Bankruptcy Professor McKinsey OBE 118, Section 3, Fall 2004 You cannot engage in transactions effectively without understanding the extent of and limits on bankruptcy rights in the United States. Bankruptcy can end an otherwise enforceable obligation, but there are limits to when, how and what it can do.

2 Bankruptcy Can terminate an otherwise legitimate collectible debt or owed obligation under a contract. Courts do this to allow individuals (people or artificial entities) to start over again by paying a limited price (but painful) to creditors according to a priority list. Different types bankruptcy have different effects

3 Types of Bankruptcy Liquidation (7) versus Reorganization (11 or 13) Voluntary versus Involuntary Individuals versus Business Entities

4 Special Rules Payments to creditors in last 90 days before BK are limited to what creditor would have gotten in BK. Fraudulent transfers in previous year are invalid. Six years required after Chapter 7 or 11 before Chapter 7 allowed. Debtor can reaffirm a debt that would have otherwise have been discharged. Creditors can seek reaffirmation (and should whenever possible)

5 Special Rules – Priority Secured Creditors have highest priority to extend of value of secured property Priority Creditors are paid next Unsecured Creditors get last feeding at the BK trough.

6 Special Rules – Debts not Discharged Student loans Alimony and child support debt Credit Card Cash Advances in last 60 days Fraudulent money acquisitions

7 Chapter 7- Liquidation Petition –Involuntary - >$10k in unsecured claims, 3 of 12 or 1 of 11 creditors, and not paying debts that are due –Creditors stopped from collecting Debtor- Creditor Meeting Proofs of Claims by Creditors BK Estate Figured Out and Divided Up –Exempt property stays with debtor –The rest is paid out to creditors Secured property first to secured creditors Priority claims paid next Unsecured claims paid last. Debtor is Discharged

8 Chapter 11- Reorganization No Trustee because debtor keeps operating Creditors’ Committee (7 largest creditors) Reorganization plan –How debts will be paid and when, how business will operate –Majority of creditors in each class must vote for it or it must be a “cramdown” by court Discharge –Only some of the debt is discharged. –Some is paid by some of the existing assets –Most debts have new right to a stream of income that will cover remainder

9 Chapter 13- Consumer Reorganization Only consumers with certain debts maximums Only voluntary Consumer’s Payment Plan –Secured and Priority paid in full –Unsecured must do at least as well as under Chapter 7 Discharge –Debts are discharged per plan (only temporarily if debtor violates the plan)

10 Advice Always be a secured creditor whenever possible, and ensure you have adequate collateral When debtor looks like trouble coming and you are an Unsecured Creditor, consider taking cents on the dollar quickly hoping that debtor makes it 90 days. Require cash for services prior to work with small or troubled companies. Don’t go let a single business dominate your income picture during any quarter, diversify among many clients.