Assignment 18
Introduction to Bankruptcy
(Claims; Automatic Stay; Relief
from Stay; After-Acquired
Property; Proceeds in
Bankruptcy)
Chapter 7 (Liquidation)
• Debtor surrenders its nonexempt property to the
bankruptcy trustee, which sells that property and
distributes the sale proceeds to pay creditors
• Debtor’s pre-bankruptcy debts are discharged (can
no longer be legally enforced vs. debtor), except for
debts that are either
– (a) Nondischargeable under bankruptcy law, or
– (b) Reaffirmed by debtor (only as permitted in
bankruptcy)
• Bankruptcy is akin to financial
“death”; debtor’s nonexempt
assets, on petition date, go into
debtor’s “estate” [BC § 541]
• Estate is administered for benefit
of pre-bankruptcy creditors
• “Claims” against debtor are paid
to creditors as dictated by U.S.
Bankruptcy Code
Bankruptcy
Reorganization (Chapters 11-13)
• Debtor keeps its pre-bankruptcy property, and uses
its post-bankruptcy income to repay creditor claims
under a “plan” of reorganization
– Plan has to satisfy certain standards for how it treats
creditors (and in Chapter 11, creditors vote on plan)
• If court confirms plan, the plan binds all creditors
(pre-bankruptcy debt terms are replaced by plan
terms); if not, case is dismissed/converted to Ch. 7
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Issues for Secured Parties
• How does bankruptcy impact the debtorcreditor relationship?
• How is a creditor’s claim calculated and paid?
• How are secured and unsecured claims treated
differently?
• What are the trustee’s “avoiding powers” and
how do they affect secured creditors?
• 11 U.S.C. § 362(a): the filing
of a bankruptcy petition results
in the imposition of the
“automatic stay”
• Automatic stay is an injunction
preventing creditors from
acting to collect debts owed by
debtor or enforce liens against
property of bankruptcy estate
• No court order needed (arises
by operation of law)
Automatic
Stay
• Hall has line of credit at First Bank
– Balance due >>> $50,000
– Hall is in default (he’s made no
monthly minimum payment for two
months)
Problem 1
• Hall files bankruptcy petition
• Loan officer sees Hall at dinner,
asks him to make payments or First
Bank would have to “freeze his
credit line.”
• Does Bank have a problem?
• 11 USC § 362(a): petition is a
“stay” (injunction) against:
– (1) any action to enforce prepetition claim vs. debtor
– (2) enforcement of a pre-petition
judgment against debtor
– (3) repossession of estate property
– (4), (5) any act to perfect or
enforce a lien vs. property of the
estate or the debtor
– (6) any other action to collect a
pre-petition claim vs. the debtor
Automatic
Stay
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Automatic Stay: Objectives
• “Breathing space” for reorganizing debtor
– Debtor can focus on “getting back on its feet,”
rather than having to defend against creditor
collection efforts in court or otherwise
• Claims are resolved/paid in a collective
proceeding, supervised by court
– Similar types of creditors are treated similarly
– Avoids “distress sale” disposition of debtor’s assets
at low prices (no “race to the courthouse”)
• Oct. 15, 10:00am: Grant
buys a Porsche for $10,000
cash at a foreclosure sale
held by Commerce Bank
• Oct. 25: Grant gets a letter
from Ch. 7 bankruptcy
trustee for Harris, demanding
return of the Porsche
– Harris (debtor/owner of
Porsche) had filed Ch. 7
petition 15 minutes prior to the
foreclosure sale
– Neither Grant nor Commerce
Bank knew this
• Must Grant comply?
Problem 1
• First Bank’s only legal collection activity is to file
a proof of claim w/the bankruptcy court [§ 501(a)]
– If so, First Bank will hold a valid claim [§ 502(a)],
unless the debtor or the trustee establishes a valid
defense to First Bank’s claim [§ 502(b)]
• Any other collection effort (automated monthly
bills, or this dinner conversation) violates the stay!
– Note: A willful (i.e., knowing) violation of the
automatic stay can result in imposition of punitive
damages! [§ 362(k)]
Problem 2
• BC § 362(a): petition is a
“stay” (injunction) against:
A. Yes
B. No, Grant was
a BFP
C. More facts
needed
– (4), (5) any act to enforce a lien
vs. property of the estate/debtor
(including a foreclosure sale)
Automatic
Stay
• Actions taken in violation of the
automatic stay are considered to
be void ab initio
[Understanding, p. 333]
• Grant must turn Porsche over to
trustee [BC § 542(a)]
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Problem 2: Effect of Sale?
• Sale was void, so it didn’t extinguish
Commerce Bank’s lien on the Porsche
• Grant can recover $10,000 cash from
Commerce Bank
– Commerce Bank still has its SI in the car to
secure the unpaid balance of Harris’s debt
(assuming the SI was properly perfected, it
remains valid despite the bankruptcy filing)
A Variant on Problem 2
• Harris files a Chapter 7
bankruptcy petition
• Commerce Bank has a perfected
SI in Harris’s Porsche
• You are Harris’s Chapter 7
bankruptcy trustee
• Do you take possession of
Porsche and sell it?
Bankruptcy and Secured Parties
• Bankruptcy generally respects state law property
rights (like a mortgage on land or an Article 9
security interest on personal property)
– Liens generally “survive” bankruptcy petition
(i.e., they remain valid against the collateral)
– This respects a secured creditor’s state law
priority over unsecured/junior creditors
• But the petition stays enforcement of lien [§ 362]
• The Porsche is property of the estate [§ 541(a)(1)]
– But, whether Ch. 7 trustee should attempt to sell it
depends on the circumstances
• Key fact: Does Harris have any nonexempt equity
in the Porsche (i.e., is car’s FMV >>> balance owed
to Commerce Bank, junior lienholders, and the
amount of Harris’s exemption in the car, if any)?
– If so, the Trustee wants to sell the car to capture that
equity for the benefit of unsecured creditors
– If not, Trustee shouldn’t bother (all sale proceeds would
go to secured creditors and/or Harris anyway)!
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• If there’s no equity (or minimal equity) in the
collateral, the Trustee will “abandon” it
– Trustee can, after notice and a hearing, “abandon
any property of the estate that is burdensome to
the estate or that is of inconsequential value and
benefit to the estate” [§ 554(a)]
– Abandonment spares the trustee the burden of
paying to maintain estate property if “there’s
nothing in it” for the estate
– Abandonment takes the property out of the
bankruptcy estate and vests title to that property
back in the debtor
• Bank can file a “claim” in the
amount of $20,000 (unpaid
amount due on petition date)
• Bank’s claim does not include
“post-petition” interest
– Creditors generally can’t
recover “unmatured” interest
as part of their bankruptcy
claim [§ 502(b)(2)]
Problem 3(a):
Calculating a
Claim
• Petition date: Tramp owes
Bank $20,000 on line of credit
(which had 10% interest rate)
• Bank has a SI in Tramp’s
equipment (value = $10,000)
• Bank’s total “claim” in
bankruptcy is:
Problem 3(a):
Calculating a
Claim
A. $10,000
B. $20,000
C. $20,000 + 10% interest until
Bank’s claim is paid
• Why not allow interest to accrue on unsecured
claims after the petition date? [§ 502(b)(2)]
– In liquidation, distribution is a “zero-sum” game
– Allowing unsecured creditors to collect interest would
just increase total $$ amount of claims, and diminish
“dividend rate” on payments to unsecured creditors
• Note: interest still accrues on debt under state
law! [distinguish between debt and claim]
– If Tramp’s case is dismissed (or discharge is denied),
creditor could later recover in state court any interest
that accrued on the debt during Tramp’s bankruptcy
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Bifurcation of Claims
• In Problem 3(a), Bank is an “undersecured”
creditor Tramp; balance of debt ($20,000) >>>
value of collateral ($10,000)
• § 506(a) bifurcates Bank’s claim (i.e., it treats it
as 2 different claims, for bankruptcy purposes)
– Bank has a secured claim, in the amount of the
value of the collateral ($10,000) [§ 506(a)]
• This claim will get paid in full; Bank keeps its SI in
the collateral until Bank gets paid
– Bank also has an unsecured claim ($10,000)
for the balance [§ 502(a)]
• This claim is paid along w/other unsecured claims
• Bank can file a claim in the
amount of $10,000 (amount
owed on the petition date) as a
secured claim
• But Bank can also add “postpetition” interest to its claim,
b/c it is an “oversecured”
creditor (i.e., collateral’s
value >> balance of debt) [BC
§ 506(b)]
Problem 3(b):
Calculating a
Claim
• Smith files bankruptcy
• Smith owes Bank $10,000 on
a promissory note (which
bears interest at 10%)
• Bank has a SI in Smith’s
diamond (value = $20,000)
• What is the amount of Bank’s
claim(s) in Smith’s
bankruptcy case?
Problem 3(b):
Calculating a
Claim
§ 506. Determination of secured status
(a) [Omitted]
(b) To the extent that an allowed secured claim
is secured by property the value of which, after any
recovery under subsection (c) of this section, is
greater than the amount of such claim, there shall be
allowed to the holder of such claim, interest on such
claim, and any reasonable fees, costs, or charges
provided for under the agreement or State statute
under which such claim arose.
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“Oversecured” Creditors
Relief from the Automatic Stay
• In Problem 3(b), Bank is an “oversecured” creditor
(value of collateral >> balance of debt) [§ 506(a)]
• Oversecured creditor’s claim accrues what is often
called “pendency” interest (i.e., interest continues to
accrue on the creditor’s claim, during bankruptcy,
until claim is paid) [§ 506(b)]
• Upon motion by secured party, secured party can
seek “relief” from the automatic stay
• If granted relief by the court, secured party can
pursue its state law remedies (e.g., Article 9
foreclosure sale)
• Standards governing a creditor’s entitlement to
relief from stay are governed by Bankruptcy Code
§ 362(d)
– Unsecured claim = no pendency interest [§ 502(b)(2)]
– Accrual of interest (out of “equity cushion”) protects
oversecured creditor from impact of delay/stay
Standards for Relief from Stay
• (1) For “cause,” including lack of
“adequate protection” of creditor’s security
interest in property [§ 362(d)(1)]
• (2) Debtor does not have any equity in the
collateral, and the collateral is not
“necessary for an effective reorganization”
of debtor [§ 362(d)(2)]
Relief from Stay: Procedure
• Secured party must file motion w/court
• After motion for relief is filed, stay remains in
place for 30 days [§ 362(e)]
• After 30 days, stay is lifted unless court, after
notice/hearing, orders it to be continued
– Secured party has burden of proof re: debtor’s lack
of equity in collateral [§ 362(g)(1)]
– Debtor has burden re: collateral’s necessity to
debtor’s effective reorganization [§ 362(g)(2)]
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• Suppose that Harris (Debtor
in Problem 2) files a Chapter
7 bankruptcy petition
– He owes Commerce Bank
$25,000, secured by a
perfected SI in Porsche
– Value of Porsche = $20,000
– Ch. 7 trustee abandons estate’s
interest in Porsche to Harris
• Commerce Bank moves to
lift the automatic stay, to
conduct a foreclosure sale
• The Court should:
Relief from Stay
A. Lift the stay
B. Deny the
motion and allow
Debtor to keep
driving the car
• Bank will argue that it should be allowed
relief from stay to foreclose under §
362(d)(2), because:
– Debtor has no “equity” in the car, and
– Debtor is not reorganizing, but is liquidating
• Bank is correct, so is there any way Debtor
can still retain the car?
Redemption [§ 722]
Reaffirmation [§ 524(c)]
• Individual debtor can redeem consumer goods from
a lien securing a dischargeable consumer debt, if:
• Alternatively, if Debtor Harris doesn’t have cash to
redeem, he could still keep the car if he enters into a
reaffirmation agreement with Bank
– The goods are exempt property or the trustee has
abandoned the goods, and
– Debtor pays the full amount of the lienholder’s secured
claim in cash, in a lump sum, at the time of redemption
• In Problem 2, Debtor could only redeem car by
making lump-sum payment of $20,000 cash!
– Debt would not be discharged; Harris would continue
to make payments on the debt as agreed with Bank
– Here, reaffirmation is a bad solution for Harris (who
would have to pay $25,000 for a $20,000 car); Debtor
may be better off allowing foreclosure, getting
discharge, and buying another car, if he can
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• If Debtor Harris can’t redeem the car and
doesn’t want to reaffirm the debt (or if court
refuses to approve Debtor’s reaffirmation
agreement), the court will lift the stay and
allow Bank to foreclose its SI in the car [§
362(d)(2)], because:
– Harris has no equity in the car (debt = $25,000,
while value of car = $20,000), and
– Car is not necessary for an effective reorganization
of Harris (who is being liquidated in Chapter 7)
Problem 4
• Court is unlikely to grant ACF relief under
§ 362(d)(2)
– Although CCC does not have equity in the
trucks, the trucks are necessary for CCC to
reorganize
– If the trucks are repossessed, CCC can’t do
concrete jobs, and can’t generate the earnings
necessary to fund its reorganization plan
Problem 4
• CCC owes ACF $200,000
• ACF has a perfected SI in six trucks (FMV =
$180,000) that CCC uses to do concrete jobs
• CCC files Ch. 11 bankruptcy petition and
begins negotiating with creditors over the
terms of its reorganization plan
• ACF moves for relief from stay to foreclose on
the trucks. Should Court grant it relief?
Debtor’s Use of Collateral
• Concern: CCC’s continuing use of the
trucks threatens ACF’s SI in the trucks
– Further use means depreciation in value
– Right now, ACF is $20,000 undersecured
– If trucks depreciate further, ACF may be even
more undersecured (and thus likely to collect
even less) if CCC is unable to confirm or
perform a Chapter 11 plan
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Adequate Protection
Adequate Protection
• CCC gets to use the trucks during bankruptcy [§
363(c)]
• But, CCC’s use of the trucks may cause them to
depreciate in value, and ACF is already
undersecured
• ACF can thus demand “adequate protection” as a
condition to CCC’s use of the trucks [§ 363(e)]
• If CCC cannot provide adequate protection, court
must lift the stay [§ 362(d)(1)]
• CCC could provide adequate protection by:
Problem 5
Problem 5: Court Should:
• CCC owes ACF $200,000
• ACF has a perfected SI in six trucks (FMV =
$300,000) that CCC uses to do concrete jobs
• CCC files Ch. 11 bankruptcy petition and
begins negotiating with creditors over the
terms of its reorganization plan
• ACF moves for relief from stay to foreclose on
the trucks. Should Court grant it relief?
– Making cash payments to ACF = expected
depreciation in value of trucks [§ 361(1)]
– Granting a “replacement lien” (a SI in other
property the value of which >> expected
depreciation in trucks) [§ 361(2)]
– Providing ACF with the “indubitable
equivalent” of its SI in the trucks[§ 361(3)]
A. Lift the stay under § 362(d)(1) (lack of
adequate protection)
B. Lift the stay under § 362(d)(2) (no equity/
collateral not necessary for reorganization)
C. Both A and B
D. Deny the motion and leave stay in place
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Problem 5
• Court should deny motion
– Debtor has $100,000 of equity (which should
be preserved for the benefit of unsecured
creditors and Debtor’s ability to reorganize), so
no relief under § 362(d)(2)
– ACF is “adequately protected” by “equity
cushion” (trucks would have to depreciate by
>> $100K before ACF would be less than fully
secured), so no relief under § 362(d)(1)
After-Acquired Property Clauses
in Bankruptcy
• Outside of bankruptcy, after-acquired clauses are
valid/enforceable [§ 9-204(a)]
• Once debtor files for bankruptcy, however, an afteracquired property clause is “cut off” and is no
longer effective [BC § 552(a)]
– Problem 6: Bank’s “after-acquired inventory” clause in
the security agreement would be ineffective to create a
SI in Nov. 7 inventory shipment (post-petition)
Problem 6
• Bank has a perfected SI in all inventory,
including after-acquired, of Sight and Sound
(an electronics retailer)
• October 31: Sight and Sound files Ch. 11
• If Sight and Sound receives a shipment of
inventory on Monday, Nov. 5, does Bank have
a SI in that inventory?
BC § 552(a): Rationale
• If Bank’s SI extended to post-petition inventory,
Sight and Sound might not be able to obtain credit it
needs to reorganize in bankruptcy
– By virtue of § 552(a), Sight and Sound can use its
“post-petition” assets as collateral to obtain credit to
enable it to operate in bankruptcy (i.e., acquire new
inventory) while attempting to reorganize
• In Article 9 terms: post-bankruptcy, Sight and
Sound is not a “new debtor” [§§ 9-203(d), (e)]
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Problem 6
• PCB has perfected SI in all inventory (incl.
after-acquired) of Sight and Sound
• October 31: Sight and Sound files Chapter 11
• November 1-5: Sight and Sound sells 200
units of inventory, either for cash or on
installment contracts
• Does PCB have a SI in the cash and
installment contracts arising from these sales?
Proceeds in Bankruptcy
• Bank did have a valid SI in the inventory that was
sold November 1-5 (b/c it was inventory acquired
prior to bankruptcy and was properly perfected)
• Even though the cash and installment contracts were
not received until after bankruptcy (post-petition),
they are still “proceeds” of the prepetition inventory
• Thus, Bank has a valid SI in the cash and the
installment contracts [BC § 552(b)(1); UCC § 9315(a)]
Problem 6
• What must Bank do as soon as it learns of
bankruptcy filing of Sight and Sound?
– Bank should immediately move for relief from stay
– Bank: Sight and Sound shouldn’t be allowed to
use/sell our collateral, unless we receive adequate
protection of our interest in it and the proceeds of it
– All cash proceeds of Bank’s inventory should be
segregated (and not used w/out court approval)
– If Sight and Sound’s wants to use that cash (i.e., if
it wants post-petition credit from Bank), Bank
should receive a SI in new post-petition inventory
(or should receive some other form of adequate
protection)
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