Creditor clients range from sophisticated lenders to part-time small businesses.  However, no matter the size or sophistication of the client, creditors often have certain misconceptions as to what is and is not permissible when a debtor files bankruptcy.  This article is intended to help demystify basic creditors’ rights when a debtor is threatening to or has filed bankruptcy.

Myth: If Debtor Threatens Bankruptcy, the Creditor Should Compromise Substantially to Avoid Bankruptcy

Not necessarily without further detailed analysis of the debtor’s assets and liabilities.  In fact, a creditor should aggressively but legally step up its collection efforts to avoid limitations brought about by a bankruptcy filing.  Although each case is different, we generally advise creditor clients that while the bankruptcy threat should be taken seriously, it should not sway a creditor from continuing to pursue the best deal possible.   Once a bankruptcy is filed a creditor’s rights quickly become limited by what a creditor will and will not be permitted to do once the “bankruptcy stay” is in effect.

Furthermore, when a deal is struck with a debtor under the belief that the debtor is or is about to become insolvent, creditors are surprised to learn that money used to pay an antecedent debt may be subject to being repaid to the bankruptcy estate.  Creditors should, however, be aware of bankruptcy pitfalls like preference and fraudulent conveyance claims when determining how and under what payment terms to settle an antecedent obligation.

Preferences

A payment made by a debtor to an unsecured creditor within 90 days (or one year if the creditor and debtor are insiders) prior to the date of the debtor’s bankruptcy is presumed to be a preferential payment pursuant to 11 U.S.C. §547.  Under the Bankruptcy Code, a preference payment is a payment:

• (1)to, or for the benefit of, the creditor;
• (2)for, or on account of, an existing debt;
• (3)made while the debtor was insolvent;
• (4)made at any time during the 90-day period before the bankruptcy filing; and
• (5)the creditor receives more than it would receive in a Chapter 7 liquidation bankruptcy.

There are many defenses to a preference claim, including but not limited to: 1) a substantially contemporaneous exchange of new debt for a product or service; 2) payments made in the ordinary course; 3) new value has been given; and 4) a purchase money security interest is taken.  Preference actions and available defenses can become very technical and require detailed analysis.  Therefore, it is vitally important to anticipate the possibility of a preference action when settling a prior indebtedness of a debtor who has failed to continue making ordinary course payments.  Section 547 may protect “ordinary trade credit transactions that are kept current” by applying the ordinary course defense, however, a “one-time” transaction cannot qualify. [i]

Fraudulent Conveyances

There are two types of fraudulent conveyance claims in bankruptcy: one premised on actual fraud and the other premised on constructive fraud.  An actual fraudulent conveyance action is committed when: 1) a transfer is made within two years before the date of the filing of a bankruptcy petition (or four years from the date of a state court claim under the Uniform Fraudulent Transfer Act); and 2) made with the intent to hinder or defraud a creditor.  Actual proof of intent must occur. [ii]

Constructive fraud requires that two years before the date of the filing of a bankruptcy petition (or four years from date of a state court claim under the Uniform Fraudulent Transfer Act): 1) in exchange for the transfer, the debtor received less than “reasonably equivalent value”; and 2) the debtor is unable to pay debts either at the time the transfer was made or as a result of the transfer itself. [iii]

Creditors should be aware that a debtor who appears to be or is threatening insolvency may attempt to liquidate its assets or property, even favoring certain creditors or “friends” of the debtor.  If a creditor receives this treatment, the property conveyed to the creditor could be subject to being returned to the bankruptcy estate.

It is not a guarantee that the Trustee or a Debtor in Possession will pursue preference and fraudulent conveyance claims; however, the larger the bankruptcy the more likely these claims will be pursued.  However, the adage—a bird in the hand is worth two in the bush—certainly applies here.  Creditors are better off to settle pre-bankruptcy and have the settlement proceeds in their hand while later, if necessary, negotiating what must be returned to the bankruptcy estate.  A settled preference or fraudulent conveyance claim will most often result in the creditor keeping a more significant percentage of an unsecured debt than not settling and merely taking what the creditor gets from submitting its proof of claim.

Myth: When a Debtor Files Bankruptcy, Creditors May Not Take Further Action That May Affect the Debtor or Pursue Claims in Which the Debtor is Involved

Yes and no, so this statement is partially true.  It is important to acknowledge that the bankruptcy stay under 11 U.S.C. § 362 of the Bankruptcy Code imposes a “super stay” against any activity that could detract from a debtor attending to its bankruptcy or that might otherwise dissipate assets of the bankruptcy estate.  A creditor is precluded from among other activities: 1) commencing or continuing an action or proceeding against a debtor that was or could have been commenced before the commencement of the bankruptcy case; 2) enforcing a judgment obtained before the commencement of the bankruptcy case; 3) taking action to obtain possession of property of the estate or to exercise control over property of the estate; 4) taking action to create, perfect, or enforce any lien against the estate; 5) taking action to create, perfect, or enforce against property of the debtor any lien to the extent the lien secures a claim that arose before commencement of the bankruptcy case; 6) taking action to collect, assess or recover a claim against the debtor that arose before commencement of the bankruptcy case; 7) setting off of any debt owing to the debtor that arose before commencement of the bankruptcy case against any claim against the debtor; and 8) commencing or continuing a proceeding before the United States Tax Court concerning the debtor.  The automatic stay is activated immediately on the filing of a voluntary petition under the Bankruptcy Code, and remains in effect until the entry of an order granting or denying a discharge or closing or dismissing the . . . case, or until the entry of an order granting relief from the stay; however that does not mean that a creditor is precluded from ceasing all activity that affects the debtor. [iv]

Permissible Activity That Does Not Violate the Bankruptcy Stay

There are many instances in which the bankruptcy stay will not prevent creditors from taking specific action.  For example, the bankruptcy stay may not preclude the creditor from acting to perfect an interest in real estate, such as recording a mechanics’ lien when labor or improvements have already been made to the real estate, but the lien document must be recorded post-bankruptcy filing.[v] However, when in doubt, the correct and best approach is to file a motion with the Bankruptcy Court seeking relief from the bankruptcy stay.

Also, creditors are not precluded from continuing to pursue co-defendants in litigation who have not themselves filed bankruptcy or have not sought equitable relief from the Bankruptcy Court to enforce the bankruptcy stay as to those co-defendants.  Just because a debtor files a Notice of Stay in a state court proceeding, the entire case is not necessarily stayed.  At times it will just take reminding the state court of what a bankruptcy stay will and will not allow.

Furthermore, there are strategies inside the bankruptcy arena that can cause a debtor to place a particular creditor’s claim into special consideration.

• For starters, when asked if a creditor should file a proof of claim, we advise that a proof of claim be filed as early in the case as possible so the creditor does not forget to file a proof of claim. The reason being that if a creditor inadvertently misses the proof of claim bar date, the proof of claim will likely be barred and not accepted, the result being that the creditor will receive nothing from the bankruptcy estate. [vi]
• Also, there are very specific deadlines set for objecting to dischargeability of a specific debt or objecting to discharge of the debtor.[vii]  The deadline to file such an adversary proceeding is no later than 60 days from the first meeting of creditors.[viii]  Unless the creditor files the complaint by this deadline or obtains an enlargement of time for this deadline from the Bankruptcy Court, the creditor will be barred from objecting to dischargeability of a specific debt or discharge of the debtor.  There are many  reasons and strategies that should be considered by a creditor in deciding whether to file a complaint objecting to dischargeability of a specific debt or objecting to discharge of the debtor.  Creditors would be surprised to learn that some of these exceptions may apply in their particular case.

Conclusion

The strategies addressed in this article are intended only to glean the surface of bankruptcy law and how it may affect a creditor’s ability to continue to pursue a claim against a debtor who has threatened to or has filed bankruptcy.  Ultimately, a creditor’s decision to move forward on pursuing a specific strategy should include seeking advice and input from bankruptcy/creditors’ rights counsel.  Effectively using specific strategies prior to and during bankruptcy can often serve to place the creditor in a better position than had it walked away from claims because of the bankruptcy filing. Indeed, bankruptcy can be an effective tool for creditors to obtain closure and assure themselves that a debtor is playing straight and properly disclosing its assets and liabilities.  Once a bankruptcy notice is received, proactive creditors will determine how to use the bankruptcy filing to their advantage and will not just lie back and wait for the eventual notice of discharge.

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[i]  Energy Co-op., Inc. v. SOCAP International, Ltd., 832 F.2d 997 (7th Cir. 1987).

[ii] See 11 U.S.C §548 and Indiana Code § 32-18-2 et seq.

[iii] See 11 U.S.C §548 and Indiana Code § 32-18-2 et seq.

[iv] See 11 U.S.C. § 362.

[v] See 11 U.S.C. § 362(b)(3).

[vi] See In re Kmart Corp., 381 F.3d 709 (7^th Cir. 2004).

[vii] See 11 U.S.C.  §§ 523 and 727.

[viii] See Rules 4004 and 4007, Federal Rules of Bankruptcy Procedure.

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Posted on Apr. 18 2019, by Anthony R. Jost