Legal Boundaries For Restructuring Debts
A debtor attempting to restructure its debts must understand the legal mechanisms available to it. While no one wants to end up in Bankruptcy Court, the bankruptcy rules set forth what can happen if the parties cannot agree upon a restructuring plan.
Pursuant to the Bankruptcy Code, the business debtor can choose between “liquidating” its business in a Chapter 7 bankruptcy filing or “reorganizing” its business in a Chapter 11 bankruptcy filing. In either case, the filing by the debtor triggers the Automatic Stay, which is an injunction that automatically stops lawsuits, foreclosure, garnishments and all collection activity against the debtor. In a Chapter 7 case, the business is turned over to a bankruptcy trustee who manages the liquidation of the debtor's assets and distributions to creditors in accordance with the priorities set forth in the Bankruptcy Code. In a Chapter 11 case, however, the debtor may continue to operate the business, under the supervision of the Bankruptcy Court, as the debtor-in-possession.
In the Chapter 11 case, the debtor tries to get all creditors to agree upon the reorganization plan. If agreement is not reached, the Bankruptcy Court may approve the reorganization plan anyway under the so-called “cramdown” provisions. A “cramdown” is the imposition of a bankruptcy reorganization plan by the Bankruptcy Court despite any objections by certain classes of creditors. The Bankruptcy Court may confirm a plan as long as “the plan does not discriminate unfairly, and is fair and equitable, with respect to each class of claims or interests that is impaired under, and has not accepted, the plan.”
To summarize in very simplified terms, by filing for a Chapter 11 bankruptcy, a debtor can bring an immediate stop to all collection efforts, continue to run the business and force creditors to accept changes as long as the changes do not discriminate unfairly, and are fair and equitable, with respect to each class of claims or interests that is impaired under the reorganization plan.
A bank or other regulated financial institution that is involved in a debt restructuring will be concerned about the classification of the debt by its regulator. Loans that are classified impact the bank's financial condition, its loan loss reserves and its capital requirements. A debtor seeking approval of its lender should try to restructure its debt in a manner that avoids classification of the debt or, at least, minimizes the amount of the debt that is subject to classification. The loan classification definitions are as follows:
Substandard Loan: Loans classified substandard are inadequately protected by the current sound worth and paying capacity of the debtor or of the collateral pledged, if any. Loans so classified must have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They are characterized by the distinct possibility that the bank will sustain some loss if the deficiencies are not corrected.
Doubtful Loan: Loans classified doubtful have all of the weaknesses inherent in those classified substandard with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently known facts, conditions and values, highly questionable and improbable.
Loss: Loans classified loss are uncollectible and of such little value that their continuance as a bankable asset is not warranted. This classification does not mean that the loan has absolutely no recovery or salvage value, but rather that it is not practical or desirable to defer writing off this basically worthless asset even though partial recovery may occur in the future.
A simple example of a restructuring to avoid classification is as follows. A debtor has a working capital loan that is secured by its accounts receivable and inventory. Due to a severe downturn in the business, the working capital loan is no longer retired fully as the level of the business working capital changes during the year. The debtor and the bank agree to reduce the amount of the working capital loan to a more appropriate level and convert the balance to a fully secured term loan payable in monthly installments from the debtor's cash flow.
A familiarity with the terminology used in bankruptcies is helpful. Here are some key definitions.
Automatic Stay: An injunction that automatically stops lawsuits, foreclosure, garnishments and all collection activity against the debtor the moment a bankruptcy petition is filed.
Bankruptcy: A legal procedure for dealing with debt problems of individuals and businesses; specifically, a case filed under one of the chapters of title 11 of the United States Code (the Bankruptcy Code).
Bankruptcy Code: The informal name for title 11 of the United States Code (11 U.S.C. § 101-1330), the federal bankruptcy law.
Bankruptcy Court: The bankruptcy judges in regular active service in each district, a unit of the district court.
Bankruptcy Estate: All legal or equitable interests of the debtor in property, both real and personal, at the time of the bankruptcy filing. (The estate includes all property in which the debtor has an interest, even if it is owned or held by another person.)
Chapter 7: The chapter of the Bankruptcy Code providing for "liquidation," i.e., the sale of a debtor's nonexempt property and the distribution of the proceeds to creditors.
Chapter 7 Trustee: A person appointed in a chapter 7 case to represent the interests of the bankruptcy estate and the unsecured creditors. (The trustee's responsibilities include reviewing the debtor's petition and schedules, liquidating the property of the estate, and making distributions to creditors. The trustee may also bring actions against creditors or the debtor to recover property of the bankruptcy estate.) The Trustee works under the general supervision of the court and the direct supervision of the United States Trustee.
Chapter 11: A reorganization bankruptcy, usually involving a corporation or partnership. (A chapter 11 debtor usually proposes a plan of reorganization to keep its business alive and pay creditors over time. People in business or individuals can also seek relief in chapter 11.)
Chapter 13: The chapter of the Bankruptcy Code providing for adjustments of debts of an individual with regular income. (Chapter 13 allows a debtor to keep property and pay debts over time, usually three to five years.)
Chapter 13 Trustee: A person appointed to administer a chapter 13 case. (A chapter 13 trustee's responsibilities are similar to those of a chapter 7 trustee; however, a chapter 13 trustee has the additional responsibilities of overseeing the debtor's plan, receiving payments from debtors, and disbursing plan payments to creditors.) The Trustee works under the general supervision of the court and the direct supervision of the United States Trustee.
Creditor: A person or business to which the debtor owes money or that claims to be owed money by the debtor.
Debtor: A person who has filed a petition for relief under the bankruptcy laws.
Discharge: A release of a debtor from personal liability for certain dischargeable debts. (A discharge releases a debtor from personal liability for certain debts known as dischargeable debts and prevents the creditors owed those debts from taking any action against the debtor or the debtor's property to collect the debts. The discharge also prohibits creditors from communicating with the debtor regarding the debt, including telephone calls, letters, and personal contact.)
Fraudulent Transfer: A transfer of a debtor's property made with intent to defraud or for which the debtor receives less than the transferred property's value.
Motion To Lift Automatic Stay: A request by a creditor to allow the creditor to take an action against a debtor or the debtor's property that would otherwise be prohibited by the automatic stay.
Preferential Debt Payment: A debt payment made to a creditor in the 90-day period before a debtor files bankruptcy (or within one year if the creditor was an insider) that gives the creditor more than the creditor would receive in the debtor's chapter 7 case.
Priority: The Bankruptcy Code's statutory ranking of unsecured claims that determines the order in which unsecured claims will be paid if there is not enough money to pay all unsecured claims in full.
Priority Claim: An unsecured claim that is entitled to be paid ahead of other unsecured claims that are not entitled to priority status.
Proof of Claim: A written statement describing the reason a debtor owes a creditor money. (There is an official form for this purpose).
Property Of The Estate: All legal or equitable interests of the debtor in property as of the commencement of the case.
Secured Creditor: An individual or business holding a claim against the debtor that is secured by a lien on property of the estate or that is subject to a right of setoff.
Secured Debt: Debt backed by a mortgage, pledge of collateral, or other lien; debt for which the creditor has the right to pursue specific pledged property upon default.
Undersecured Claim: A debt secured by property that is worth less than the amount of the debt.
United States Trustee: An officer of the Justice Department responsible for supervising the administration of bankruptcy cases, estates, and trustees, monitoring plans and disclosure statements, monitoring creditors' committees, monitoring fee application, and performing other statutory duties.
Unliquidated Claim: A claim for which a specific value has not been determined.
Unscheduled Debt: A debt that should have been listed by a debtor in the schedules filed with the court but was not.
Unsecured Claim: A claim or debt for which a creditor holds no special assurance or payment, such as a mortgage or lien; a debt for which credit was extended based solely upon the creditor's assessment of the debtor's future ability to pay.
Source: Glossary of Bankruptcy Terms | United States Bankruptcy Court - District of New Jersey, at: http://www.njb.uscourts.gov/content/glossary-bankruptcy-terms.