optional at the beginning: maybe that loan modification, family help, or creditor concession will come through and save the day. Even once a person knows they need to file, they often wait, paralyzed, until something truly forces their hand.

I figure this is all just human nature, and usually, when and if someone needs to file for bankruptcy, the waiting and hoping has not truly hurt them. Maybe it has caused a bit more credit damage, but no irreparable harm has been done. However, debt default has real consequences and events do come along to make even the most recalcitrant file for bankruptcy protection. Here are some:

1. Wage garnishment. This is a big one. Having your paycheck shrink on very short notice causes major shock and distress. This is an example of having waited too long and getting yourself into a tough spot. Bankruptcy will stop the garnishment, but the garnishment makes it harder to pay the fees to get into bankruptcy. Plus, a normal bankruptcy takes time to file, and this is in conflict with the next looming pay period and garnishment.

2. The Approaching Foreclosure: Sometimes this is just tragic because people wait too long. If a bankruptcy is filed on the eve of a foreclosure sale, it will still stop the sale. However, once the hammer falls and the memorandum of sale is signed, the foreclosure is final and cannot be reversed absent the rarest of circumstances.

3. The Arrest Warrant. In Massachusetts, it is common for procrastinators to be served with lawsuits and supplementary process summons. If a debtor ignores the latter, civil arrest warrants will follow. A sheriff will usually make telephone contact with the debtor to arrange voluntary attendance at the courthouse, but all the same, an arrest warrant is scary stuff. It makes people get serious and take action about handling their debt problems.

I want to stress something and dispel a misconception some have: A normal bankruptcy takes time to prepare. If you wait until the last minute, you will have an “emergency case”. Lawyers will charge you more money than they do for a normal case to put whatever they are doing on hold and take on your emergency–if they can take it on at all. My advice would be to not let things become an emergency before taking action.

The government can garnish 15 percent of disposable pay to collect a defaulted student loan. They do not need a court judgment to do so. “Disposable pay” means the amount of money left in your paycheck after amounts required by law, like taxes, come out. However, you are always guaranteed to be left with an amount per week that is 30 times the federal minimum wage, which is now $7.25 per hour. If you have other debt troubles and are getting garnished for other debts, the maximum total amount that can be taken from you is 25 percent of your disposable income.

Being subject to a student loan garnishment is tough, but there are strategies for dealing with it. One option is to rehabilitation the loan by arranging to make payments. Another option is to consolidate out of the defaulted loan. Some people even file Chapter 13 bankruptcy cases to stop the garnishment and get a three to five year reprieve from their student loan problems, though this only makes sense if one has other debt problems.

Student loan are the next wave of defaults in this country, as I wrote about here.