Class 1
Bankruptcy, Spring, 2009
Case Initiation &
Property of the Estate
Randal C. Picker
Leffmann Professor of Commercial Law
The Law School
The University of Chicago
773.702.0864/r-picker@uchicago.edu
Copyright © 2005-09 Randal C. Picker. All Rights
The Dark Side of
Bankruptcy?

The Hypo
Zero
real rate of interest
Project requires $100 cash investment
Firm want outside financing
10% of the time the project yields $50
90% of the time the project yields $V > 50
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Social Q: Do We Want This
Project?

Expected Value of the Project
+ .9*V – 100
Want the project undertaken if V > 105.55
.1*50
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Outside Funding of the
Project



Assume lending market is competitive
Funding decision, with zero interest rate,
requires recovery of $100 investment
Let D be the amount of debt to be owed to
the lender
Then
we need 100 = 0.1*50 + 0.9*D
D = 105.55
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Take Stock

Social Incentives = Private Incentives
Want
project undertaken if V > 105.55
Lender will finance with D = 105.55
Lender will finance if and only if project is
socially useful
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Introduce Bankruptcy

If project fails ($50 value of project results)
Assume
mechanism exists that will enable
firm to undertake new investment project
With project, invest $50
90% of the time get nothing, 10% of the
time get $300
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Social Q: Do We Want This
Project (and this Mechanism)?

Expected Value of the Project
.9*0

+ .1*300 – 50 = -20
Bad Investment!
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What will the Firm Do?

With D = 105.55
On
failure with $50, firm keeps nothing
(Lender owed 105.55 is entitled to all of the
money)
But if Firm undertakes new investment
.9*0 + .1*(300-105.55) = 19.45
 Firm will undertake bad project if allowed to
do so

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What will the Firm Do?

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Lender gets .9*105.55 + .1*(.9*0 +
.1*105.55) = 96.05
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How will Lender Respond?

Needs new debt amount upfront, call it F,
where F needs to satisfy
.9*F
+ .1*(.9*0 + .1*F) = 100
.91*F = 100
F = 109.89
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What Does This Mean?

Is Lender Harmed by this Mechanism that
Allows the Bad Investment when Firm
Fails?
Not
in this example
Lender takes into account ex ante
anticipated bad investment when Firm fails
Lender raises debt amount from 105.55 to
109.89
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What Does This Mean?

Is Firm Harmed by this Mechanism?
Yes
Firm
can’t fool Lender
Firm loses ability to finance projects where
105.55 < V < 109.89

Is Society Harmed?
Yes,
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in exactly the same way
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More Meaning

Possible Downside of Bankruptcy
If
bankruptcy makes it possible for firm to
undertake bad investments, lenders will
anticipate that and adjust lending
accordingly
Good upfront investments will be lost
We would be better off without bankruptcy
or if we allowed firms to waive access to
bankruptcy
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Other People’s Money

Investment Incentives with Debt
Firm
is willing to undertake bad project
because it isn’t spending its own money
Presence of debt changes investment
incentives
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Other People’s Money

Bankruptcy Rules Matter
If
bankruptcy rules facilitate bad inbankruptcy investments, rules matter
Creditors will adjust but we will lose socially
valuable investments upfront

Is this a Fair Characterization of
Bankruptcy?
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Initiating a Case: Statutes

109
Eligibility

Rules
301
Voluntary
Petitions: Mechanics and
Consequences

303
Involuntary
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Petitions
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Initiating a Case: Statutes

305
Abstention

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When may the bankruptcy court decline to
exercise jurisdiction over a case within its
power?
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109: Relation to the U.S

Who may be a debtor
(a)
Notwithstanding any other provision of
this section, only a person that resides or
has a domicile, a place of business, or
property in the United States, or a
municipality, may be a debtor under this
title.
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109: Chapter 7 Eligiblity

Who may be a debtor (cont.)
 (b)
A person may be a debtor under chapter
7 of this title only if such person is not—
 (1) a railroad;
 (2) a domestic insurance company, bank,
savings bank, cooperative bank, savings
and loan association, building and loan
association […]; or
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109 (cont.)

Who may be a debtor (cont.)
(3)(A) a foreign insurance company,
engaged in such business in the United
States; or
 (B) a foreign bank, savings bank,
cooperative bank, savings and loan
association, building and loan association,
homestead association, or credit union, that
has a branch or agency … in the United
States.

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109: Chapter 9 Eligibility

Who may be a debtor (cont.)
(c)
An entity may be a debtor under chapter
9 of this title if and only if such entity-(1) is a municipality;
 (2) [omitted];
 (3) is insolvent;
 (4) desires to effect a plan to adjust such
debts;
 […]

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109: Chapter 11 Eligibility

Who may be a debtor (cont.)
(d)
Only a railroad, a person that may be a
debtor under chapter 7 of this title (except a
stockbroker or a commodity broker), and an
uninsured State member bank, or a … may
be a debtor under chapter 11 of this title.
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109: Chapter 13 Eligibility

Who may be a debtor (cont.)
(e)
Only an individual with regular income
that owes, on the date of the filing of the
petition, noncontingent, liquidated,
unsecured debts of less than $336,900 and
noncontingent, liquidated, secured debts of
less than $1,010,650
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109 (cont.)

Who may be a debtor (cont.)

or an individual with regular income and such
individual's spouse, except a stockbroker or a
commodity broker, that owe, on the date of the filing of
the petition, noncontingent, liquidated, unsecured
debts that aggregate less than $336,900 and
noncontingent, liquidated, secured debts of less than
$1,010,650
 may
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be a debtor under chapter 13 of this title.
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109: Chapter 12 Eligibility

Who may be a debtor (cont.)
 (f)
Only a family farmer or family fisherman
with regular annual income may be a debtor
under chapter 12 of this title.
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109: Serial Filings Limit

Who may be a debtor (cont.)
(g)
Notwithstanding any other provision of
this section, no individual or family farmer
may be a debtor under this title who has
been a debtor in a case pending under this
title at any time in the preceding 180 days
if—
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109 (cont.)

Who may be a debtor (cont.)
(1) the case was dismissed by the court for
willful failure of the debtor to abide by orders
of the court, or to appear before the court in
proper prosecution of the case; or
 (2) the debtor requested and obtained the
voluntary dismissal of the case following the
filing of a request for relief from the
automatic stay provided by section 362 of
this title.

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109 (cont.)

2005 Amendments on Prepetition
Counseling
See
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109(h)
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301: Commencing A
Voluntary Case

Voluntary Cases
(a)
A voluntary case under a chapter of this
title is commenced by the filing with the
bankruptcy court of a petition under such
chapter by an entity that may be a debtor
under such chapter.
(b) The commencement of a voluntary case
under a chapter of this title constitutes an
order for relief under such chapter.
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Bankruptcy Forms

Go to
http://www.uscourts.gov/bkforms/bankruptc
y_forms.html

Voluntary Petition Form
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303: Involuntary Cases:
Eligibility

Involuntary Cases

(a) An involuntary case may be
commenced only under chapter 7 or 11 of
this title, and only against a person, except
a farmer, family farmer, or a corporation that
is not a moneyed, business, or commercial
corporation, that may be a debtor under the
chapter under which such case is
commenced.
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303: Dollar Amounts and
Numbers

Involuntary Cases (cont.)
 (b)
An involuntary case against a person is
commenced by the filing with the bankruptcy court
of a petition under chapter 7 or 11 of this title 
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(1) by three or more entities, each of which is either
a holder of a claim against such person that is not
contingent as to liability or the subject of a bona fide
dispute, or an indenture trustee representing such a
holder, if such claims aggregate at least $13,475
more than the value of any lien on property of the
debtor securing such claims held by the holders of
such claims;
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303 (cont.)

Involuntary Cases (cont.)
(b)(2)
if there are fewer than 12 such
holders, excluding any employee or insider
of such person and any transferee of a
transfer that is voidable under section 544,
545, 547, 548, 549, or 724(a) of this title, by
one or more of such holders that hold in the
aggregate at least $13,475 of such claims;
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303: Substantive Standard
for Involuntary Petition

Involuntary Cases
(h)
If the petition is not timely controverted,
the court shall order relief against the debtor
in an involuntary case under the chapter
under which the petition was filed.
Otherwise, after trial, the court shall order
relief against the debtor in an involuntary
case under the chapter under which the
petition was filed, only if 
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(1) the debtor is generally not paying such
debtor’s debts as such debts become due
unless such debts are the subject of a bona
fide dispute;
or …
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305: Abstention

Abstention
(a)
The court, after notice and a hearing,
may dismiss a case under this title, or may
suspend all proceedings in a case under
this title, at any time if

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(1) the interests of creditors and the debtor
would be better served by such dismissal or
suspension; or …
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More Ways to Make the
Case Go Away

707
Dismiss

the case for “cause”
1112
Dismiss
or convert the case (to another
chapter) for cause
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Shawmut Bank
I --- I
1
N
Trust Certificates
1st Priority Secured $200MM
2nd Priority Secured $200MM
3rd Priority Secured $100MM
Equipment
Trust
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1. How should
we characterize
this transaction?
2. Why does it
matter?
$500MM Sale
and Leaseback
Copyright © 2005-09 Randal C. Picker
Eastern
37
Two Characterizations

Transaction Between Trust and Eastern
Nominally
a sale and leaseback
That means title to the planes leaves
Eastern and comes to the Trust
If Eastern files for bankruptcy, planes won’t
be part of the bankruptcy estate created
when Eastern files a bankruptcy petition
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Two Characterizations

Status of the Trust
What
kind of entity is the trust?
Is it bankruptcy eligible or is it “bankruptcy
remote”?
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Sale and Leaseback as
Secured Transaction

Parties Agree Deal is Secured Transaction
Implications
Trust makes loan to Eastern and is a
creditor of Eastern
 Title to Assets Remain with Eastern and
assets will be part of Eastern bankruptcy
 Trust as secured creditor will have priority
over other creditors as to the planes

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Sale and Leaseback as
Secured Transaction

Why?
Historically,
parties seek to use form to
control results in deals
Law frequently looks through form to
underlying substance
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The Eastern Bankruptcy

Follow the Airplanes
3/9/89:
Eastern files Chapter 11 (official
name of the bankruptcy “In re Ionsophere
Clubs”)
1/23/91: Eastern cuts deal with collateral
trustee to turnover planes and $230MM in
cash from sales of planes
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Why File?

Why was an involuntary bankruptcy petition
filed against the Trust?
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Why the Filing?

Conf Call April 5, 1991: David Sherman, a vice
president of Charter National Life Insurance
Company
 MR.
SHERMAN: [One reason for the filing is that the
First Series certificate holders are seeking payment of]
interest on interest and redemption premium if entitled
to it. And they have been very strongful [sic ] with that
way. And as a result if that were to happen there would
be no cash left in the estate for the Second or the
Thirds to take care of their planes and generate asset
sales or even help upkeep their lease requirements. …
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Why the Filing?
 Two,
the structure between the Indenture Trustees and
the Collateral Trustee, as Barbara has experienced, is
horrible. The Collateral Trustee really won't do
anything if he can avoid it because he is afraid of
getting sued. And the Indenture Trustees say we think
you should do this but we're not going to instruct you.
So no one ... nothing ever gets done. If Northwest or
some other firm came to the Collateral Trustee and
said we can sell you, we can sell 20 planes tomorrow,
we'll buy them, but it's a one week offer and you have
to decide, the Collateral Trustee would say "Gee, I
don't know. What should I do.“
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Why the Filing?
The
Firsts would say "We don't care as long
as we can get our cash out." The Seconds
would probably say "as long as it's relatively
reasonable price we should do this because
we could hopefully get our cash out." The
Thirds would be objecting because they
won't be satisfied in today's market prices
because, you know, they figure they get
wiped out.
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