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Business Bankruptcy Issues The Financially Troubled Company

Forced Into Bankruptcy: The Involuntary Bankruptcy Process

When a company is facing financial distress, the question often comes up whether creditors can "force" the company into bankruptcy. Although the answer is more complicated than it may seem, this post aims to sort out what being "forced into bankruptcy" really means (hint: there are two different ways this can happen) and why it matters to companies and creditors.

Forced But Voluntary Bankruptcy. When a company is "forced" into bankruptcy, often what actually has happened is that the company filed a voluntary bankruptcy petition under Chapter 11 (reorganization) or Chapter 7 (liquidation) of the U.S. Bankruptcy Code in response to creditor actions. For example, a secured lender may have declared a default under its loan documents and commenced foreclosure proceedings, or an unsecured creditor may have filed a lawsuit or obtained a judgment against the company. In response, the company filed bankruptcy.

While it may be fair to describe the company as having been "forced" into bankruptcy, technically the company’s board of directors made a voluntary decision to file bankruptcy given the company’s financial circumstances or creditor actions. The distinction is important because a voluntary bankruptcy filing puts the company in bankruptcy immediately, making it subject to the Bankruptcy Code’s provisions and the bankruptcy court’s supervision. In contrast, the other kind of bankruptcy — an involuntary bankruptcy filing — does not. 

A Truly Involuntary Bankruptcy. This begs the question: if the company does not consent, can creditors literally force a company into bankruptcy anyway? The answer is yes, under certain circumstances, and subject to meeting the requirements for filing an involuntary bankruptcy petition. The major requirements, discussed below, are found in Section 303 of the Bankruptcy Code.

  • Required number of creditors. The Bankruptcy Code specifies the minimum number of creditors and amount of their claims: 
    • If a company has 12 or more creditors, an involuntary bankruptcy petition requires (a) three or more creditors whose claims are not contingent as to liability or subject to a bona fide dispute as to either liability or amount to file the petition, and (b) those qualifying claims must total, in the aggregate, at least $14,425 if unsecured or $14,425 more than the value of any liens securing those claims if any are secured.
    • If the company has fewer than 12 creditors, it only takes one qualifying creditor to file an involuntary petition.
    • Additional creditors can join the petition later, and if only one creditor files and it turns out that the company has more than 12 creditors, the bankruptcy court will give other creditors an opportunity to join.
    • The $14,425 amount is adjusted every three years, with the next adjustment due in April 2013.
  • Generally Not Paying Debts. If the company timely objects to the involuntary filing, for the company to be placed in bankruptcy, the company also must: 
    • generally not be paying its debts as they become due unless those debts are subject to a bona fide dispute as to liability or amount, or
    • have had a custodian appointed within the past 120 days to take possession or control of substantially all of its assets.
  • Choosing The Chapter. In the involuntary petition, the petitioning creditors must designate which bankruptcy chapter (Chapter 7 or 11) into which they seek to force the company.

How Is An Involuntary Different? When an involuntary petition is filed, the automatic stay of bankruptcy kicks in immediately to prevent creditor actions, but that’s where the similarities with voluntary bankruptcy end.

  • Unlike a voluntary bankruptcy filing, when an involuntary bankruptcy petition is filed, a company is not immediately placed into bankruptcy and the company may continue to operate its business and use, acquire, or dispose of its property as if an involuntary bankruptcy case had not been filed.
  • Instead, an involuntary bankruptcy petition functions more like a complaint asking the court to declare that the company should be put into bankruptcy. Like a complaint, the involuntary petition must be served together with a summons.
  • Although the bankruptcy court has the authority to appoint an interim trustee or order other restrictions on the company, those do not automatically apply, have to be sought by motion, and may be denied by the bankruptcy court.
  • The company can consent to the involuntary bankruptcy filing. When an involuntary Chapter 7 filing is made, the company can also respond with its own voluntary Chapter 11 filing and take control over the case as a debtor in possession.
  • To contest an involuntary petition, the company must do so within the time allotted by the Federal Rules of Bankruptcy Procedure, currently 21 days after service of the summons. Typically that involves filing an answer or a motion to dismiss.
  • Litigation over whether the requirements discussed above have been met, and thus whether the company should be put in bankruptcy, can involve various pleadings, document and deposition discovery, status conferences, motions for summary judgment, and/or an evidentiary hearing or trial. 
  • If the bankruptcy court ultimately rules in favor of the petitioning creditors, an "order for relief" is entered and the company is officially placed into bankruptcy. At that point, the company is subject to the Bankruptcy Code’s provisions and supervision by the bankruptcy court.

What If The Involuntary Fails? Filing an involuntary bankruptcy petition against a company is, of course, serious business, and the consequences of failing are equally serious.

  • Once filed, an involuntary petition cannot be dismissed without a notice and an opportunity for a hearing, even if the petitioning creditors and the company agree.
  • If the involuntary petition is dismissed, the petitioning creditors can be liable for costs and attorney’s fees of the company.
  • If the bankruptcy court determines that the involuntary petition was filed in bad faith, the petitioning creditors can be liable as well for damages caused by the involuntary filing and even for punitive damages.

When Do Creditors Typically File An Involuntary? The prospect of creditor liability for costs, attorney’s fees, damages, and possibly punitive damages makes involuntary petitions one of the lesser-used creditor tools. Involuntary bankruptcy is most often used when unsecured creditors suspect fraud on the part of a company, such as when a Ponzi scheme is discovered, or for some other extraordinary reason. Otherwise, creditors will typically pursue collection of their own claims directly, including through litigation in state or federal court. That might end up "forcing" the company into bankruptcy, but technically it would be a bankruptcy of the voluntary kind.

Business Bankruptcy Issues Recent Developments

Bankruptcy Judge’s Free Online Research Binder Now Updated

I have posted in the past about the helpful research binder that former Judge Randall J. Newsome of the United States Bankruptcy Court for the Northern District of California had made available on the Bankruptcy Court’s website. Although Judge Newsome has retired from the bench, fortunately Judge Charles Novack, also of the U.S. Bankruptcy Court for the Northern District of California, has picked up the mantle and has continued to update the research binder. Judge Novack recently released the updated version covering cases through Volume 436 of Bankruptcy Reports. Follow the link in this sentence to access the entire binder in PDF format, which is capable of being searched using a key word or phrase.

The primary focus of the research binder is on Ninth Circuit law, as Judge Novack presides in the Northern District of California, but some out-of-circuit law is also included. The disclaimer Judge Novack includes puts the binder’s use in context:

I have the privilege of continuing Judge Randall Newsome’s research binder. Although this represents the aggregation of his 22 years of research (and my own several months of work), I make no claim as to its current level of accuracy. Some of the cases may well have been superseded, reversed or otherwise no longer be good law. I, like Judge Newsome, post it with the intention of assisting those who are researching bankruptcy matters within the 9th Circuit. Users should consider it a first, but not final research tool, and should cite check all cases before relying on them.

With those caveats, and with Judge Novack’s continuing work, the binder remains a good place to start when researching bankruptcy law issues in Ninth Circuit.

Business Bankruptcy Issues Recent Developments

Second Circuit Decides Whether Unsecured Creditors Can Recover Post-Petition Attorney’s Fees

On November 5, 2009, the U.S. Court of Appeals for the Second Circuit became the second court of appeals to answer the question left open in the U.S. Supreme Court’s March 2007 decision in Travelers Casualty & Surety Co. of America v. Pacific Gas & Electric Co., 549 U.S. 443 (2007): Can unsecured creditors recover post-petition attorney’s fees as part of their unsecured claims? For more on the Travelers decision, follow the link to this earlier post.

The Ninth Circuit’s Earlier SNTL Corp. Decision. In June 2009, the Ninth Circuit, in a per curiam decision in In re SNTL Corp., 571 F.3d 826 (9th Cir. 2009), held that post-petition attorney’s fees were allowable as part of an unsecured prepetition contract claim. The Ninth Circuit adopted the December 2007 opinion of the Ninth Circuit Bankruptcy Appellate Panel, In re SNTL Corp., 380 B.R. 204 (9th Cir. BAP 2007), which is available by following the link in this sentence. You may find this earlier post on the SNTL Corp. case of interest as well.

The Second Circuit’s New Decision. In its November 5, 2009 opinion in Ogle v. Fidelity & Deposit Company of Maryland, the Second Circuit held — as the Ninth Circuit did in the SNTL Corp. case — that an unsecured creditor can include post-petition attorney’s fees authorized under a prepetition contract valid under state law. In Ogle, the Second Circuit extended its holding in United Merchants & Manufacturers, Inc. v. Equitable Life Assurance Society of the United States, 674 F.2d 134 (2d Cir. 1982), a case decided under the Bankruptcy Act, and concluded that United Merchants survived both the statutory revisions made by the Bankruptcy Code and the Supreme Court’s Travelers decision.

In reaching this result, the Second Circuit analyzed the issues presented, in part, as follows:

All of the fees at issue in Travelers were incurred post-petition; so the amount was necessarily unknown when the bankruptcy petition was filed. It follows that if an unsecured claim for post-petition fees was for that reason unrecoverable, the Travelers Court could have disposed of the claim on that simple, available ground alone. Travelers, therefore, proceeds along lines that, reasonably extended, would suggest (notwithstanding the Court’s express disclaimer) that section 502(b)’s requirement–that the court “shall determine the amount of such claim . . . as of the date of the filing of the petition”–does not bar recovery of post-petition attorneys’ fees.

In the present appeal, as in Travelers: The underlying contract is valid as a matter of state substantive law; none of the section 502(b)(2)-(9) exceptions apply; and the Code is silent as to the particular question presented–in Travelers, whether the Code allows “unsecured claims for contractual attorney’s fees incurred while litigating issues of bankruptcy law,” 549 U.S. at 453; and here, whether the Code allows unsecured claims for “fees incurred while litigating issues of” contract law more generally.

Accordingly, we hold that an unsecured claim for post-petition fees, authorized by a valid pre-petition contract, is allowable under section 502(b) and is deemed to have
arisen pre-petition.  Accord SNTL, 571 F.3d at 844 (“[W]e reject the position . . . that section 502(b) precludes such fees.”).
 

The Court then turned to the question of whether Section 506(b) of the Bankruptcy Code expressly disallows the recovery of attorney’s fees as part of an unsecured claim:

As Travelers makes clear, the question is whether the Code disallows post-petition attorneys’ fees, and does so expressly. It was therefore decisive in Travelers that “the Code says nothing about unsecured claims for contractual attorney’s fees incurred while litigating issues of bankruptcy law.” 459 U.S. at 453 (emphasis in original). And while Travelers declined to address section 506(b) (because the parties had not raised the issue below), see id. at 454-56, it is decisive here that the Code says nothing about such fees incurred litigating things other than issues of bankruptcy law. The teaching of Travelers is therefore fully consonant with our decision in United Merchants.

Accordingly, we hold that section 506(b) does not implicate unsecured claims for post-petition attorneys’ fees, and it therefore interposes no bar to recovery.

Finally, the Second Circuit rejected arguments that (1) Section 502(b)(2)’s disallowance of unmatured interest bars claims for post-petition attorney’s fees, (2) Section 502(e)(2) regarding claims for reimbursement or contribution implicitly forecloses post-petition attorney’s fees, and (3) as a policy matter it would be unfair to allow contract creditors to recover post-petition attorney’s fees when tort claimants and many trade creditors cannot.

Conclusion. We now have two U.S. Court of Appeals decisions this year holding that, after Travelers, post-petition attorney’s fees are allowable as part of an unsecured claim if otherwise recoverable under a prepetition contract. Particularly given the major bankruptcy cases filed in the Southern District of New York, within the Second Circuit, unsecured creditors may make a point of including post-petition attorney’s fees as part of their claims when their contracts so provide. This decision raises questions as well:

  • Will the potential allowance of post-petition attorney’s fees for bankruptcy-related issues impact a debtor’s reorganization prospects?
  • What procedures will debtors propose for managing the process as unsecured creditors amend their claims to add attorney’s fees incurred in protecting their rights during the course of a bankruptcy case?
  • Will individual unsecured creditors become more active in Chapter 11 cases, particularly in those cases in which a large distribution is likely?
  • What standards will bankruptcy courts use to assess the reasonableness of an unsecured creditor’s post-petition attorney’s fees for bankruptcy-related issues?
  • Will claims buyers pay more for unsecured claims based on contracts providing for recovery of post-petition attorney’s fees now that bankruptcy-related fees are recoverable?
  • Will creditors be more insistent on including attorney’s fees provisions in contracts?

Not every unsecured creditor will have the right to attorney’s fees, and most may not incur significant fees after a bankruptcy is filed. However, those that do now have another important arrow in their quiver when seeking to add those fees to their unsecured claims. It will be interesting to see how these issues play out in the months ahead.

 

Business Bankruptcy Issues Recent Developments

A Matter Of Time: Important Amendments To The Bankruptcy Rules Are Coming December 1st

Nearly every year, changes are made to the set of rules that govern how bankruptcy cases are managed — the Federal Rules of Bankruptcy Procedure. Normally, the changes address issues identified by an Advisory Committee made up of federal judges, bankruptcy attorneys, and others. This year, the amendments to the national bankruptcy rules are mainly the result of statutory changes enacted by Congress. The new amendments will take effect on December 1, 2009.

Timing Changes Across The Board. For years, the standard time periods for many actions in bankruptcy cases have been measured in round numbers — 10 days for some, 20 days for others. Sometimes this has led to confusion about deadlines, especially when time periods straddle weekends or holidays. To simplify the calculation of bankruptcy time periods, and those in other non-bankruptcy laws, earlier this year Congress enacted the Statutory Time-Periods Technical Amendments Act of 2009. The main purpose of the Act is to switch to 7, 14, 21, and 28 day intervals for most bankruptcy procedures. Here’s how the changes will be implemented in the Federal Rules of Bankruptcy Procedure:

  • 5 day periods become 7 day periods;
  • 10 day periods become 14 day periods;
  • 15 day periods become 14 day periods;
  • 20 day periods become 21 day periods;
  • 25 day periods become 28 day periods.

For example, a motion set for hearing on a Friday will now have objection and reply deadlines fall on Fridays. It also means that the era of the "20 day notice" in bankruptcy is over — but it’s just being replaced with the era of the "21 day notice." The change should make calculating due dates easier, although be aware that it will shorten or lengthen most of the previously standard notice periods under prior law. Rule 9006 is being revised extensively to reflect the new way of accounting for weekends and holidays. Periods that were 30 days or longer are essentially unchanged.

A Longer Appeal Period. So where is this going to have the biggest effect in the business bankruptcy realm? I think the impact will be felt most in the time to file an appeal from a bankruptcy court order. Amendments to Rule 8001 will extend the time for filing a notice of appeal by four days — from 10 days to 14 days. This means that an order approving a settlement under Rule 9019, authorizing a Section 363 sale of assets, or confirming a plan of reorganization, among others, will not become final and no longer appealable until the 15th day following entry compared to the 11th day following entry under current law. After years of counting on bankruptcy court orders being final after only 10 days, parties will need to adjust their expectations on the finality of orders.

How To Access The Amended Rules. Bankruptcy attorneys and other professionals should review the amended rules to see the full range of the changes.

Local Rule Changes Are Also Coming. Expect to see bankruptcy courts around the country adopt conforming changes to their local rules. Two examples: the Northern District of California has already done so and the Southern District of New York is proposing to do so.

Conclusion. Although these timing changes are not as significant as amendments made a few years ago, they will affect virtually all time periods in the national, and in time local, bankruptcy rules that are currently less than 30 days. With under a month to go before they take effect, now is a good time to get on top of these amendments.

Business Bankruptcy Issues

The SIPC And SIPA Liquidations: When A Brokerage Firm Goes Bankrupt

It’s an organization that can go for years without ever making the news. Then along comes a financial crisis — and Lehman Brothers and Madoff — and suddenly the SIPC finds itself at the center of some very big stories. This post takes a look at the SIPC, its role in broker-dealer liquidations, how a SIPA liquidation differs from Chapter 7 liquidation, and how it affects businesses and individuals with accounts at a failed brokerage firm.

What Is The SIPC? SIPC stands for the Securities Investor Protection Corporation. This federally-created nonprofit corporation describes its mission as follows:

When a brokerage firm is closed due to bankruptcy or other financial difficulties and customer assets are missing, SIPC steps in as quickly as possible and, within certain limits, works to return customers’ cash, stock and other securities. Without SIPC, investors at financially troubled brokerage firms might lose their securities or money forever or wait for years while their assets are tied up in court.

The SIPC and its activities are governed by the Securities Investor Protection Act, known as SIPA, which was enacted in 1970. The SIPA is not in Title 11 of the United States Code where the Bankruptcy Code is found, but in Title 15, together with other securities laws. That said, the SIPA incorporates many provisions of the Bankruptcy Code.

When Does The SIPC Get Involved? When a SIPC-member brokerage fails, the SIPC has the authority to step in. If the brokerage has filed a bankruptcy — and notwithstanding the automatic stay — the SIPC can file a lawsuit in the district court seeking a protective decree. Once granted, the Chapter 7 bankruptcy proceeding is put on hold and the case becomes a SIPA liquidation instead.  Here’s how the SIPC explains its role:

The [SIPC] either acts as trustee or works with an independent court-appointed trustee in a missing asset case to recover funds. The statute that created SIPC provides that customers of a failed brokerage firm receive all non-negotiable securities that are already registered in their names or in the process of being registered. All other so-called "street name" securities are distributed on a pro rata basis. At the same time, funds from the SIPC reserve are available to satisfy the remaining claims of each customer up to a maximum of $500,000. This figure includes a maximum of $100,000 on claims for cash. Recovered funds are used to pay investors whose claims exceed SIPC’s protection limit of $500,000. SIPC often draws down its reserve to aid investors.  

As this explanation notes, there is a $500,000 per customer limit to SIPC protection, including a $100,000 limit on claims for cash held in an account. These apply to both businesses and individuals. Some brokerage firms also have private insurance in addition to the SIPC protection.

How Is A SIPA Liquidation Different From A Chapter 7 Bankruptcy? Although Chapter 7 bankruptcy and SIPA liquidations both involve the liquidation of a brokerage firm, there is an enormous difference in terms of what happens to each customer’s securities.

In a Chapter 7 bankruptcy of a brokerage firm, the bankruptcy trustee is required to liquidate — that means sell — all of the securities held in "street name" by the failed brokerage. Section 748 of the Bankruptcy Code, part of Chapter 7’s special stockbroker liquidation provisions, spells it out:

As soon as practicable after the date of the order for relief, the trustee shall reduce to money, consistent with good market practice, all securities held as property of the estate, except for customer name securities delivered or reclaimed under section 751 of this title.

Subject to certain exceptions, in Chapter 7 customers receive a pro rata share of the proceeds from the sale of the securities, not the securities themselves. The only securities that are not sold are "customer name securities," which are handed back to their owners. (More on the difference between street name and customer name securities below.)

In a SIPA liquidation, the trustee’s goal is exactly the opposite. Instead of being required to sell the securities, a SIPA trustee works to return to customers the securities in their accounts, often through a transfer of the accounts to a financially healthy brokerage firm.  When that isn’t possible, the SIPA trustee has the authority to purchase securities to replace any that were missing, tapping into the SIPC’s reserve fund when necessary to cover the acquisition costs. If securities are missing or the SIPA trustee is otherwise unable to return a customer’s "street name" securities, then the brokerage’s firms remaining customer assets are divided up and funds distributed on a pro rata basis based on the total size of "net equity claims" of customers (generally, net of any margin loans owed by the customer). As in a Chapter 7, "customer name securities" are returned to the customer, including those in the process of being registered in the customer’s name.

Customers generally prefer SIPA liquidations over Chapter 7 bankruptcy. (Stockbrokers and commodity brokers are not permitted to file a Chapter 11 bankruptcy.) Most SIPC member brokerages that file bankruptcy end up either in a SIPA liquidation or with the SIPC directly involved.

What Are Customer Name Securities? As an aside, there is a big distinction between street name and customer name securities.

  • As the term implies, customer name securities are a typically limited group of securities held by a brokerage firm that are literally registered with the issuer in the customer’s name, such as an actual stock certificate registered in and bearing the customer’s own name.
  • These days most securities are registered in "street name," with the actual legal owner being Cede & Co., the Depository Trust Corporation’s nominee name.
  • Each brokerage has its own DTC participant account holding the securities for all of its customers, and the brokerage in turn keeps records of which customer owns which securities in the DTC account.
  • Street name securities are far easier to trade than customer name securities because the trade can be accomplished via DTC instead of having to make a physical transfer of a stock certificate.

The Customer Claim Bar Date. In both a Chapter 7 and a SIPA liquidation, a deadline, known as a bar date, will be established by which creditors claims must be filed. However, in a SIPA liquidation a separate "customer claim" bar date is also set. Customers seeking SIPC protection must file their claims by that date using a special customer claim form, which asks for details on the securities in the customer’s account, dates of trades, and other information. Follow the link for an example of the SIPC claim form used in the Lehman Brothers SIPA liquidation. If the customer’s account has not already been transferred to a solvent brokerage firm, a customer with an allowed claim will receive back the securities that were held in their account at the failed brokerage firm, together with any cash held, up to the SIPC protection limits.

Where To Learn More About SIPA Liquidations. For additional information on SIPA liquidations and their Chapter 7 counterparts, you may find this discussion on the U.S. Court system’s website of interest. In addition, SIPA trustees appointed in brokerage cases frequently establish a case-specific website. These links will take you to the websites created by the Lehman Brothers SIPA trustee and the Bernard L. Madoff Investment Securities SIPA trustee.

Conclusion. They may not be common, and the SIPC does not provide the same type of protection as the FDIC, but SIPA liquidations can play an important role in protecting investors when brokerage firms fail. However, the SIPC is generally able to intervene only when one of its member firms fails, making that little-noticed "Member SIPC" designation more significant that most investors realize.