An Introduction To Bankruptcy

by John H. Anderson, Esq.

“Information to Help Agents and Manufacturers Protect Their Interests Both Before and After Bankruptcy is Filed”

Why the Law Provides Protection to Bankrupt Entities

Congress has decided that, as a matter of public policy, society will benefit from granting relief to heavily burdened debtors. Congress’ goals are:

• To relieve the debtor from creditor pressure.
• To provide the debtor with a “fresh start.”
• To ensure that similarly situated creditors are treated equally.

Legal Bankruptcy

Where an individual, partnership, corporation, or municipality is insolvent or is otherwise unwilling to pay its debts, that entity may be ordered and adjudged to be “bankrupt.” This status will entitle the entity to the protection provided it by the federal bankruptcy laws. Note: The term “debtor” is used instead of “bankrupt” in the federal Bankruptcy Code.

Bankruptcy law is federal law, but the bankruptcy courts must apply state law to determine whether a claim is valid and whether a claim is exempt.

The Bankruptcy Code affects the rights of not only debtors, but also those of creditors, especially general and unsecured creditors. For example, even though a creditor collects a debt before the debtor files bankruptcy, the bankruptcy court may require the creditor to transfer that money to the bankruptcy estate for disbursement under the Bankruptcy Code.

As of 2005, many bankruptcy filers are required to get credit counseling before they can file a bankruptcy case — and additional counseling on budgeting and debt management before their debts can be wiped out.

All potential creditors should consider the effect the bankruptcy laws might have on their business before extending credit.

The Automatic Stay

The Bankruptcy Code provides that once the bankruptcy petition is filed, all actions intended to collect a pre-petition debt must stop. The idea behind this rule is to preserve the assets of the bankruptcy estate pending termination of the bankruptcy proceedings, and to relieve the debtor from creditor pressure.

Unless a creditor obtains relief from the stay by an order of the bankruptcy court, it will be bound by its provisions.

Any action taken by a creditor after the filing has no legal effect and is either void, voidable by the bankruptcy trustee, or voidable by the debtor. If the bankruptcy petition has been filed, a creditor may not even continue against the debtor a previously filed lawsuit for a pre-petition debt.

A creditor may be held civilly liable for any damages caused by a violation of the automatic stay.

Creditors are generally deemed by the court to know when the stay is in effect, even if they never actually learned that the bankruptcy petition was filed.

Extending Credit

Credit is the right granted by a creditor to a debtor to incur debt and defer its payment. Debts are often incurred when goods are sold, loans are made, and when services are rendered.

Before a creditor sells goods on credit, renders services on credit, or otherwise makes a loan, it should first evaluate the risk that the debtor will default (not pay what is owed). In making this evaluation, the credit history, net worth, and cash flow of the borrower should be considered.

If the debtor is a partnership, it is possible to make the partners themselves “jointly and severally liable” for the credit in a future court proceeding. If this is desired, a copy of the partnership agreement should be obtained by the potential creditor to determine the creditworthiness of each of the partners.

Whether a loan is “secured” is of utmost importance to any potential creditor, as more fully discussed below.

Once a debtor has filed a bankruptcy petition, an “automatic stay” of collection activities against the debtor is declared, and many creditor claims become subject to the power of the bankruptcy court’s decisions.

Before extending credit, creditors often want the debtor to fill out a detailed credit application including:

• All bank account information.
• A detailed balance sheet with a fair market value estimation for each category of assets.
• A list of accounts receivable, with addresses, because the creditor may decide to seek garnishments against third parties that owe the debtor money or are holding the debtor’s property.
• Copies of all other loan applications made by the debtor.
• Copies of any valuable contracts on which the debtor is working.

Insolvency

If an entity is unable to pay its debts as they become due, that entity is insolvent.

If an entity has liabilities greater than its assets, including the “good will” and “going concern” value of a business, then that entity is likewise insolvent.

Where creditors seek an involuntary bankruptcy (see definition below), a court is not likely to grant it if the debtor is able to pay its debts as they become due (regardless of whether its liabilities are greater than its assets.)

How the Issue of Bankruptcy Arises

Voluntary Bankruptcy:
Where an insolvent individual, partnership, corporation, or municipality initiates bankruptcy proceedings, the bankruptcy is termed “a voluntary bankruptcy.” A debtor must meet the requirements of the Bankruptcy Code to file voluntary bankruptcy. These requirements include petitioning the court for relief, filing a schedule with the court, and filing a statement of affairs with the court.

Involuntary Bankruptcy:
A bankruptcy is termed “an involuntary bankruptcy” where creditors either: a) seek to have the debtor’s remaining non-exempt assets distributed among themselves through straight bankruptcy (see definition below), thereby agreeing to discharge the debtor from any further obligation, or b) seek to restructure and reorganize the insolvent’s debt structure, thereby agreeing to look to the bankrupt’s future earnings to satisfy their claims.

If creditors wrongfully file an involuntary bankruptcy proceeding, and this wrongful action causes the debtor to suffer damages, then the debtor has a cause of action against the creditors.

Straight Bankruptcy (Chapter 7)

A straight bankruptcy proceeding is designed to liquidate the debtor’s non-exempt assets and distribute them among the creditors in accordance with the priority and distribution provisions of the Bankruptcy Code. This proceeding discharges the debtor from any further obligation to the creditors on the previously extended credit.

Before 2005, the bankruptcy rules allowed most filers to choose the type of bankruptcy which was best for them — and most chose Chapter 7. Since 2005, however, the law prohibits some filers with higher incomes from using Chapter 7 bankruptcy. Debtors wishing to file Chapter 7 must first measure one’s current monthly income against the median income for a household of similar size in the same state. If it is more than the median, the debtor must then pass a “means” test in order to file Chapter 7.

The purpose of the “means” test is to figure out whether the debtor has enough disposable income to make payments on a Chapter 13 plan. To determine whether one passes the means test, he should subtract certain allowed expense and debt payments from his current monthly income. If the income left over after these calculations is below a certain amount, the debtor can file Chapter 7.

The debtor is required to file schedules of assets and liabilities and a statement of affairs for the trustee to examine. The creditors may question the debtor concerning the schedules, and assist the trustee in discovering assets that the debtor failed to list.

In a straight bankruptcy proceeding, a creditor’s claim is subject to:

• The payment of expenses associated with the administration of the bankrupt estate.
• The payment of other claims and expenses which are deemed to take “priority” over that creditor’s claim.
• A pro-rata distribution.

The Bankruptcy Code allows the trustee to reverse pre-bankruptcy advantages (sometimes called “preferences”) that may have been gained by creditors through their collection efforts. The trustee is empowered to undo these transactions, and have previously collected money and/or assets transferred to the bankruptcy estate.

Unless the plan so provides, post-petition earnings do not become property of the bankruptcy estate.

Reorganization (Chapter 11)

If a debtor (such as a corporation, partnership, or individual) is facing insolvency, it may wish to keep its assets and/or continue to operate a business with the hope of becoming financially solvent. In such situations, the debtor may petition a bankruptcy court for reorganization under chapter 11 of Bankruptcy Code.

The court will not confirm the debtor’s proposed plan without the approval of a majority of the debtor’s creditors. The creditors may decide that they will benefit more by supporting a debtor’s plan (agreeing to a workout plan) than if they forced the debtor into straight bankruptcy. This is a business decision of the creditors.

A large number of Chapter 11 cases are eventually converted to Chapter 7 cases.

Under Chapter 11, a debtor business is generally permitted to continue its operations under court supervision, until some plan of reorganization is approved by more than half in number and more than two-thirds in amount of the creditors.

Sometimes no trustee is appointed. In such a case, the debtor remains in control of its estate assets and is called a “debtor-in-possession.” A debtor-in-possession holds the estate assets as a fiduciary for the benefit of its general creditors.

If the court is willing to grant permission, a creditor may settle its claim with the debtor after the debtor has filed Chapter 11.

If a corporation is insolvent at the time it files a petition for reorganization, a majority of the corporation’s owners (called shareholders) must also approve the plan. If an agreement cannot be reached, then the corporation’s assets will be liquidated and distributed in straight bankruptcy.

Unless the debtor’s plan so provides, post-petition earnings by the debtor do not become property of the estate. Therefore, before agreeing to a plan, the creditors may want to make sure that the plan provides that the debtor’s post-petition earnings become property of the estate.

Individuals with Regular Income (Chapter 13)

Under Chapter 13 of the Bankruptcy Code, any individual debtor (or husband and wife filing jointly; businesses cannot file Chapter 13) who is insolvent, and who is a wage earner (earns wages, salary or commissions) can formulate and file a plan with the court intended to provide the debtor with additional time to pay off his creditors.

A plan made in good faith and acceptable to the unsecured creditors will usually be confirmed by the court. Should the wage earner ultimately be unable to pay the debts, the bankruptcy may be converted to Chapter 7.

If the unsecured creditors do not accept the plan, or if the court decides that the creditors are not likely to receive at least as much as they would receive if the debtor’s assets were liquidated and dispersed in straight bankruptcy, then the court will reject the plan.

Unlike chapters 7 and 11, the debtor’s plan must provide (as opposed to “may provide”) that all property acquired by the debtor after the petition is filed, including post-petition earnings, becomes part of the estate (until the debts are satisfied).

The Law Regarding Promises to Pay Debts Discharged or Dischargeable in Bankruptcy

If a legal obligation is unenforceable, such as where a debt was discharged in bankruptcy under Chapter 7, a new written promise by the debtor to fulfill the unenforceable legal obligation is enforceable according to the terms of the new writing (not necessarily the terms of the original legal obligation).

Warning: During the time between when the bankruptcy petition is filed and when the debts are discharged in bankruptcy, the automatic stay prohibits a creditor from trying to collect a debt from the debtor. If a creditor decides to contact the debtor during this time, the creditor should proceed with caution. For example, creditors who have contacted the debtor directly, after the petition was filed and before the debt was discharged in bankruptcy seeking to obtain reaffirmation agreements without the knowledge of the debtor’s attorney, have been found liable for violating the automatic stay.

Example 1: Paul owes Alice $10,000. This debt is discharged in bankruptcy on February 1, 2013. After this date, Paul sees Alice at a cocktail party and says to her, “I feel bad that I never paid you. I will pay you $7,000 as soon as Bill pays me on a contract that I have with him.”

Discussion: Notwithstanding Paul’s statement to Alice, Paul continues to have no legal obligation to pay Alice anything, even if he gets paid on his contract with Bill. Paul’s new promise was not in writing and has no legal effect (assuming that there is no new consideration given in exchange for Paul’s promise).

Example 2: Paul owes Alice $10,000. Paul’s debts are discharged in bankruptcy on February 1, 2013. After this date, Paul, feeling guilty that the debt to Alice was never paid, writes Alice a letter which states, “I know I owe you $10,000. I will pay you $7,000 as soon as I get paid on my contract with Bill.”

Discussion: As soon as Paul gets paid on his contract with Bill, he will be liable to Alice for $7,000. If Alice sues Paul after Paul gets paid on his contract with Bill, she should win a judgment for $7,000 against Paul.

The Bankruptcy Estate

The bankruptcy estate should include all of the debtor’s legal and equitable interests in property as of the date the bankruptcy petition is filed, as well as all legal and equitable interests in property that must be transferred to it through the court’s reach-back power (such as “preferences” and fraudulent conveyances, discussed below).

A creditor is generally interested in making sure that all of the debtor’s property interests are disclosed to the court.

The Role of the Bankruptcy Trustee

The trustee is commissioned to investigate and “take control of” the debtor’s estate, and to administer it for the benefit of the unsecured creditors. For example, if a lien has not been properly created or perfected, the trustee may destroy it through its “strong arm powers.”

In Chapter 7 cases, the duty of the trustee is to collect and liquidate the debtor’s assets for the benefit of the unsecured creditors.

The trustee may initiate actions on behalf of the debtor’s estate, defend actions against the debtor’s estate, and set aside claim preferences.

If a Chapter 13 plan has been approved, the trustee acts largely as a collection and disbursing agent for the debtor’s plan payments to creditors.

The Secured Creditor

Secured creditors are generally favored over unsecured creditors in any bankruptcy proceeding.

If a secured creditor desires to receive a distribution through a confirmed Chapter 13 plan, or through a Chapter 7 liquidation, then the secured creditor needs to file a proof of claim (and thus become a claimant).

A secured creditor with an “unchallenged” lien may choose not to file a proof of claim because an unchallenged lien survives the discharge of a debtor in bankruptcy.

Secured Creditors with Voluntary Liens

As a condition to extending credit, a secured creditor receives collateral intended “to guaranty” the payment of the debt. This is accomplished:

• When the debtor gives the creditor physical possession of personal property for the creditor to hold.
• When the debtor grants a voluntary lien on personal property which is in the debtor’s possession by executing a security agreement, which is definite and certain in its terms.
• When the debtor grants a lien on real property by executing a promissory note secured by either a mortgage or a trust deed.

A creditor with a lien should promptly file or record the lien in the appropriate governmental office. If the creditor fails to do this, the creditor risks having the lien stripped from it by a future bankruptcy court action.

Also, a creditor with a lien should file or record the lien to serve as notice:

• To any and all future potential creditors of the debtor.
• To any future purchaser where the debtor is the seller. This is so because many states have adopted notice statutes that “protect” a bona fide purchaser of property who pays value for the property and does so without notice of prior unrecorded interests/claims. This may mean that a bona fide purchaser who pays value may successfully quiet title in its name through a court proceeding (an action to quiet title). Such a court proceeding would “cut off” the rights of the prior unrecorded interest holder and leave him without any property interest in the property.

If a “non-insider” secured creditor received the security on or within 90 days of the filing of the bankruptcy petition, that non-insider secured creditor may have no more rights than an unsecured creditor. If an “insider” secured creditor received the security between 90 and 365 days before the date the petition was filed, that insider secured creditor may have no more rights than an unsecured creditor (see “Insider Status and The Reach-Back Power of the Court,” below). Sometimes a debtor wishes to sell property which is encumbered by a creditor lien. Before granting permission to the debtor to do so, a creditor would be well advised to first obtain a court order giving that creditor a lien on the new property (the property gained by the sale, such as cash) as “adequate protection.” If a creditor gives the debtor permission to sell the encumbered property without first obtaining such a court order, the creditor may lose its security interest.

While it is true that a creditor will not lose the security interest simply by granting the debtor permission to sell the encumbered property, so long as the creditor can trace the new property (often cash) to the old property, tracing may become too difficult to accomplish where the debtor commingles the new property with other property of the debtor or otherwise fails to keep accurate records.

Secured Creditors with Involuntary Liens

Even where a debtor does not voluntarily give the creditor collateral, a creditor may sometimes take action against a debtor in a state court proceeding which gives the creditor a lien interest in the debtor’s property. While this is true, many involuntary liens are judicial liens, and, if they hurt a debtor’s exempt property interest, they may be successfully “taken away” or “pushed back” by the debtor through certain lien avoidance procedures.

The Unsecured Creditor

An unsecured creditor is a lender who extends credit without receiving collateral. If the debtor fails to pay the debt when it becomes due, an unsecured creditor may commence legal proceedings against the debtor. If the debtor files a bankruptcy petition, the unsecured creditor is generally at the end of the line when it comes to collection on the debt.

Note: Some court actions automatically give a judgment holder a lien against all real property owned by the debtor within a certain geographical boundary. If the debtor has equity in real property, this may convert the status of an unsecured creditor to that of a secured creditor.

The Oversecured Creditor

A creditor is “oversecured” when the value of his lien (or the value of the collateral being held, as the case may be) exceeds both:

• The amount of all claims prior to his.
• The full amount of his claim.

The Undersecured Creditor

A creditor is “undersecured” when the value of his lien (or the value of the collateral he is holding, if such is the case) does not exceed both:

• The amount of all claims prior to his.
• The full amount of his claim.

The portion of the debt which does not have sufficient lien value or collateral to cover it is treated as an unsecured claim. Creditors often attempt to show that the debtor’s total property value is greater than that of the debtor’s valuation, especially when the creditor is at risk of being partially unsecured. Creditors must be aware that the debtor has an economic interest in undervaluing an asset. The debtor is interested in having as many claims discharged as possible, and an unsecured claim is often discharged.

The Special Creditor

Some creditors enjoy rights superior to that of other creditors under the Bankruptcy Code. For example, parties to a contract that has not been fully performed on either side may proceed to enforce their rights pursuant to the contract free of the bankruptcy proceeding. These and other creditors, such as creditors who hold a lien secured only by the debtor’s personal residence, are known as special creditors.

Exempt Property

Under the Bankruptcy Code, the debtor is allowed to claim certain property as exempt which eliminates from the trustee the power to liquidate that property for the benefit of the creditors (usually the unsecured creditors are the most affected). Exemption categories are generally written with the idea of exempting property interest which the debtor “needs” to ensure his basic welfare and that of his family.

Each bankruptcy court has a list of the property interests which are exempt, and the list varies from state to state. This list will often include rights granted under state law.

For example, exempt property interests may include part or all of: a personal residence, a homestead, a burial plot, a motor vehicle, a “non-collector” firearm, a piece of household furnishing, an item of wearing apparel, a book, a tool of one’s trade, an unmatured life insurance policy, a contract right, a dividend interest, an interest or loan value in a life insurance policy, a health aid, a Social Security benefit, an unemployment compensation benefit, an assistance benefit, a veterans’ illness and/or disability benefit, an alimony and/or support right interest, a stock interest, a bonus interest, a pension interest, a profit-sharing interest, an annuity interest, a disability or other compensation plan interest, a wrongful death benefit, a life insurance proceed interest, a personal injury award, and/or a loss of future earning award.

Unsecured creditors often attach the debtor’s claimed exemptions in an effort to increase the dividend that they will eventually receive. A debtor must claim an exemption or it is lost. If the exemption is lost, the trustee is free to liquidate and distribute the property interest.

Where applicable, a creditor generally has only 30 days from the conclusion of “the meeting of creditors” to file a formal objection to a debtor’s claimed exemption. If a formal objection is not made on time, it is deemed “waived” and is permanently lost.

Deciding Not to Sue

Sometimes a creditor is better off not suing the debtor. For example, when the debtor is willing to transform the creditor’s claim from an unsecured claim to a secured claim, the creditor may end up being able to collect more money by not suing.

Even where settlement cannot be reached, a creditor may want to wait before instigating legal action. For example, if a note and trust deed were given to secure a loan, and monthly payments were required to be made every 30 days, and the debtor fails to pay on time, the creditor may be better off doing nothing until 91 days after the creditor’s trust deed was recorded. If the creditor sues too soon, the debtor may file bankruptcy and have the lien taken away as “a preference.” If the creditor waits, the creditor can get past the preference period and protect the lien from the possibility of being taken away by the court.

Bankruptcy Fraud

In the situations where bankruptcy results in the liquidation and distribution of the debtor’s then existing assets, as in a straight bankruptcy proceeding, the court is in charge of gathering all the debtor’s assets and distributing them according to the law.

Before a court will grant the debtor the protection provided by the bankruptcy laws, the debtor must declare to the court that no assets have been fraudulently transferred or concealed.

Sometimes a debtor, in anticipation of bankruptcy proceedings, will seek to perpetrate a fraud on some of its creditors. This is sometimes accomplished:

• Where the debtor allocates assets to creditors with “an uneven hand,” either before or after bankruptcy proceedings have begun (this is often called a preferential transfer).
• Where the debtor conceals its assets from the creditors by failing to declare assets which the debtor should have declared.
• Where the debtor fraudulently transfers assets to others (such as to the friends or relatives of the debtor) with the expectation of later receiving the beneficial use of those assets.

An Example of Debtor Fraud by the Uneven Treatment of Creditors:
A manufacturer-debtor is anticipating bankruptcy and wants to preserve a business relationship with one of its creditors.

Before bankruptcy proceedings have begun, this manufacturer ships out a large order of goods to the creditor at a discounted price. Under such circumstances, the recipient of the goods could be held liable to the other creditors (through the bankruptcy court) for the difference in value between the goods received and the value paid for them, as well as be held liable to the other creditors for any damages that they suffered as a result of the fraudulent transfer.

An Example of Fraud Through the Concealment of Assets:
An individual is anticipating bankruptcy but does not want to forfeit all of his assets. This individual:

• Fails to declare some of his assets to the court.
• Transfers some of his assets to “friends” or relatives with the idea of the later receiving the beneficial use of those assets.

A creditor may bring a cause of action against a debtor who thus perpetrates a bankruptcy fraud. Before bringing suit, the creditor should consider the sufficiency of the evidence, the anticipated cost of bringing suit, and the likelihood of collecting on a judgment.

Insider Status and the Reach-Back Power of the Court

The trustee may avoid (force the recipient to transfer the property to the bankruptcy estate) certain transfers that were made by the debtor. For example, the trustee may avoid certain transfers made by the debtor while the debtor was insolvent or when the debtor was close to filing bankruptcy (usually within 90 days for “non-insiders” and within 365 days for “insiders.”)

An “insider” is a person or entity with a certain close relationship to the debtor. Transactions between the debtor and insiders are more closely scrutinized than other transactions.

An insider may be a general partner, an affiliate of a general partner, a director or officer of a corporation, a relative, a managing agent, an affiliate of a managing agent, or another person with management responsibilities. Thus, an agent who participates in the management of a business is exposed to the risk of having to transfer to the bankruptcy estate assets transferred to it (or equal value) on or within 365 days before the date the petition was filed.

A bankruptcy court may decide that the debtor is not insolvent (and does not thus qualify for a discharge in bankruptcy) after recouping the assets previously transferred to insiders.

Willingness of the Bankruptcy Court to Disregard the Corporate Form of Business (“Piercing the Corporate Veil”)

Where it is necessary to prevent fraud or to enforce equity, the bankruptcy court will disregard a corporate entity and hold individuals liable for corporate obligations. These individuals may include the owners of the corporation (called shareholders), the corporation’s directors, and the corporation’s officers.

The corporate veil is often pierced:

• Where the corporation ignores corporate formalities such that it may be considered the “alter ego” of either the shareholders or another corporation (this situation can arise where shareholders treat corporate assets as their own or otherwise fail to observe corporate formalities and some basic injustice results therefrom).
• Where the corporation was undercapitalized at the time it was formed such that there was not enough unencumbered capital to reasonably cover prospective liabilities.
• Where necessary to prevent an individual shareholder from using the corporate form of business to avoid personal obligations which existed at the time the corporation was formed.

Tortious Interference With Business Relations

Sometimes an individual, partnership, corporation, or municipality will intentionally interfere with the business relationship or legal expectancy of another and induce a breach or termination of the relationship or expectancy.

To prevail against that individual, partnership, corporation, or municipality in civil court, a plaintiff must:

• Have had a valid contractual relationship with a third party (a party other than the defendant) of which the defendant was aware at the time the defendant induced a breach or termination of the relationship, or the plaintiff must have had a valid business expectancy of which the defendant was aware at the time the defendant induced a breach or termination of the expectancy.
• Show that the defendant intentionally interfered with the business relation and caused the plaintiff to suffer damages.

Example #1: Manufacturer and Independent Sales Representative have entered into a valid contract for Independent Sales Representative to represent the products produced by Manufacturer to potential buyers. X Corporation is interested in purchasing Manufacturer’s assets. If X Corporation induces Manufacturer to file bankruptcy promising Manufacturer’s management that they will be hired by X Corporation once X Corporation purchases Manufacturer’s assets from the bankruptcy court, then X Corporation can be held liable to Independent Sales Representative in a civil action brought by Independent Sales Representative against X Corporation for “Tortious Interference with Business Relations.” Independent Sales Representative should prevail in court if he can produce sufficient evidence.

Example #2: Buyer tells Seller that Buyer will enter into a contract with Seller to purchase goods from Seller, but will do so only if Seller breaches its agreement with its agent, Y. Perhaps Buyer does not want Y to receive such a large commission for bringing Buyer and Seller together. If Buyer has knowledge of the relationship between Seller and Seller’s Agent Y, or otherwise has knowledge of Y’s business expectancy, then Buyer can be held liable to Y for any damages suffered by Y as a result of the “Tortious Inference with Business Relations.”

Creditor Rights and the Uniform Commercial Code (the “UCC”)
Where a contract for the sale of goods is involved, the UCC governs and provides both buyer and seller certain rights and remedies. Where a contract is solely for the rendition of services, the UCC does not apply.

The seller may stop delivery of goods in the possession of a carrier or other bailee when the seller discovers that the buyer is insolvent. The seller may stop delivery of a carload, truckload, or larger shipments of goods when the buyer breaches the contract or when the seller has a right to withhold performance pending receipt of assurances.

When a seller (such as a manufacturer-seller) learns that a buyer has received delivery of goods on credit while that buyer was insolvent, the seller may reclaim the goods on demand made to the debtor/buyer:

• Before 10 days after receipt of such goods by the debtor/buyer.
• If the 10-day period expires after the debtor/buyer files bankruptcy, before 20 days after the debtor/buyer received the goods.

Creditor Rights and “Boilerplate” Bankruptcy Clauses

Except in situations where the contract is solely for the performance of personal services, or where the contract consists of a loan agreement, boilerplate bankruptcy clauses are generally unenforceable. This means that if the debtor uses language in a contract, purchase order, or invoice indicating that the agreement is terminated or otherwise modified in the event of bankruptcy, such language will not terminate or otherwise modify the agreement. Such clauses are often included in installment type contracts and leases.

Whether an agency agreement between a manufacturer and an independent sales representative is considered to be for “solely personal services” is determined by the arrangement between the manufacturer and the agent. Normally, if the agent is a corporation and the contract does not specify that the services are to be performed by specifically named individuals, then the contract will not be considered to be for “solely personal services.”

Keeping the Principal Informed

When a seller’s agent receives reliable information, from any source, that a buyer or potential buyer is or is about to become insolvent, or is otherwise having financial difficulty, the agent should immediately inform the seller of that fact.

The seller may be able to protect its interests, as well as the interests of the agent, by acting quickly. This can be accomplished, for example, by either stopping delivery of goods in transit or reclaiming goods already received by the buyer.

A Creditor’s Right to Receive Notice

The due process clause of the U.S. Constitution requires that creditors be given reasonable notice before their property rights can be adversely affected.

Collecting on a Creditor Claim

In order to share in the distribution of the debtor’s assets, a creditor must file a timely claim. A “claim” is a right to payment, whether or not reduced to judgment. A claim may be liquidated or unliquidated, fixed or contingent, matured or unmatured, disputed or undisputed, legal or equitable, and secured or unsecured.

When a debtor defaults on a loan, a secured creditor is more likely to collect than an unsecured creditor. Also, when the debtor files bankruptcy, a creditor is more likely to collect when his claim is a priority claim rather than a general claim.

Both the security, and whether a claim is a priority or general claim will often determine whether the creditor will be able to collect on the debt.

Agents should be aware that independent contractors have a right to file quasi-employee status for their commission claims. Many bankruptcy provisions read as if the priority preferences are limited to those who are employees rather than independent contractors. The term “wages” would seem to so indicate; however, the classification of an individual’s “employee status” by one branch of the government does not prohibit another branch of the government from classifying that same individual’s “employee status” differently. Therefore, an agent may be deemed to be an independent contractor for labor law purposes and “an employee” for bankruptcy purposes.

Filing a Proof of Claim

Creditors should file a proof of claim in all bankruptcy cases unless the debtor has no assets or the court has told the creditor not to file.

The proof of claim must be filed within 90 days after the first date set for the meeting of creditors (which may not be the same as 90 days from the date the meeting of creditors is actually conducted).

Priorities

Claims and expenses have priority as follows:

First: Domestic support obligations. These are claims for support that are to be given to the spouse, former spouse, child, or child’s representative.

Second: Expenses associated with the administration of the bankrupt estate.

Third: Where the bankruptcy is involuntary, a claim arising after the beginning of the case, but before the appointment of a trustee.

Fourth: Certain unsecured claims, but only to the extent of $10,950 for each individual (or corporation) if that individual (or corporation) earned the money within 180 days of the date the bankruptcy petition was filed, or the date of the cessation of the debtor’s business, whichever occurs first. This claim may be for wages, salaries, or commissions, including vacations, severance, and sick leave pay earned by the individual, or for sales commissions earned by an individual (or corporation, if that corporation has only one employee) acting as an independent contractor in the sale of goods or services for the debtor in the ordinary course of the debtor’s business if during the 12 months preceding that date, at least 75 percent of the amount that the individual (or corporation) earned by acting as an independent contractor in the sale of goods or services was earned from the debtor.

Fifth: Certain unsecured claims for contributions to an employee benefit plan arising from services rendered within 180 days before the date of the filing of the bankruptcy petition or the date of the cessation of the debtor’s business, whichever comes first.

Sixth: Certain claims related to:

• The production of grain.
• The production of “fish produce.”

Seventh: Certain unsecured claims of individuals, to the extent of $2,425 for each such individual, arising from the deposit, before the commencement of the case, of money in connection with the purchase, lease, or rental of property, or the purchase of services for the personal, family, or household use of such individuals, that were not delivered or provided.

Eighth: Certain claims by governmental units.

Ninth: Certain unsecured claims based on any commitment by the debtor to “a Federal depository institution’s regulatory agency” (or predecessor to such agency), to maintain the capital of an insured depository institution.

Tenth: Claims for death or personal injury from a motor vehicle that occurred while the debtor was driving intoxicated.

Final Thoughts

The following are appropriate items to consider for both manufacturers and independent agents:

• Consult your own attorney to determine the possibility of collecting your claim through bankruptcy court.
• If your claim is economically significant, you should hire an attorney who specializes in bankruptcy.
• Consider the possibility that your claim should be given preference.
• Consult with your bankruptcy specialist to see if you qualify for a priority claim.
• If your debtor files bankruptcy, commissions earned may qualify as a super priority claim.
• Ask your bankruptcy specialist if you have any right to a secured position.
• If you owe the debtor and the debtor likewise owes you, consider the possibility of offsetting claims.

John H. Anderson, Esq., was born and raised in Safford, Arizona. Prior to law school, he lived abroad for three years in Latin America and Western Europe, where he learned to speak fluent German and Spanish. He later received a B.A. degree from the University of Arizona in 1964 and a J.D. from the same institution in 1968. He was admitted to the Arizona and California Bars in 1968 and 1969, respectively. In 1975, he became Assistant General Counsel to ICN Pharmaceuticals, Inc., a Fortune 500 company, with the primary responsibility of directing litigation. In this capacity, he successfully resolved a multitude of cases with millions of dollars at issue. Being trilingual substantially benefitted him as he negotiated major agreements in Germany, Sweden, Ireland, Switzerland and Yugoslavia. In 1978, Anderson opened his law office in San Clemente, where for more than 30 years he has aided his clients in avoiding costly and unproductive litigation, paving the way for successful working relations. He may be reached at (949) 492-9944 or at his website, www.johnandersonlaw.com.