"What Every Community Banker Should Know About Bankruptcy Basics: Part 2 of a Series," by Julia A. Chincheck and Salene Mazur Kraemer

The Community Banker
Spring 2017

What Every Community Banker Should Know About Bankruptcy Basics:  Part 2 of a Series

Bankruptcy Timeline
        In our prior article, we discussed how a secured lender can protect itself prior to the filing of any bankruptcy petition.  What must every community banker know, however, after one of the bank’s borrowers has filed for bankruptcy?   Following is a summary of a few significant bankruptcy concerns with which a lender should be familiar during a bankruptcy case:

        Stake Your Claim.  Review how the debtor listed your claim on his, her or its bankruptcy schedules.  Timely file a proof of claim if necessary, asserting your secured position by the date established by the bankruptcy court.  The value of the bank’s asserted collateral may be an issue.

        Attend the Meeting of Creditors.  Attend the debtor’s meeting of creditors to ask questions of the debtor or the debtor’s management, while he or she is under oath.   At this meeting, the lender can gain a better understanding of why a person or a business filed bankruptcy and, in a chapter 11 case, the lender may be able to learn what the debtor’s plan for a reorganization may be.   Don’t hesitate to ask the debtor or a debtor’s representative specific questions regarding the bank’s debt, how it was obtained, and how the debtor has protected and preserved collateral.

        Protect Your Collateral.  Has the debtor properly insured the bank’s collateral?  Is the real property falling into disrepair?  Are the debtor’s premises locked? Have essential utilities been paid?  Has water been shut off?  Will pipes freeze and break? Does the bank’s collateral include perishable items, such as food inventory, that may be going to waste? 

        How can the debtor adequately protect the bank’s interest in its collateral?  Will the debtor make “adequate protection” payments to the creditor in order to compensate the bank for its patience and risk?  In exchange for the use of cash collateral (i.e., cash from operations such as rent proceeds, receipts of accounts receivable), will the debtor grant the creditor “replacement liens” on all collateral that comes into a debtor’s estate post-petition? 

        One of the first actions a debtor must undertake in a chapter 11 reorganization case is to obtain permission to use its existing cash and revenues derived from sales of inventory, payments on accounts receivables, and other forms of cash convertible collateral.  A debtor should propose a budget that identifies how it will use existing and newly-generated cash.  A bank with a lien on this form of collateral should negotiate with the debtor what should or should not be in this budget.  If the debtor and secured lender cannot agree on a budget, the bank may be compelled to seek protection from the bankruptcy court, including recovery of its collateral and the right to liquidate that collateral outside of bankruptcy.    

        Instead of collateral recovery, a secured lender may believe that a bankruptcy auction of the debtor’s assets may generate a greater recovery for the bank.  A lender then must actively participate in what would, hopefully, be a robust sale process; lender’s counsel should review and approve all bidding procedures and any proposed distribution of proceeds.

        Protect Your Lien Position.  Be sure the bank has properly perfected its security interest in collateral, which may include real estate, cash, inventory, accounts receivables and equipment.  Be certain that all steps are taken to continue or maintain the perfection of the lender’s security interest.   

        During the course of a bankruptcy case, other creditors may emerge, such as taxing bodies and equipment lessors, attempting to assert intervening or higher priority liens.  Be vigilant and question all such attempts.  Occasionally, the lender may need to initiate an action in the bankruptcy case to determine the extent, validity and priority of various liens on the debtor’s property.

        In a chapter 11 reorganization case, a lender may choose to extend additional credit to a debtor after bankruptcy.  In that case, the debtor must first seek bankruptcy court approval of such a loan.   Be sure to craft the terms of the loan to protect the lender’s interest, including a “super-priority lien” status on certain of the debtor’s assets.

        Consider Filing Nondischargeability Actions.   Does the bank have grounds to object to the general discharge of the debtor or the dischargeability of the bank’s specific debt?  Dischargeability actions must be asserted after a bankruptcy is filed but within a certain timeframe, and are usually rooted in inappropriate behavior of the debtor relative to the extension of the bank’s specific loan. 

        Consider Ousting Management. Oftentimes, in a chapter 11 reorganization case the filing of a bankruptcy petition is accompanied by a significant event that served as a catalyst for the filing.  Has there been a gross mismanagement of the affairs of the company by corrupt officers?  Was there fraud, embezzlement or loss of a key man?  These circumstances may warrant the appointment of a trustee in a chapter 11 case who then takes over the management of the affairs of the debtor and the officers are displaced.  The threat of being ousted can be terrifying for debtor’s management.   The question is, what is in the best interest of all creditors?    

        Preservation of the Estate.  A bank’s lawyer must monitor all matters in a case to be certain that proceeds from liquidating bankruptcy assets are maximized and that the bankruptcy estate is not being unnecessarily diminished by expenses of the debtor in a chapter 11 case or a bankruptcy trustee.   A lender should review all pleadings in the case, including sale motions, requests for relief from the stay, abandonment notices, and fee applications filed in a chapter 11 case, to ensure reasonableness.

        Negotiate Plan Treatment.  If a lender is impaired (i.e., the debtor is proposing to change the original loan terms or alter a collateral position), the lender must work with a debtor in a chapter 11 case to negotiate an acceptable plan treatment.  What can the debtor afford, given its projected budget, and at what interest rate?  Will the debtor retain or surrender your collateral?  If a lender does not want to vote for the plan, a debtor can “cram down” a lender if the plan satisfies certain requirements set forth in the Bankruptcy Code. 

        We hope that the two articles in this series on “bankruptcy basics” has been informative and helpful, and provided you with a better understanding of what a bank can do to better its interests when a bankruptcy petition is filed.