What Type Of Long Term Relief Can A Debtor Obtain In A Chapter 11 Bankruptcy?
- The Automatic Stay
Bankruptcy can provide powerful relief to a debtor. For instance, upon filing bankruptcy papers the first thing that is triggered, regardless of the chapter, is the automatic stay.
In the law, a stay means stop. In bankruptcy, the automatic stay stops all action by creditors against the debtor, the debtor’s possessions, and the bankruptcy estate that’s created when the debtor files for bankruptcy protection. In practical terms this means that the creditor cannot contact the debtor on the telephone, send bills, write letters, garnish wages, seize money out of bank accounts, repossess assets, and foreclose on the assets. In essence, it erects a legal brick wall around the debtor to protect from the depredations of the creditors. It’s powerful protection. And a stay violation can be a very expensive mistake for the creditor. The automatic stay lasts until the debtor receives a discharge or until the stay is lifted for some reason. (In some instances, the creditor can successfully move the court to lift the stay for limited purposes. That’s something that isn’t peculiar to Chapter 11.)
In the longer term, the Chapter 11 debtor gets that most precious thing of all: Time. Unlike a Chapter 13 debtor who must file a plan right away, the Chapter 11 debtor has months in which to formulate a repayment plan. The debtor has time to formulate a plan that’s going to work, and if necessary, find some financing for the plan. The Chapter 11 plan can have more flexibility than a Chapter 13 plan — provided that the creditors vote in favor of confirmation — and make it possible to stretch out the payments of the debts over a very long time. However, there are some limitations on how long the payments can be stretched out. The length of the plan depends on the kind of debts involved, the idiosyncrasies of the judge who’s presiding over the case, and what the creditors will tolerate.
How Are Secured Debts And Unsecured Debts Dealt With In A Chapter 11 Bankruptcy Plan?
- Secured And Unsecured Debt
In the taxonomy of debt, there are different ways to break things down. One way is to distinguish between secured debts and unsecured debts. A secured debt is a debt that’s secured by a tangible asset. If the debtor doesn’t make the payments, the creditor can retrieve the asset. Typical examples include car loans and home mortgages. If the debtor fails to make the payments, the creditor repossess the car, or foreclose on the house. The car and house serve as collateral or security for the debt. That’s why it’s called a secured debt. Secured creditors have special rights attached to their collateral, so their claims are treated differently from the claims of unsecured creditors.
Unsecured debt, as the name suggests, is debt that isn’t secured by something that can be repossessed in the event of a default. Typical examples include credit cards, medical bills, student loans, and taxes. Some unsecured debts are dischargeable in bankruptcy, some are not.
- Secured Debts In Chapter 11
In a Chapter 11 bankruptcy case, secured creditors are supposed to be paid in full. However, there can be some complications. For instance, suppose the debt isn’t entirely secured. For example, the collateral could be a piece of real property that’s worth $2 million dollars, with a single mortgage of $3 million. $1 million of that mortgage has no real estate behind it, so it’s only partially secured.
In a Chapter 11 the debtor can bifurcate that debt into a secured portion and an unsecured portion. The secured portion doesn’t get to vote on the plan. The unsecured portion does get to vote on the plan. Therefore, the unsecured portion goes into a different class than the secured portion. However, a partially secured creditor has the option of having its claim treated as fully secured under section 1111(b) of the Bankruptcy Code. In doing so, the creditor loses the right to vote on the plan, unless the creditor’s claim is impaired in the plan. (An informal definition of impairment: A claim is impaired if it is given different treatment in the plan than the treatment it would have received outside of bankruptcy.) A fully secured creditor is entitled to get postpetition (i.e., after the date of filing the bankruptcy petition) interest. However, most unsecured debt is not entitled to postpetition interest.
The Bankruptcy Code permits the debtor to modify the rights of secured debts in a classic Chapter 11 case — both business and personal — with one important exception: A debt that is secured solely by the debtor principal’s residence cannot be modified unless the creditor consents to the modification.
However, in a Subchapter V Chapter 11 case, the debtor can modify the rights of a secured creditor, even if the collateral is the debtor’s principal residence. However, the debt to be modified has to have been incurred for business purposes.
- Unsecured Debts In Chapter 11
Unsecured debts are further broken down into priority and nonpriority debts because Congress in the Bankruptcy Code has given certain unsecured debts better treatment than other unsecured debts. A simple example illustrates the point. Most tax debt is listed as priority debt in the Bankruptcy Code. The Code requires that priority tax debt must be paid in full within sixty months of the petition date (not sixty months from the date when the plan is confirmed). Again, it has to be sixty months from the date the debtor filed the bankruptcy petition. Therefore, the longer it takes to get the plan confirmed, the less time the debtor has to pay the priority tax in full.
Nonpriority unsecured debt — also known as general unsecured debt — doesn’t get special priority treatment. It is typically all put into a single class unless there is good reason not to. General unsecured creditors usually don’t vote unless there is a large balance on the debt because they don’t see much of a benefit to voting. The best they can hope for is to receive over time the amount they would have received in a Chapter 7 liquidation.
What Limitations Are Placed On A Debtor’s Right To Use, Sell, Or Lease Estate Assets During A Chapter 11 Bankruptcy Case?
- First Day Motions
During a Chapter 11, the debtor does not have the right to use, sell, or lease estate assets without the Court’s permission. Right from the beginning of the case, the Court and the U.S. Trustee keep the debtor on a fairly short leash. This can be seen in the first day motions, which include requests for permission to use, sell, or lease assets. Despite the name, the first day motions don’t have to be granted on the first day of the bankruptcy case. However, they must be filed and granted pretty quickly.
- Cash Collateral Motion
One fairly typical first day motion is a cash collateral motion. What is cash collateral?
- Example: Rental Income
Let’s say that the debtor has occupied rental property. The mortgage holder on the rental property undoubtedly has an assignment of rents provision in the mortgage documents that says that the mortgage company has a claim against the rental income (unless there is no mortgage, which is somewhat unusual). Once the debtor files for Chapter 11 protection, that money can’t be used for anything. It belongs to the bank. It is called cash collateral. The debtor must get the Court’s permission for authority to use that money. This is done using a cash collateral motion.
Exception: If the creditor consents to the use of the cash collateral, the debtor doesn’t have to get the Court’s permission. However, it’s safest to get the Court’s permission anyway.
- Example: The Floating Lien
If the debtor is in the business of buying merchandise and then selling it, the vendor typically has a lien against the merchandise. Since there may be a steady stream of merchandise, the lien is against all unpaid merchandise. Such a lien is called a floating lien. In practical the vendor has a claim against the money that is being paid by the customers to purchase the merchandise. That income is another example of cash collateral.
If the debtor has employees, then prior to the bankruptcy filing the debtor undoubtedly paid the employees using the income from the sale of the merchandise. As with the rental income, the debtor must get permission from the Court to use the cash collateral to pay the employees. That too is done using a cash collateral motion.
- The Sale Of Estate Assets
The debtor cannot sell estate assets without the Court’s permission.
For example, if the debtor wants to sell a piece of real estate, the debtor must successfully prosecute a sale motion. If the Court grants the motion, then the sale has to take place in the Bankruptcy Court. This is done through an auction in front of the Bankruptcy Judge. As with any auction, the highest bidder gets the asset.
Why is this micromanaging taking place? The filing of the bankruptcy petition creates a bankruptcy estate, and everything that the debtor has goes into that estate. The bankruptcy estate must be managed for the benefit of creditors. This is ensured through judicial oversight.
In sum, a Chapter 11 debtor must obtain the Court’s permission before using, selling, or leasing estate assets.
For more information on Chapter 11 bankruptcy, or a Subchapter V Chapter 11 bankruptcy, call (562) 777-9159 for a free 20 minute phone strategy session today.
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