BANKRUPTCY ISSUES FOR THE BUSINESS LAWYER AN OVERVIEW. Jon D. Schneider, PC Goodwin Procter LLP, Boston

Transcription

1 BANKRUPTCY ISSUES FOR THE BUSINESS LAWYER AN OVERVIEW Jon D. Schneider, PC Goodwin Procter LLP, Boston

2 TABLE OF CONTENTS Page INTRODUCTION...1 ELIGIBILITY FOR RELIEF...2 Chapter Chapter Chapter CASE COMMENCEMENT...3 A. Voluntary Petition...3 B. Involuntary Case...3 CONVERSION; DISMISSAL; ABSTENTION...4 PARTIES TO A CASE...4 A. Chapter Debtor Trustee Counsel to Trustee...5 B. Chapter Debtor Committees...5 a. Formation...5 b. Duties of a Committee Trustee and Examiner...6 a. Appointment...6 b. Duties...6 c. Examiner United States Trustee Professional Persons...7 C. Chapter Debtor Chapter 13 Trustee...8 GENERAL MATTERS RELATING TO BUSINESS OPERATIONS...8 A. Automatic Stay...8 B. Use, Sale, or Lease of Property In General Outside the Ordinary Course of Business Cash Collateral Sale Free and Clear of Interests of Others...9 C. Obtaining Credit...10 EXECUTORY CONTRACTS AND UNEXPIRED LEASES...10 A. In General...10 i

3 B. Assumption...11 C. Assignment...12 D. Executory Contracts in Limbo; Unexpired Personal Property Lease Obligations Must Be Performed...13 E. Rejection...13 F. Assumption of Shopping Center Leases...13 PRIORITY SCHEME...14 A. The Estate...14 B. Exemptions...14 C. Secured Claims...15 D. Statutory Priorities...15 SECURED CLAIMS AND BANKRUPTCY...15 A. Adequate Protection and Other Rights of Secured Creditors Adequate Protection Relief from Stay Setoff Dismissal of Case...17 a. For Cause...17 b. Dismissal of Bad Faith Filing...17 B. Risks to Secured Creditors Claims Avoidance of Invalid or Unperfected Liens Avoidance of Preferential Transfers...18 a. Elements...18 b. Exceptions...19 c. One-Year Period and Guarantors Fraudulent Transfers Secured Creditor's Interest in Post-petition Property...20 a. In General...20 b. Rents Equitable Subordination of Secured Claims...21 C. Extent of Secured Claims Claim is Secured to Extent of Value Right to Collect Interest and Attorneys Fees...21 a. Interest on Secured Claims...21 b. Attorneys' Fees and Other Costs of Collection Preservation Costs...22 D. Alternative to Contesting Debtor's Right to Use Collateral; Post-petition Financing Settlement of Adequate Protection Issues Post-petition Financing...23 E. Strategic Considerations...23 PROOFS OF CLAIM...24 A. General...24 B. Form for Proof of Claim...25 ii

4 C. Time for Filing Chapter 7, 12 or Chapter D. Determination of Claims...25 E. Declining to File a Proof of Claim...25 THE PLAN OF REORGANIZATION AND TREATMENT OF CLAIMS...26 A. General Provisions Who May File Disclosure and Solicitation...26 B. Classification and Impairment of Claims Classification Impairment of Claims...27 C. Acceptance and Confirmation of Plan Voting and Acceptance Hearing on Confirmation General Requirements for Confirmation Cram Down Absolute Priority Rule and New Value Exception Optional Treatment of Secured Claim Effect of Confirmation Asbestos Cases...31 CRAM DOWN OF SECURED CREDITOR'S CLAIM AND 1111(b) ELECTION...31 A. In General...31 B. Protections and Election Under 1111(b)...32 Chapter 13 CRAMDOWN...33 PARTNERSHIP BANKRUPTCIES...33 A. Case Commencement Voluntary Petition Involuntary Case...34 B. Case Administration...35 C. The Estate The Partnership The Partner...35 D. The Automatic Stay The Partnership The Partner...36 E. Rights of Chapter 7 Partnership Trustee Against Partners and Their Estates...36 F. Avoiding Powers...36 G. The Partner's Case...37 H. Distribution...37 iii

5 BANKRUPTCY ISSUES FOR THE BUSINESS LAWYER AN OVERVIEW Jon D. Schneider, Esq. Goodwin Procter LLP, Boston January 17, 2003 INTRODUCTION Bankruptcy is a federal court proceeding to administer the assets of an individual or an entity experiencing financial trouble. Such proceedings are conducted under 11 U.S.C. 101 et seq. (the Bankruptcy Code ). There are a variety of techniques and receivership proceedings administered by state or federal courts which deal with insolvent entities, but these materials will focus on formal bankruptcy proceedings under Chapters 7, 11 and 13 of the Bankruptcy Code. A business debtor may seek to reorganize or conduct its own liquidation under Chapter 11 or to be liquidated by a trustee under Chapter 7. Individuals may proceed under Chapter 11 or Chapter 7. In addition, individuals with regular income and liabilities under certain dollar limits may seek to reorganize under Chapter The primary goal of Chapter 7 is to sell assets as quickly as possible, usually by auction. Although this procedure has the advantage of speed, assets are usually sold at liquidation, rather than going-concern value. Conversely, the primary goal of Chapter 11 is to reorganize an entity or individual so that they may continue in business. Chapter 13 provides a mechanism for individuals to share a portion of their future income with creditors in return for a discharge from claims of creditors. Proceedings in bankruptcy are normally administered by Federal Bankruptcy Judges. Venue is normally determined by the location of the debtor. 2 In Massachusetts, the Bankruptcy Court maintains two divisions. The Eastern Division is administered in the O Neill Federal Office Building, 10 Causeway Street, Boston by Judges Carol J. Kenner, William C. Hillman and Joan N. Feeney. The Western Division is administered at the Donahue Federal Building, 595 Main Street, Worcester, Massachusetts by Bankruptcy Judges Joel B. Rosenthal and 1 Individuals who are farmers may seek to reorganize under Chapter 12. There are special provisions of Chapter 7 dealing with the liquidation of stock brokers and commodity brokers and a special provision of Chapter 11 dealing with railroad reorganizations. In addition, Chapter 9 deals with the reorganization of a municipality. These proceedings are very unusual and not likely to be encountered by the business lawyer in Massachusetts. 2 Alternate venues, such as place of incorporation, are available to corporations, but normally used only in very large business cases.

6 Henry J. Boroff. 3 Geographical guidelines published by the Court to determine venue as between the two Massachusetts divisions are attached. The Bankruptcy Court is an adjunct to the Federal District Court. By local rule, bankruptcy matters are automatically referred to the Bankruptcy Court. However, the Federal Court retains the discretion to remove the administration of any bankruptcy case to District Court and, under certain limited circumstances, a party has a right to have certain matters heard before the District Court. These jurisdictional and venue matters are set forth in 28 U.S.C In order to practice before the Bankruptcy Court, one needs access to the following materials Bankruptcy Code; Federal Rules of Bankruptcy Procedure ( FRBP ); Federal Rules of Civil procedure (many of which are incorporated by reference into FRBP); Local Rules of the Bankruptcy Court; Local Rules of the Federal Court; and specific information concerning procedures and filing fees published by the Clerk of the local Bankruptcy Court. (See generally ELIGIBILITY FOR RELIEF Section 109 of the Bankruptcy Code defines who may be a debtor. Certain entities, such as banks and insurance companies, are not eligible for relief under the Bankruptcy Code. Insolvency of these entities is handled under separate state or federal insolvency statutes. The general rules of eligibility under the Bankruptcy Code are as follows: Chapter 7. Any individual, partnership or corporation may be a debtor under Chapter 7 unless it is a railroad, bank or insurance company. Chapter 11. Any person that may be a debtor under Chapter 7 (except a stock broker or commodity broker) may be a debtor under Chapter 11 and a railroad may be a debtor under Chapter 11. Chapter 13. Any individual with (a) regular income and (b) unsecured debts less than $290,525 and secured debts less than $871,550 on the date of filing may file under Chapter Judge Boroff normally holds court in Springfield, Massachusetts and Judge Hillman also maintains a part-time courtroom in Hyannis to deal with proceedings from Barnstable County, Dukes County and Nantucket. 2

7 Generally a testamentary trust or a nominee trust is not considered eligible for relief under the Bankruptcy Code. However, if the trust is a business trust with transferable shares or a trust that conducts business, it falls within the definition of corporation and is eligible for relief. See 11 U.S.C. 101(9). In addition, a trust may be deemed to be a partnership eligible for relief. In re Medallion Realty Trust, 103 B.R. (Bankr. D. Mass., 1989). CASE COMMENCEMENT A. Voluntary Petition 1. A voluntary case is commenced by the filing of a petition with the Bankruptcy Court. When the debtor is a corporation, an officer of the corporation must have authority from the corporation s board of directors to file the petition. 2. The debtor need only allege that it is qualified to file the petition and that it is entitled to the benefits of the Chapter. No allegation is required with respect to insolvency or inability to pay debts. The filing of the petition automatically results in the entry of the order for relief which means that the proceeding is administered by the Bankruptcy Court. B. Involuntary Case 1. An involuntary petition under Chapter 7 or Chapter 11 may be filed against a person that may be a debtor under the Chapter, except that an involuntary proceeding may not be filed against a farmer or a corporation that is not a moneyed, business or commercial corporation. There are no involuntary proceedings under Chapters 9, 12 or Any three unsecured creditors holding aggregate claims of $11,625 that are not contingent and not subject to bona fide dispute may file an involuntary petition. If a debtor has fewer than twelve creditors, excluding employees or insiders of the debtor, there need be only one petitioning creditor. 3. The petition must contain an allegation that the debtor is generally not paying its debts as they come due, or that a custodian, such as an assignee under an assignment for the benefit of creditors, was appointed for or has taken possession of substantially all of the property of the debtor within 120 days prior to the filing date. 4. An involuntary petition is analogous to filing a complaint to commence a lawsuit. It does not constitute an order for relief although the automatic stay, explained below, does apply. The debtor is given the opportunity to contest the involuntary petition. Until final adjudication of the petition, the debtor is free to operate its business unless the court orders otherwise. 4 Chapter 12. A farmer with a regular annual income may be a debtor under Chapter 12. Chapter 9. A municipality that is specifically authorized by state law to make use of the Bankruptcy Code may file under Chapter 9. 3

8 5. A petitioner who files an involuntary bankruptcy petition in bad faith is subject to actual as well as punitive damages. CONVERSION; DISMISSAL; ABSTENTION A debtor may convert a proceeding under Chapter 7 to a proceeding under Chapter 11 or 13 if the debtor is eligible for relief under one of those Chapters. The conversion may be before or after an order for relief is entered. A proceeding under Chapter 11, 12 or 13 may be converted to a liquidation under Chapter 7 upon order of the Court. Conversion is the normal result of a failed reorganization, although the court has authority, upon notice to creditors, to dismiss the case. Bankruptcy Code 1112 and A court may dismiss a case for cause under Bankruptcy Code 707 or abstain from conducting a proceeding under Bankruptcy Code 305. PARTIES TO A CASE 1 A. Chapter 7 1. Debtor The debtor and his counsel have a limited role under Chapter 7. The debtor s basic duties are to: (a) file a list of creditors, schedules of assets and liabilities, a schedule of current income and expenditures and a statement of financial affairs; (b) cooperate with the trustee; and (c) surrender all his property, books and records to the trustee. Bankruptcy Code 521. In addition, the Debtor must appear and be examined under oath at a so-called Section 341 Meeting. Bankruptcy Code 341. An individual debtor may also make a claim for exemptions (see discussion below). The debtor normally has no further role. Unless an objection to discharge is filed within the time set by the court, the individual is granted a discharge. Bankruptcy Code 727, 523, 524 and Trustee A trustee is appointed by the United States Trustee (see discussion below) to administer the Chapter 7 liquidation. The United States Trustee maintains a list of qualified individuals who are appointed in rotation based upon the order in which petitions under Chapter 7 are filed. The compensation of the trustee is limited to a percentage of the assets administered. Bankruptcy Code 326. A large number of Chapter 7 cases contain no assets because all the assets are foreclosed upon by secured creditors or, in the case of individuals, claimed as exempt (see discussion below). 5 These materials will discuss Chapters 7, 11 and 13. A Chapter 12 is substantially similar to Chapter 13 and Chapter 9 is analogous to Chapter 11. 4

9 3. Counsel to Trustee If there are assets to be administered, the trustee will normally employ counsel who may be himself or his law firm. A trustee and his counsel must be disinterested. Bankruptcy Code 327. B. Chapter Debtor In Chapter 11 there is a strong presumption that the debtor should retain control of its business during reorganization, subject to some degree of supervision by one or more committees and by the United States Trustee. In that capacity, the debtor is characterized as a debtor in possession and remains in possession unless a specific showing is made justifying appointment of a trustee. As a debtor in possession, the debtor is a fiduciary and is responsible for protecting, collecting and conserving the bankruptcy estate's property for the benefit of creditors. The debtor in possession generally has all the rights and powers and must perform all the functions and duties of a Chapter 11 trustee. It may operate its business without specific court authorization, except that actions outside the ordinary course of business, for example a major asset sale, require court approval. The debtor in possession may prosecute or appear in and defend pending actions or proceedings on behalf of the estate. In most Chapter 11 cases, the debtor in possession is the central focus of the case and is expected to conduct normal business operations, protect the rights of the bankruptcy estate, and take the lead in proposing and negotiating a plan of reorganization. Once a trustee is appointed the role of the debtor in the case essentially ends. 2. Committees a. Formation i. As soon as practicable after the order for relief is entered, the United States Trustee is directed by statute to appoint a committee of creditors holding unsecured claims. In addition, the United States Trustee may appoint additional committees of creditors or of equity security holders. On request of a party in interest, the Bankruptcy Court may order the appointment of additional committees if necessary to assure adequate representation of creditors or of equity security holders. ii. In large bankruptcy cases, there may be several committees representing different interest groups such as trade creditors, equity security holders, debenture holders or preferred stockholders. Committee work can be time consuming and members are not entitled to compensation (although they are entitled to reimbursement of certain expenses). Thus, in cases involving assets of little value to unsecured creditors, a committee is not always appointed because few, if any, creditors are willing to serve. 5

10 iii. Governmental units are eligible to sit on creditor's committees in circumstances where they had acquired claims from a guarantor or when they are guarantors of a pension benefit payable by or on behalf of a debtor. b. Duties of a Committee The Bankruptcy Code specifies that a committee may: i. consult with the trustee or debtor in possession concerning the administration of the case; ii. investigate the acts, conduct, assets, liabilities, and financial condition of the debtor, the operations of the debtor's business and the desirability of the continuance of such business, and any other matter relevant to the case or to the formulation of a plan; iii. participate in the formulation of a plan, and advise those represented by such committee of such committee's recommendations as to any plan formulated; iv. request the appointment of a trustee or examiner; represented. v. perform such other services as are in the interest of those 3. Chapter 11 Trustee or Examiner a. Appointment Although Chapter 11 contemplates retention of control by the debtor of its business operation, the Court may appoint a trustee in reorganization. A trustee can be appointed at any time after the filing of the petition and before confirmation of a plan, on request of a party, upon the following conditions: (1) for cause, including fraud, dishonesty, or gross mismanagement, or (2) if such appointment is in the interests of creditors, equity security holders and other interests of the estate. Upon request, creditors have the right to meet and vote for the election of the trustee after the Court has determined that one should be appointed. The appointment of a trustee is considered an extraordinary remedy. b. Duties Upon appointment, the trustee replaces the debtor in possession, and it is authorized to operate the debtor's business. An operating trustee has, among his powers, the right to replace management personnel of the debtor. The trustee also has the duty to investigate the debtor's affairs, to file a report of his investigation, and to file a plan or a report setting forth why he is unable to file a plan. 6

11 c. Examiner If no trustee is appointed, at any time before confirmation of a plan, on request of a party in interest, the court may appoint an examiner to conduct an appropriate investigation of the debtor's affairs. Under the Bankruptcy Code, appointment of an examiner would appear mandatory if the debtor's fixed, liquidated unsecured debts, other than those owing to an insider, exceed $5,000,000. Several court decisions, however, have concluded that satisfaction of this standard does not mandate appointment of an examiner. The examiner's role is investigative and should not conflict with the debtor's operation of the business. 4. United States Trustee a. The United States Trustee system began as an experimental pilot program pursuant to which supervisory and administrative functions formerly undertaken by the bankruptcy judge under the repealed Bankruptcy Act would be handled by the Office of the United States Trustee which is part of the Department of Justice. The system was subsequently made permanent. The United States Trustee functions through a staff of attorneys and analysts. b. The United States Trustee has standing to be heard on any issue but its primary function is to insure the fairness and integrity of the bankruptcy system. c. In most cases, the United States Trustee is concerned with issues regarding: (1) formation of committees; (2) compensation of professionals retained by the debtor, the committees and trustee; (3) adequacy of disclosure statements filed in connection with a plan of reorganization; and (4) undue delay in the progress of the case. 5. Professional Persons The debtor, each committee and the trustee may employ professional persons to represent or perform services with respect to the estate. Such professionals include attorneys, accountants, auctioneers, appraisers, investment bankers and financial advisers. Professionals are entitled to reasonable compensation for actual and necessary services rendered, as well as reimbursement for actual and necessary expenses. These amounts are paid from the bankruptcy estate and are subject to court approval. Parties in interest may object to the retention of and amounts paid to professionals. C. Chapter Debtor In addition to the duties of a Chapter 7 debtor, the Chapter 13 debtor has an obligation to file a plan that provides for the payment of unsecured creditors generally over a period of three years. Payments are made to and distributed by the Chapter 13 trustee. The plan is confirmed without the vote of creditors if the court finds that the plan complies with the provisions of the Bankruptcy Code. 7

12 2. Chapter 13 Trustee An individual appointed by the United States Trustee who administers all Chapter 13 proceedings. Service as a Chapter 13 trustee in Massachusetts is a full time position. The trustee participates in hearings as an adviser to the court and provides nonlegal advice to the debtor. GENERAL MATTERS RELATING TO BUSINESS OPERATIONS A. Automatic Stay 1. The Bankruptcy Code provides that the commencement of a case (by a voluntary petition by the debtor or an involuntary petition by creditors) acts as an automatic stay, or injunction, against a wide variety of debt collection and lien enforcement activities by all creditors and other parties, including: (a) (b) (c) (d) The commencement or continuation of all judicial, administrative, or other proceedings against the debtor to recover on a pre-petition claim; The enforcement of pre-petition judgments; Actions to obtain possession or to create, perfect, or enforce liens against any property of the debtor's estate; and Any acts to collect or recover on pre-petition claims, or to set off debts owed by the creditor to the debtor. 2. The stay is aimed at halting, at least temporarily, all litigation, foreclosure, and other creditor enforcement activities against the debtor. It is intended to give the debtor a breathing spell, permitting the debtor an opportunity to reorganize its operations and affairs for the benefit of all creditors, particularly unsecured creditors which as a body would be injured by an uncontrolled race to the courthouse and piecemeal dismemberment of the debtor's assets. 3. The automatic stay voids any actions which violate it and under certain circumstances, could expose violators to severe penalties. Any person injured by a willful violation of the stay may recover actual damages and, in appropriate cases, punitive damages. B. Use, Sale, or Lease of Property 1. In General Upon the commencement of a Chapter 11 or Chapter 13 case, the debtor is authorized to conduct its business and is under a duty to protect and preserve the assets of the estate. Unless the bankruptcy court orders otherwise, the debtor may, without notice or a hearing, use, sell, or lease property of the estate in the ordinary course of business. Though ordinary course of business is not defined, it encompasses a wide range of routine activities of the debtor's business. For example, a debtor's sale of its inventory to the public for approximately the same prices, and in the same quantity as undertaken pre-petition, would be in the ordinary course. 8

13 In one case, the hiring of a lobbyist was considered in the ordinary course of business. A Chapter 7 trustee normally proceeds with liquidation, but may be authorized by the court to operate the business of a debtor for a limited period. 2. Outside the Ordinary Course of Business The use, sale, or lease of property other than in the ordinary course of business requires notice and hearing. In the case of sales, the Bankruptcy Rules require not less than 20 days notice to creditors and other interested parties, although a shortening of the notice period can be obtained for cause. The notice of the proposed use, sale, or lease will normally allow the parties to file objections and counteroffers, in the case of a sale or lease. If you are a third party dealing with a debtor or a trustee, you should insist upon court approval if there is a question whether the transaction is ordinary course. The failure to obtain such authority will leave the third party without enforceable rights and without the right to make an administrative claim in the proceedings (see discussion below). 3. Cash Collateral An exception to the ordinary course of business rule applies with respect to cash collateral. As defined in the Bankruptcy Code, cash collateral includes cash, negotiable instruments, documents of title, securities, and deposit accounts. Because of its highly liquid nature and value as collateral, cash collateral may not be used unless (a) the secured creditors which have liens on such collateral consent or (b) the Bankruptcy Court, after notice and hearing, authorizes its use. The court will prohibit or condition use of cash collateral to insure that adequate protection is given to the party who has a lien or other interest in that property. The debtor in possession or trustee has the burden of establishing adequate protection. Adequate protection has a technical meaning in bankruptcy cases and is discussed below. 4. Sale Free and Clear of Interests of Others The debtor may sell property of the estate to a third party free and clear of any interest of another person (usually a lien, encumbrance, or other claim) in such property, only if: (a) (b) (c) (d) (e) applicable non-bankruptcy law permits such a sale free and clear; the lien or interest holder consents; the interest is a lien and the sale price exceeds the aggregate value of all liens on the property; the interest is in a bona fide dispute; or the other person could be compelled in a legal or equitable proceeding to accept a money satisfaction of the interest. 9

14 The holder of the interest is entitled to adequate protection of its interest, which usually takes the form of a lien on the proceeds of the sale. The court may, for cause, prohibit a lienholder from bidding at a sale of property and offsetting its debt against the price. C. Obtaining Credit 1. Unless the court orders otherwise, the debtor may obtain unsecured credit and incur unsecured debt in the ordinary course of business. Thus, trade credit can usually be obtained without any special approval. Such claims are payable as a first priority administrative expense of the bankruptcy estate, that is, they are paid in full prior to any payment of general unsecured claims. Unsecured credit or debt not in the ordinary course of business must first be authorized by the Bankruptcy Court. 2. If no party is willing to extend unsecured credit to the debtor with an administrative priority equal to other administrative priority claims, the bankruptcy court may, after notice and hearing, authorize the debtor to obtain credit that: (a) has a superpriority over all other administrative expenses; (b) is secured by a lien on property of the estate not otherwise subject to a lien; or (c) is secured by a junior lien on property of the estate subject to a prior lien. 3. If credit is unobtainable on any of the above terms, the court may, after notice and hearing, authorize the debtor to obtain credit or incur debt that is secured by a senior or equal lien on property of the estate, that is already subject to a lien. Since such financing will directly affect existing lienholders, the debtor must demonstrate that the interests of preexisting lienholders will be adequately protected. Generally, to prime a preexisting lien, the debtor must establish that there is a sufficient equity cushion so that the existing lienholders will not be harmed by the imposition of a senior or equal lien. EXECUTORY CONTRACTS AND UNEXPIRED LEASES A. In General The Bankruptcy Code contains special provisions regarding executory contracts and unexpired leases. Although there is no definition of an executory contract in the Bankruptcy Code, legislative history and case law have construed the term to mean a contract on which performance is due to some extent on both sides. A contract that has been terminated or that has expired before the commencement of a bankruptcy case is not executory. 1. Under section 365 of the Bankruptcy Code and with court approval, a debtor may: (i) reject an executory contract or unexpired lease; (ii) assume an executory contract or unexpired lease; or (iii) in a Chapter 11 proceeding, if the debtor neither rejects nor assumes a contract, let the contract ride through the reorganization and leave the rights of the parties thereunder unchanged upon the emergence of the debtor from Chapter 11. With limited exceptions and subject to certain requirements discussed below, the debtor may assume any executory contract or lease even though the debtor is, at the time, in default under such contract or lease. Upon assumption, the agreement is in full force and effect and binding on the debtor as well as the other parties to the transaction; a debtor who assumes a contract receives not only the benefits of the contract, but also must undertake any burden or obligations under the contract. Alternatively, the debtor may reject the agreement rendering it prospectively unenforceable; a 10

15 debtor cannot reject a contract, and still assert rights under provisions of the agreement. Rejection of an agreement constitutes a breach, which is deemed to occur just prior to the bankruptcy filing and entitles the nondebtor party to assert a pre-petition claim for damages against the estate; such claim is treated as a general unsecured claim. 2. A debtor's decision to assume or reject an executory contract does not have to be made immediately. In Chapter 7 liquidation cases, a contract is deemed rejected unless it is assumed within sixty days after the order for relief is entered or within such additional time as the court permits. In Chapter 11 reorganization proceedings, the debtor has until confirmation of the plan of reorganization to assume or reject executory contracts or leases, other than leases of non-residential real estate, which are subject to a sixty day limit subject to extension for cause. If the debtor fails to assume an unexpired lease of nonresidential real property under which it is the lessee within the required timeframe, the lease is deemed rejected and the debtor must immediately surrender such property to the lessor. In complex cases, a plan may not be confirmed for a year or more after the bankruptcy filing. Consequently, the bankruptcy court may, on the request of a party to the executory contract, require the debtor to decide within a shorter period whether to assume or reject. 3. The decision whether to assume or reject a contract is generally left to the debtor's discretion, guided only by the broad confines of the business judgment rule. Under this standard, the debtor's decision regarding assumption or rejection is generally upheld absent bad faith or abuse of business discretion. Where the future benefits accruing to the debtor under the contract outweigh the costs of assumption, a court would almost certainly approve such assumption. With a long term contract, however, a court will analyze the likelihood of a successful reorganization before approving the debtor's decision to assume a contract. If, for example, a successful reorganization of the debtor does not appear likely, the assumption of a contract or lease followed by its termination would result, to the detriment of the creditors, in a large administrative claim against the estate which must be paid in full prior to the satisfaction of any general unsecured claims. In that scenario, a court probably would determine that a debtor's decision to assume would not fall within the protection of the business judgment rule. In addition, the court will consider whether assumption of a contract prior to confirmation of a plan prematurely limits the debtor's business or plan of reorganization options. B. Assumption There are no specific statutory requirements for assuming a contract under which the debtor is not in default, other than the requirement of court approval. Where there is a default, however, the debtor must provide adequate assurance that it will (i) promptly cure the default; (ii) promptly compensate the other party for any actual pecuniary loss resulting from the default; and (iii) perform the contract in the future. The adequacy of these assurances is governed by the standard of commercial reasonableness and thus the debtor does not have to make a showing of absolute certainty of performance. 1. The debtor may cure defaults under an executory contract by rendering all performances then due under the contract. Certain defaults, however, need not be cured for the debtor to assume the contract; under the Bankruptcy Code, defaults arising from a breach of a contractual provision relating to the commencement of a bankruptcy case, the appointment of a 11

16 bankruptcy trustee or the insolvency or financial condition of the debtor at any time prior to the closing of the case need not be cured for the debtor to assume the contract or release. Although the Bankruptcy Code does not specify the types of contract provisions which relate to the financial condition of the debtor, essentially default provisions based on a debtor's profits or revenues are likely to be considered provisions related to the debtor's financial condition. Contract provisions creating defaults solely because of the debtor's insolvency are unenforceable under the Bankruptcy Code. Thus, most standard bankruptcy default clauses are meaningless. Often, the financial circumstances leading to bankruptcy preclude the debtor from being able to cure defaults by rendering performance. Consequently, the debtor may defer its cure but must provide adequate assurance of its ability to affect the cure. The Bankruptcy Code contains no standards for determining what constitutes adequate assurance of prompt cure and therefore a prompt cure will depend on the circumstances of each case. 2. The debtor must also provide adequate assurance that it will compensate the non-debtor party for any actual pecuniary loss resulting from defaults under the contract in order to assume that contract. Generally the case law suggests that the debtor's cure of defaults in most instances moot any claim for actual pecuniary loss. 3. Finally, in order to assume a contract the debtor must provide adequate assurance of future performance thereunder. A court's determination of whether a debtor has complied with this requirement may be based upon, among other things, whether the debtor's financial data indicates its ability to generate an income stream sufficient to meet its obligations, the general economic outlook in the debtor's industry, and the presence of a third party guaranty. The words adequate assurance are to be given a practical construction and a determination of what constitutes adequate assurance of future performance is determined under the facts of each particular case. C. Assignment Under the Bankruptcy Code, the debtor has the authority to assume and then assign the contract. Generally, anti-assignment clauses in executory contracts are not enforceable. Except as discussed below, the debtor is free to assign a contract if it cures prior defaults and compensates the nondebtor for pecuniary losses, and the assignee provides adequate assurance of future performance under the contract. Upon assignment, the debtor has no further obligation under the agreement. 1. There are two general limitations on the debtor's assignment powers. First, the debtor is not permitted to assign (and the trustee is not permitted to assume) contracts to loan money or extend other financial accommodations. This limitation, however, does not extend to ordinary contracts for goods and services which incidentally provide for extensions of credit. 2. Second, regardless of the actual terms of the agreement, the debtor may not assign and the trustee may not assume, without the other party's consent, an agreement which under nonbankruptcy law is not assignable. The prime example of contracts which are not assignable as a matter of law are personal services contracts. 12

17 D. Executory Contracts in Limbo; Unexpired Personal Property Lease Obligations Must Be Performed Until an executory contract is assumed or rejected, it is not enforceable against the debtor. The debtor may, however, elect to receive benefits under the agreement from the nondebtor party and require such party to perform contracts that are otherwise in limbo pending assumption or rejection. During this limbo period the performing party is entitled to payment for the value of its performance to the debtor and such claims for payment are entitled to administrative priority status (that is, such claims must be paid in full prior to any payment of unsecured claims). The nondebtor party can take several steps to ameliorate any adverse effects which might result during the period the contract is in limbo pending the debtor's decision to assume or reject. First, it can request that the court order the debtor to assume or reject the agreement within a specified time period. The general rule, however, is that the debtor should have a reasonable time in which to make its decision regarding assumption or rejection. Second, the court has the authority to order the debtor to comply with parts of the agreement, the noncompliance of which would unfairly prejudice the nondebtor party. For example, in one case a debtor/lessor intended to construct a building on a common area in its shopping center, which may have been prohibited by various leases that the lessor had not yet assumed or rejected. Prior to the debtor's decision to assume, the court prohibited the debtor from commencing construction. Prior to the Bankruptcy Reform Act of 1994, the Debtor had an unspecified period of time to determine whether to assume or reject a lease of personal property. Pending the decision to assume or reject, lessors were permitted to petition the court to require the lessee to make lease payments to the extent that the use of the property was actually benefitting the estate. This was unduly burdensome on lessors of personal property. As a result of the amendments, the Bankruptcy Code now specifies that 60 days after the order for relief, the debtor must perform, unless the court orders otherwise, all obligations under a lease or personal property. E. Rejection Instead of assuming an executory contract, a debtor can reject the contract. No standard for rejection is expressly set forth in the Bankruptcy Code; the business judgment test is applied if a contract is rejected, the creditor has a claim for damages. This claim is treated as a pre-petition claim. Damages arising from rejection of leases and employment contracts are limited by the Bankruptcy Code; in all other cases, actual damages may be claimed. When the debtor as a lessor rejects a lease, the lessee still retains its rights appurtenant to a leasehold. These rights include the amount and timing of payments of rent or other amounts payable by the lessee, the right of use, possession, quiet enjoyment, subletting, assignment or hypothecation. F. Assumption of Shopping Center Leases The Bankruptcy Code contains a provision that limits the debtor's power to assume an unexpired lease of real estate located in a shopping center under which the debtor is a tenant. As discussed previously, the debtor must provide adequate assurance of performance if the debtor is 13

18 in default of the lease. Although the Bankruptcy Code does not define adequate assurance, it does contain several requirements that must be met in order to assure adequately the performance of shopping center leases. These requirements are based on the recognition that a shopping center is a carefully planned enterprise consisting of a particular tenant mix designed to attract higher patronage of stores. These requirements are also based on the fact that the lease agreement in a shopping center often gives the landlord a percentage of the tenant's gross receipts as the rental. To protect the investments of the shopping center owner, the financier, and the other tenants, it is necessary to provide assurance that the tenant mix will not be adversely affected by a tenant's bankruptcy. Specifically, the debtor may not assume a shopping center lease under which the debtor is a tenant unless there is adequate assurance: (1) of the source of future rent and any other consideration due under the lease; (2) that any percentage rent due under the lease will not decline substantially; (3) that assumption or assignment is subject to all the provisions of the lease, including but not limited to provisions on radius, location, use, or exclusivity, and will not breach any such provision contained in any other lease; and (4) that assumption or assignment of the lease will not disrupt any tenant mix or balance in the shopping center. If any of these assurances cannot be made, the landlord may insist on rejection of the lease so that the premises may be rented to a new tenant who is in a position to make such assurances. PRIORITY SCHEME A. The Estate All legal or equitable interests of the debtor, subject to very limited exceptions set forth in Bankruptcy Code 541(b) through (d), become property of the estate and subject to administration in the bankruptcy. Bankruptcy Code 541. Third parties have an affirmative obligation to turn over possession of property to the estate representative. Bankruptcy Code 543. B. Exemptions In the case of individual debtors, they may exempt and thereby retain certain property from the estate. The debtor must elect between the federal exemptions set forth in Bankruptcy Code 522(d) or the state exemptions provided by statute in the place where the case is filed. Federal exemptions include $17,425 of value in a residence, $9,300 of household furnishings, $2775 of a motor vehicle, and $8,725 as a miscellaneous exemption if the residential exemption is not employed. See Bankruptcy Code 522(d) for a complete list. The Massachusetts exemptions include a homestead exemption up to $300,000 per homestead and $300,000 per person for elderly and disabled homeowners. See M.G.L. c. 188, 1 and 1A. In re Boucher, 203 B.R. 10 (Bankr. Ma. 1996); In re Goldman, 152 B.R. 1 (D. Ma. 1996). 14

19 C. Secured Claims Secured creditors are entitled to the value of their collateral (as more fully discussed below). While reorganization plans under Chapter 11 and 13 can modify the rights of secured creditors, they preserve a priority to the extent of the value of the collateral. In a typical Chapter 7 case, the secured creditors have encumbered substantially all the assets of a debtor. D. Statutory Priorities Under the Bankruptcy Code, certain unsecured claims are entitled to priority in order of payment from unencumbered assets. Briefly, the priorities are as follows: (1) administrative expenses; (2) claims arising between the filing of an involuntary petition and the entry of an order for relief known as involuntary gap claims; (3) pre-petition wage claims to the extent of $4,650 for each individual; (4) employee benefit plan contributions to the extent of $4,650 per employee, less any priority wages paid; (5) claims by farmers storing grain in grain elevators and fishermen who sell fish to a fish storage or processing facility, up to $4,650 for each such individual; (6) consumer deposit claims, up to $2,100 for each individual; (7) claims for alimony and child support obligations; and (8) unsecured claims for specified taxes. General unsecured claims are paid after these priorities have been fully satisfied. Administrative expenses are the costs and expenses of operating the debtor in bankruptcy proceedings. Such costs include any actual, necessary costs and expenses of preserving the estate, including wages, salaries, or commissions earned after the commencement of the case, and other expenses. Administrative expenses also include the cost of any fees and expenses of trustees, attorneys, accountants, examiners and other professionals, which fees are subject to review and allowance by the bankruptcy court. SECURED CLAIMS AND BANKRUPTCY A. Adequate Protection and Other Rights of Secured Creditors 1. Adequate Protection a. The filing of a bankruptcy petition places a secured creditor at risk on two fronts. First, the automatic stay prevents the creditor from taking action to enforce its claim or lien. Second, the debtor is permitted to use property in the ordinary course of business, thereby subjecting the secured party's collateral to depreciation, dissipation and casualty loss. The Bankruptcy Code, however, balances these risks by the requirement that a secured party's interest be adequately protected. A party in interest may obtain relief from stay if its interests are not adequately protected. In addition, the debtor's use of collateral, either in or out of the ordinary course of business, may be restricted as necessary to provide adequate protection. As noted earlier, cash collateral receives special consideration; it can be used only if the debtor first obtains consent or establishes to the court's satisfaction that the secured party's interest is adequately protected. b. Adequate protection can take many forms although the two most usual are: (i) periodic payments to the secured party or (ii) an additional or replacement lien on property of the debtor. A finding of adequate protection may also be based on the existence of 15

20 an equity cushion in the collateral sufficient to protect the secured party's interest. In all instances, the secured creditor is entitled to relief that will result in the realization by it of the indubitable equivalent of its interest in the property that is the subject of the adequate protection order. c. The debtor has the burden of proof in demonstrating that a secured creditor's claim is adequately protected. However, the Supreme Court has stated that the secured party is only entitled to protection against erosion of its collateral base. United States Savings Ass'n of Texas v. Timbers of Inwood Forest Associates, Ltd., 484 U.S. 365, 108 S.Ct. 626 (1988). Protection for lost opportunity costs and payment of accrued interest are not required to satisfy the adequate protection standard. See also In re Delta Resources, Inc., 54 F.3d 722 (11th Cir. 1995); In re Andrew J. Lane, 108 B.R. 6 (Bankr. D. Mass. 1989). 2. Relief from Stay a. A creditor or other party in interest can apply to the Bankruptcy Court for relief from the stay (by a modification or termination of the stay) on two alternative grounds: (1) for cause, including lack of adequate protection of the secured party's interest in the property; or (2) (i) the debtor has no equity in the property; and (ii) the property is not necessary to an effective reorganization. It is not uncommon for a secured creditor to assert both grounds in a motion for relief from stay and except for cash collateral litigation, such a motion is the typical method by which a secured creditor will force the debtor to confront the adequate protection issue. b. The secured creditor has the burden of proof on the issue of lack of equity; the debtor has the burden of proof on all other issues. Lack of equity can be established not only by reference to the amount of the secured party's claim but the total amount of all liens and encumbrances on the property. The Supreme Court's decision in Timbers also shed light on what is meant by property being necessary to a reorganization. Under Timbers, property is necessary if required for the reorganization and there is a reasonable chance of effecting reorganization in a reasonable period of time. Thus, even if the debtor provides adequate protection, a lack of equity and extremely poor prospects for reorganization may permit the secured party to obtain relief from stay. c. Final hearings on relief from the automatic stay must be concluded within thirty days after the conclusion of any preliminary hearing unless the parties agree to an extension or the court grants an exception based upon a showing of compelling circumstances. d. With respect to real property that constitutes single asset real estate, the automatic stay may be lifted if the debtor has not filed a feasible plan of reorganization within 90 days of filing, or has not commenced monthly payments to secured 16

21 creditors. Single asset real estate is defined as real property, other than residential real property with fewer than four units, that (i) constitutes a single project, (ii) generates substantially all of the gross income of the debtor, and (iii) has aggregate noncontingent, liquidated secured debts in the amount up to four million dollars. 3. Setoff a. The Bankruptcy Code recognizes state law rights of setoff involving debts that are mutual and that arose pre-petition. A bank may have a right of setoff where it is owed money and the debtor maintains its pre-petition deposit accounts with the bank. b. A creditor may not immediately exercise setoff rights once a bankruptcy petition has been filed since such action is subject to the automatic stay. In the case of a bank deposit, the bank may place an administrative freeze on the account, if the bank promptly seeks relief from stay in order to exercise its setoff rights. Citizens Bank v. Strumpf, 116 S.Ct. 286 (1995). c. The right of setoff is not available where the claim was acquired for the purpose of obtaining a mutual debt subject to setoff. Setoff rights also are subject to the preference analysis discussed below. 4. Dismissal of Case a. For Cause - The Bankruptcy Code, gives the court broad discretion to either convert a Chapter 11 or Chapter 13 reorganization case to a Chapter 7 liquidation proceeding or dismiss the case in its entirety for cause. Cause for conversion or dismissal, can include the debtor's inability to effectuate a plan of reorganization or the debtor's unreasonable delay that is prejudicial to its creditors. b. Dismissal of Bad Faith Filing - The Bankruptcy Court may also exercise its judicial discretion to dismiss a case on the ground that the debtor filed its petition in bad faith or was attempting to abuse the reorganization-oriented purposes of Chapter 11 or Chapter 13. Single asset cases filed on the eve of a foreclosure sale often raise questions concerning the debtor's motivations. One court has noted the following 14 fact patterns as indicative of whether a bankruptcy petition was filed in bad faith: 1. The debtor has few or no unsecured creditors; 2. There was a previous bankruptcy petition by the debtor or a related entity; 3. The pre-petition conduct of the debtor was improper; 4. The petition effectively allows the debtor to evade court orders; 5. There are few debts to non-moving creditors; 17