Bankruptcy vs. Negotiated Settlement In California

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Before discussing this topic, I’ll let you in on the secret to a successful negotiation: You have to appeal to your interlocutor’s self-interest. In other words, you must convince the guy on the other side of the table that it’s in his best interest to accept your proposal. Don’t waste time appealing to compassion or mercy.

1. 1. Bankruptcy Is Unavailable Because The Debtor Is Ineligible For A Discharge
      1. There Is A Single Creditor
         Suppose an individual has only one creditor, but owes it a lot of money. Suppose further that the individual went through Chapter 7 bankruptcy three years ago. Then the debtor is ineligible for a discharge under either Chapter 7 or Chapter 13.However, the debtor could still file for Chapter 13 bankruptcy, and go through the Chapter 13 bankruptcy plan. But if the debt isn’t paid in full at the end of the plan, the debtor will still owe the unpaid balance. With these facts the debtor may wish to negotiate with the creditor.

         To begin the negotiation, I will provide the creditor with a financial profile — with copious supporting documentation — of my client: A list of assets, income, expenses, and liabilities. I will include a detailed liquidation analysis of the assets, so the creditor sees exactly what is available to pay the debt. I won’t conduct the negotiations without the analysis and supporting documentation because my credibility with the creditor must be based on provable facts.

         Based on this evidence I will offer the creditor a choice: either a single lump-sum payment, in which case the time value of money is a significant factor; or a monthly payment plan for a fixed time, say a year. If the creditor is realistic and motivated solely by money, this sort of negotiation will succeed.

         Unfortunately, some creditors are motivated by hatred and a desire for vengeance. This happens, for example, in acrimonious divorces, where one spouse wants to destroy the other no matter what it takes. If that is the case, negotiations may be useless. Even bankruptcy may not take care of the problem because the debt to the soon-to-be ex-spouse may be non-dischargeable.

         Horror story: I knew an attorney whose ex-wife gutted him in the divorce. Although he was making a lot of money, he lived in a studio apartment and ate low-grade food. He saw no point in working, so he quit his job and moved in with his girlfriend. As a consequence, the ex-wife got nothing. The moral of the story is, don’t be too greedy in a divorce; you might end up with nothing.

      2. There Are Multiple Creditors
         Things are much harder if the debtor has lots of creditors because of something called the free rider problem: Each creditor wants to receive full payment and let the other creditors take the bath. Since the negotiations have to be done one creditor at a time, the process is time consuming and concomitantly expensive. This is why bankruptcy makes a great deal of sense: The whole process is streamlined without having to deal with one creditor at a time. However, under the hypothesis at the beginning of this section, the debtor can’t file for bankruptcy protection. Therefore, the multi-pronged negotiation may be the only option.
   2. Bankruptcy is a Viable Option — The Debtor Is Eligible For A Discharge
      If the debtor is eligible for a discharge — especially a Chapter 7 discharge — I have a powerful negotiating tool.I still provide the creditor (or creditors as the case may be) with a documented financial profile of my client, but add an analysis of the creditor’s recovery in a bankruptcy: Typically, zero in a Chapter 7, and a calculated reduced amount in a Chapter 11 or Chapter 13. I then offer the creditor a bit more than the bankruptcy liquidation recovery, again appealing to the creditor’s self-interest. I have had good results with this negotiating stance.

      Honesty is crucial in negotiations. This point is not a mere platitude. If, for example, I assert that my client is eligible for Chapter 7 relief, and the creditor discovers that my assertion is false, I have destroyed my credibility and any possible settlement. I have had potential clients who wanted me to lie for them. They never become my clients. And contrary to the popular canard, most lawyers are very honest. Those who aren’t are eventually disciplined, and may end up being disbarred.

      1. Liquidation Analysis
         I stated that I provide the creditor with a liquidation analysis as part of the negotiations. What is involved? A simple example will illustrate the process.Suppose the debtor owns a residence. I calculate the equity — fair market value minus the sum of the balances on all encumbrances against the property — and support the calculation with an appraisal of the property, recent mortgage statements, and copies any other types of liens. I then discount the equity by the estimated cost of sale to get the realizable equity outside of bankruptcy.

         If the debtor is eligible for Chapter 7 protection, I also subtract the homestead exemption and an estimate of the Chapter 7 Trustee’s fees. The final result is the bankruptcy liquidation value, i.e., what the creditor would share pro rata with the other creditors in a Chapter 7 liquidation of the residence.

         I apply a similar analysis to the debtor’s other assets, and add all the bankruptcy liquidation values together to calculate the amount available to pay the creditors pro rata. If there are multiple creditors, I then calculate the portion of the payout that that particular creditor would receive in a Chapter 7 liquidation.

         Determining the homestead exemption in California is a little tricky. If the debtor acquired the residence during the 1,215 days (i.e., three years and four 30-day months) prior to filing the petition, then the homestead exemption on the equity is $170,350. If the debtor acquired the residence more than 1,215 days before filing the bankruptcy petition, then the equity exemption is the median price of a home in the debtor’s county, with a minimum of $300,00, and a maximum of $600,000. Therefore, based on the current real estate market, the homestead in Los Angeles and Orange counties is $600,000.

      2. Negotiations On Behalf Of A Business Debtor
         A similar analysis goes into the negotiations for businesses, which I have handled as well.For example, I once represented a shoe company in a debt negotiation. The problem arose because of the difficulty it was having selling last year’s shoes. As the owner put it, “Shoe fashions are like fish —they don’t last long, and they start to smell bad because fashion changes so rapidly.”

         This specific client was selling women’s shoes (I don’t think fashion for men’s shoes changes quite as rapidly as for women’s), and the business had a particularly large debt to one creditor. I contacted that creditor and laid out the business’s resources, assets, and inventory, as well as the likelihood of being able to sell that inventory, and the likelihood of a Chapter 7 bankruptcy. The creditor ended up accepting our proposal, so we were able to greatly reduce the debt.

         In sum, while I think bankruptcy is the most powerful tool of all because it is backed by the power of the United States Federal Government, there are times when avoiding bankruptcy via a negotiated settlement makes a lot of sense.

   3. Trustees and Debtors in Possession
      In a Chapter 7 bankruptcy, the court will appoint a Chapter 7 trustee, whose duties involve liquidating nonexempt assets for the benefit of creditors, avoiding fraudulent transfers, avoiding preferential transfers, and conducting the meeting of creditors.In a Chapter 13 bankruptcy, the Chapter 13 Trustee is tasked with administering the plan. The debtor must make payments to the Chapter 13 Trustee each month, and the Trustee distributes those payments to the creditors according to the terms of the judge-confirmed plan.

      In a typical Chapter 11 bankruptcy, while the U.S. Trustee exercises significant oversight, there is no Chapter 11 Trustee (unless something has gone terribly wrong, and the judge appoints one). As a result, the debtor becomes a quasi-trustee called the debtor in possession (DIP). The DIP is tasked with administering the bankruptcy estate that is created upon filing the petition, has the obligation to avoid preferential transfers and fraudulent transfers, and is authorized to do the things that would normally be done by a Chapter 7 Trustee. Typically, the DIP will also serve as the disbursing agent for the plan. In that sense, there is similarity between the Chapter 11 DIP and the Chapter 13 Trustee.

      Because trustees won’t work without receiving compensation, any debt settlement negotiations must take into consideration trustee fees.

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