16 Jul Should Your Company Pursue a Debtor in Bankruptcy Court?

In last week’s blog, we discussed how your company can properly engage in debt collection activity without violating state and federal debt collection laws.  We also discussed in a prior blog the need to conduct a public records search on your debtor before expending company time and resources attempting to collect a debt from a person or company that may be “judgment proof.”  But sometimes not even the most diligent of efforts will help you anticipate the inevitable bankruptcy filing.  If the debtor from which/whom you are attempting to collect a debt files bankruptcy, you and your company must take into consideration a whole new host of issues.  Depending on the answers to the following questions, you may or may not want to continue to pursue your bankrupt debtor.

What Type of Bankruptcy Did the Debtor File?

Your corporate debtor will generally file a petition for relief under Chapter 11 or 7 of the Bankruptcy Code, depending on the circumstances.  Your determination of whether to pursue the debtor may depend on which bankruptcy the debtor filed.

Chapter 11:  Generally speaking, unless a debtor has committed some evident wrongdoing (via a showing of fraud, dishonesty, incompetence, or gross mismanagement), Chapter 11 bankruptcy cases allow the debtor to “remain in possession” or in control of his or her company’s assets and causes of action, without a trustee, and give the debtor the opportunity to “reorganize” and “confirm” a plan of reorganization; restructure company debts; and exit bankruptcy as a new and lean company.  Individuals, partnerships and corporations can be Chapter 11 debtors.  For a period of 120 or more days after the debtor files for bankruptcy (up to 18 months), the debtor-in-possession has the exclusive right to propose a plan of reorganization.

Despite the opportunity to reorganize, most Chapter 11 cases end up in a liquidations, where the debtor’s assets are sold and the proceeds are distributed to its creditors, through (1) a Chapter 11 plan of liquidation; (2) a conversion of the Chapter 11 case to a Chapter 7 case; or (3) a dismissal of the bankruptcy.

Chapter 7:   Chapter 7 is the liquidation chapter of bankruptcy.  Both individuals and companies can be Chapter 7 debtors.  In a Chapter 7 case, a trustee is automatically appointed to take control of (1) the debtor’s assets; (2) the causes of action of the debtor’s estate; and (3) the distribution of assets to creditors.

Is Your Company’s Claim Within the Bankruptcy Court’s Scope of Authority?

Depending on the claims your company is bringing (or defending) against the debtor, your company may be able to dispute the bankruptcy court’s authority to make a ruling on the matter.  For example, if your company files a “proof of claim” in the bankruptcy (more on that below) and the bankruptcy estate brings counterclaims against your company, you may be able to argue that the bankruptcy court does not have authority under the constitution to hear the debtor’s counterclaims.  Depending on your counsel’s advice, your company may want to raise this issue early in the bankruptcy to avoid waiver and preserve the issue for appeal, especially if it seeks to avoid a debtor-friendly ruling on its claim in the bankruptcy court.

Can Your Company Remove the Claim to District Court?

Bankruptcy rules provide for removal of a claim, where the district court would have jurisdiction to hear the claim.  The notice of removal must be filed either (1) 90 days after the bankruptcy is filed or (2) 30 days after the bankruptcy court’s “automatic stay” is terminated (more below), whichever is longer.  Depending on the case, your company may need to act quickly to preserve its right to remove its claim from the bankruptcy estate.  However be sure to consult your attorney before making this decision, as removal of a claim might in some cases constitute a violation of the automatic stay and subject your company to fines and penalties.

Can Your Company File A Motion to Obtain Relief From the Automatic Stay?

The filing of a bankruptcy petition immediately gives rise to an “automatic stay” or injunction that prevents creditors like your company from taking any further action against the debtor or its property.  This automatic stay is meant to assist the debtor in getting a fresh start and preserving the assets of the estate while the debtor gets its business in order.

The stay does not eliminate or adversely affect your company’s claims against the debtor, but merely suspends your company’s rights to enforce its claims during the bankruptcy.  If your company violates this stay by trying to collect on its debt, the court can impose sanctions against the creditor, including stiff punitive damages.

However, there may be ways to seek relief from the stay to allow your company to collect on its debt in the bankruptcy case.  For example, if your company’s claims concern certain types of securities or similar financial transactions, they may be excepted from the stay.  Your company may also be able to file a motion to lift the stay “for cause” if, for example (1) your claim is a tort claim, and your company seeks only a determination of liability, and intends to collect from a third (non-debtor) party or insurance company; or (2) if your claim is secured by debtor property and there is lack of adequate protection of your interest in the property of the estate.

Your company can also seek relief from the stay if the debtor does not have any equity in the property securing your interest, and the property is thus “not necessary for an effective reorganization of the debtor.”  However the burden is on your company to show that the debtor does not have any equity in the property.  Your company must seek this relief from the bankruptcy court, even if it is pursuing counterclaims in a lawsuit being brought by the debtor, but such relief is routinely granted by the bankruptcy court in these circumstances.

Does Your Company Need to File a Proof of Claim? 

Your company as a creditor must file a proof of claim (i.e., information about your claim) in a Chapter 7 case to participate in a distribution from the bankruptcy estate.  Your company should also file a proof of claim in a Chapter 11 case by the claims bar date.  If your company fails to timely file a proof of claim after it receives notice to do so, it cannot participate in and receive a distribution from the estate.  This means that your company will likely forego the right to collect from the debtor in a Chapter 7 case, once the debtor receives a discharge in bankruptcy, or even in a Chapter 11 case, if the debtor converts the Chapter 11 case to a Chapter 7 case and ultimately dissolves.  The best course of action is to prepare and file a proof of claim early, in the event a distribution becomes available for creditors.

This being said, in a Chapter 11 case, your company may not need to file a proof of claim unless (1) it disagrees with the amount that the debtor has scheduled to pay your company from the bankruptcy estate; or (2) if the debtor disputes that it owes your company the debt.  If you file the proof of claim in the Chapter 11 case and the debtor subsequently converts to a Chapter 7 case, your company does not need to file another proof of claim.  Please note that, by filing the proof of claim, your company is consenting to the jurisdiction of the bankruptcy court, and thus it will not be able to take advantage of certain rights, like the right to a jury trial that exists outside of bankruptcy.

Contact Edwards Law today if a debtor your company is pursuing has recently filed for bankruptcy.  We can provide a complimentary initial consultation to help you and your company decide whether it makes financial sense to continue to pursue that debt in bankruptcy court.