Under certain situations, a bankruptcy trustee may try to recover transfers made by a debtor to creditors before the filing of his case. These types of conveyances are termed “fraudulent conveyances.” But does an innocent transferee, who had no knowledge of a debtor’s coming bankruptcy, have any way to prevent a trustee from recovering this kind of a transfer? Under Section 548( c) of the Bankruptcy Code, a transferee can have an affirmative defense in such a situation.
When in doubt, file a claim. This is the take-away lesson from a recent bankruptcy court case coming from Nebraska. Proofs of claim in a Chapter 11 case are handled somewhat differently than those in Chapter 7 or Chapter 13 cases. Under Fed. R. Bankr. P. 3003(b)(1) and Section 1111(a) of the Bankruptcy Code, a creditor is permitted to have an allowed claim without actually filing a proof of claim with the bankruptcy court (provided, of course, that the claim is not otherwise disputed, contingent, or unliquidated).
A recent court case from the District of Nebraska, however, interestingly ruled that a creditor who failed to file a timely proof of claim was unable to vote on the debtor’s Chapter 11 plan. This was so even though the plan sought to modify the creditor’s claim.
The case in question is In Re Woodward (D. Nebraska, case number 11-40936, from April 2014). The debtor here argued that the plan was eligible for confirmation under Section 1129(a)(10) because an impaired creditor had voted in favor of the plan. An objecting creditor argued, however, that no “class” of impaired claims had accepted the plan as required by Section 1129(a)(10).
The bankruptcy court was particularly irked by the fact that the objecting creditor had not filed a proof of claim. Under Section 1126(a) of the Bankruptcy Code, a creditor is entitled to share in plan distributions as a result of being listed on the debtor’s schedules (even if the creditor had not filed a claim). But this was not good enough, the court believed. Under Section 1126(a), the only parties entitled to vote on a Chapter 11 plan are holders of claims or interests which are allowed under Section 502.
Unfortunately for the objecting creditor, a look at Section 502(a) specifically calls for claims or interests to be “filed under Section 501…” Using this reference bank to Section 502 and 501, the court interpreted Section 1126(a) as restricting voting to creditors who have actually filed a proof of claim. In other words, when it comes to voting, there is a big difference between scheduled claims and filed claims.
A harsh ruling? Perhaps. It is odd that the court did not consider Section 1111(a) of the Code, which states that a proof of claim is “deemed filed” under Section 501 if it appears on the debtor’s schedules (unless that claim is contingent, disputed, or unliquidated). Looking at Section 1111(a) give one the impression that the ruling here may have been unduly harsh.
In addition, it appears that the court could have used its (limited) equitable powers to find an imputed or constructive proof of claim from any of the creditor’s previous filings. This, however, did not happen. F.R. Bankr. P 3003, after all, specifically states that a Chapter 11 creditor does not have to file a claim.
The rule in Woodward is not the majority view, it should be noted. It seems that the court looked more towards the circumstances of the plan as a whole, and the need for a plan to be confirmed that had little opposition. Taken as a whole, it seems to be bad precedent. The weight of authority recognizes that Chapter 11 creditors are not required to file claims in order to assert their voting rights under a proposed plan.
But this case illustrates an important point that we would do well to bear in mind: if you are a creditor in a Chapter 11 case, it is to your advantage to participate in the case by keeping informed of developments in the case, and filing a claim. When in doubt, file a claim, even if you are not required to do so. Sleeping on your rights benefits no one except the opposing party.
Does a debtor have to be insolvent in order to file a Chapter 11 case? How is this word interpreted? These are the key questions that were addressed in the recent Ninth Circuit Court of Appeals case In Re Marshall III, 2013 WL 3242478 (9th Cir. June 28, 2013). The parties involved may be familiar to readers.
Texas millionaire J. Howard Marshall died, leaving almost all of his estate to his son Pierce. His wife Vicki (pop culture figure Anna Nicole Smith) and other son Howard were given nothing. Vicki and Howard contested the will in Texas probate court, and lost. In the probate proceedings, son Pierce won a significant judgment against brother Howard for fraud. Howard then filed for bankruptcy protection.
Pierce tried to contest brother Howard’s bankruptcy and plan. He moved to dismiss Howard’s case, arguing that debtor Howard was not “insolvent” under the “balance sheet” test. Looking at the debtor’s schedules and forms that were filed, Pierce noted that the debtor’s assets and income exceeded his liabilities. Under the Bankruptcy Clause of the Constitution, Pierce argued, a bankruptcy court could only deal with situations where a petitioner was insolvent. But what does the word actually mean?
The bankruptcy court first addressed the meaning of “insolvency.” Pierce believed that the court should apply the definition contained in section 101(32)(A) of the Bankruptcy Code. That section provides, in relevant part, that “insolvent means . . . with reference to an entity other than a partnership and a municipality, financial condition such that the sum of such entity’s debts is greater than all of such entity’s property, at fair valuation.” Section 101(32)(A) basically uses the “balance sheet test” as the test for insolvency.
But this isn’t the end of the story. The word “insolvency” does not appear often in the Bankruptcy Code. One such instance is in Section 109(c)(3), which requires a municipality to be insolvent prior to filing for bankruptcy protection. But the meaning of “insolvency” in this section is governed by Section 101(32)(C) of the Bankruptcy Code, which uses a “cash flow test” for solvency.
The cash flow test is thus the only measuring stick that has some authority in the Code. And even there, it was only to describe a yard stick for a municipality. Should the same test be applied to persons or corporations? The bankruptcy court in the Marshall case rejected the “balance sheet test” as a proper guide for a debtor’s solvency.
The court noted that the Bankruptcy Code is designed to help people who have cash flow difficulties, even if they are “solvent” when looking at their balance sheet. Trying to apply a “balance sheet standard” would be unfair and inappropriate. The cash flow test (even assuming we should apply any test at all) would be the more appropriate test. There are sound reasons for this logic. The prospects of crafting an effective reorganization are better when a debtor is still solvent by any measure; erecting roadblocks and tests as barriers to filing a case would not be good policy.
A debtor should not have to wait until he is insolvent before filing a case. From studying other nations that had adopted such rules, the court found that substantial economic value was lost in applying those rules. In addition, a review of American and British common law demonstrated that “insolvency” was never a determinative factor in filing a petition until the 1978 adoption of the Bankruptcy Code.
Balance sheet insolvency is irrelevant even there; under Section 303(h)(1), an involuntary filing, for example, only requires a showing that the debtor is “not paying such debts as they become due.”
Thus, a debtor who is solvent (under any test) can file a voluntary Chapter 11 case and seek to have a plan of reorganization confirmed. A debtor is not required to wait until things are hopeless or nearly so.
This case highlights a principle that should be understood clearly: there is no reason for a debtor to wait until he becomes insolvent before filing a bankruptcy case. In almost all situations, his situation will be dramatically improved by getting a case filed as soon as cash flow problems begin. Waiting too long is neither required, nor advisable.
Judges in general are believers in mediation. It can be a highly effective way of identifying differences between litigants, crafting solutions to sticking points, and permitting litigants to vent their grievances. Bankruptcy judges can and do order mediation in situations where contested matters are in need of a push forward. But there are qualifications and limitations on arbitration, like anything else.
A recent Kansas bankruptcy case laid out some of these standards, and it is useful for us to discuss them. These issues were discussed in a memorandum opinion written by Judge Somers in the case of In Re Brooke in 2013. The opinion discusses who can compel arbitration, how a litigant can waive his ability to compel arbitration, and what things can be arbitrated in bankruptcy court.
Attorneys who deal with Chapter 13 and Chapter 11 cases will often see, in the claims registers listing the filed proofs of claim, corporate entities that have “bought up” proofs of claim from smaller creditors. There are many companies, businesses, distressed debt investors, and hedge funds that specialize in purchasing bankruptcy debt. There are also situations where larger creditors in Chapter 11 cases will make offers to buy the claims of smaller creditors, in an attempt to control the voting and direction of the Chapter 11 case. Small creditors in bankruptcy cases may find themselves in confusion about what to do if they are contacted by a large organization asking to buy their claim.
What issues should be considered? What are the advantages and disadvantages of selling a proof of claim?
Claims buyers can scrutinize bankruptcy court records and comb cases to see if it makes economic sense for them to purchase claims. Claims buyers will prefer to purchase claims that are listed as “undisputed” rather than “contingent” or “disputed”, since undisputed debts are less likely to subject to litigation in a bankruptcy case. They are seen as less of a risk.
Claims buyers will frequently sent out documents called “claim assignment agreements” or “confirmation” documents. These documents should be reviewed carefully with an attorney with bankruptcy experience, before the claim is sold. Things are not often what they appear. Claims buyers have as their goal the maximization of their profit with a minimization of their risk. With this in mind, let us examine the pros and cons of selling a bankruptcy proof of claim.
One of the most attractive reasons for selling a claim is the prospect of cash now, rather than the uncertainty of knowing when (if ever) the creditor will recover any funds in the bankruptcy estate. Cash now has a real attraction to many small creditors who may not want to participate in the bankruptcy process. Small creditors are enticed with the prospect of immediate liquidity, rather than dealing with the possibility of drawn-out legal proceedings. Selling a claim now carries with it the perception of cutting one’s losses and eliminating future risk. This “immediacy” value is the primary attraction of selling a claim.
But this immediate liquidity can be deceptive. For one thing, it is important to remember that claims buys always want to buy at a steep discount. It is a numbers game to them, and they buy claims in volume. The amount you may be offered for your claim will be a fraction of what it may be worth. Bankruptcy cases can be unpredictable. Many cases that initially appear to offer nothing to unsecured creditors can generate significant funds down the road. You never know when assets can and will be recovered. To sell your claim too early can be a mistake.
- Claims buyers often put crafty language into their “claim assignment agreements” that shift their risks back on to you, the seller. Some of these provisions are buried in the fine print of the agreements. Sometimes, language will be inserted that give the buyer the option of dumping the claim back on you (the seller) if an objection is filed to the proof of claim, even if the objection is later defeated. Basically, the claims buyer can often use the fact of a claim challenge (by a bankruptcy debtor) to get its money back from a claims seller. Objections to claims, preference actions, and other things that create work for a claims buyer can be used as a way of bailing out of their agreement with a claims seller. Remember, the claims buyer is interested in making money with as little effort as possible. Their goal is not to litigate claims in bankruptcy court. Faced with a challenge, they will move on.
- Another tactic used by claims buyers is to insert language in their agreements to require you (the seller) to defend the claim against possible objections at your own expense, and to pay the claims buyer back for any portion of the claim that might be disallowed. The bottom line is this: even after selling your claim, there is a possibility that you could incur costs in a bankruptcy case.
- Your setoff rights may also be limited in a claim assignment agreement. Some provisions of these agreements contain provisions limiting your rights to assert a setoff or recoupment against the bankruptcy debtor, or requiring you to pay back some (or all) of the purchase price if you do assert a setoff .
- Unsecured creditors who may be serving on a creditors’ committee in a Chapter 11 case may have limitations on their rights to sell claims. In some circumstances, there are confidentiality or other issues that will prevent such sales. It is important to get legal advice in this type of situation. Bankruptcy courts also sometimes restrict the rights of creditors from selling their claims. Such rules are intended to prevent large institutional creditors from buying up claims and controlling the voting dynamics in Chapter 11 cases. Another reason is to preserve the tax benefits of a debtor’s net operating losses (NOL), which can be lost if ownership of large amounts of claims changes.
- When a claim is sold, a document called a “evidence of transfer of claim” is produced which is filed with the bankruptcy court. As a safeguard against fraud, when such a document is filed, the seller is given an short opportunity to object to the transfer, just in case the transfer was fraudulent.
Buying debt in bankruptcy cases, for large claims buyers, is all about making a profit. Their goal will be to maximize their profit potential, while minimizing their risk. Small creditors in bankruptcy cases should be aware of this. The enticement of immediate money may be an illusion. A small creditor who ignores the risks may find that he got more than he bargained for. It is critical to consult with a bankruptcy attorney before selling your claim, so that you are aware of all the risks involved.