In light of current economic indicators and the potential for an increase in financial distress, this article is intended to serve as a general resource regarding financial restructurings, workouts, insolvency, and bankruptcy. It is not exhaustive, but provides a useful framework of practical advice and key insights on financial restructurings, bankruptcy processes, and the protection of creditors’ interests.

Financial Restructurings and Workouts

Before any formal insolvency proceeding, there is often a critical window for reaching a consensual out-of-court restructuring, or “workout.” These are typically faster, less expensive, and more flexible than a court-supervised process, and can take the form of a forbearance, amendment to an existing agreement, or surrender of assets.

The key to a successful workout is early engagement. We encourage clients to contact us at the first sign of counterparty distress, such as persistent late payments or unusual requests for credit or other accommodations. The actions taken during the pre-bankruptcy phase can be critical, as they can either strengthen a creditor’s rights in a subsequent proceeding or, if handled without expert counsel, severely weaken them.

Common Types of Insolvency Proceedings

Bankruptcy isn’t a one-size-fits-all item. There are several types of common insolvency proceedings, each offering different potential outcomes and strategic advantages and disadvantages for the debtor and its creditors.

1. 1. Chapter 7 – Liquidation

This is most suitable for individuals or entities with overwhelming debt and limited assets. If the debtor is an entity, a chapter 7 results in its termination. A chapter 7 trustee is appointed to control and liquidate the debtor’s assets, then repay creditors according to the Bankruptcy Code’s priority scheme. Creditors should be focused on accurately asserting their claims while ensuring the trustee maximizes asset value.

1. 2. Chapter 11 – Reorganization

This is the most common vehicle for reorganizing a business, allowing it to continue operations while restructuring its debts. The debtor typically retains control of operations (subject to the oversight of the court) while working towards confirming a reorganization plan to manage and repay obligations.  Creditors may have opportunities to influence the process and ultimately the treatment of their claim, through negotiating or contesting their treatment in the plan, the terms under which the debtor obtains financing to fund the bankruptcy process, or other aspects of the proceeding.

1. 3. Chapter 13 – Individual Reorganization

For individuals with a steady income, Chapter 13 involves proposing and attempting to confirm a three to five year repayment plan. For creditors, properly navigating this process can be a highly technical exercise that is best done with understanding of local chapter 13 practice and careful attention to proposed plan provisions. Without this expertise and care, significant impairment of claims can occur.

1. 4. Receivership – State Court Proceeding

A state-court receivership can sometimes be a more efficient, faster, and less public alternative to a federal bankruptcy proceeding. Often, receiverships are initiated at the behest of the first position secured creditor for these very reasons. Typically, these proceed most like a chapter 7 liquidation, with the receiver taking on a similar role to the chapter 7 trustee by taking control of the debtor’s operations to preserve value, liquidate assets, and resolve debts.

Critical Issues for Creditors

A bankruptcy filing triggers a number of legal mechanisms that can fundamentally alter a creditor’s rights and remedies. Navigation of this process requires prompt and precise action. Schwabe emphasizes the following key concerns regarding protection of creditor interests:

Automatic Stay

One immediate effect of a bankruptcy filing is the automatic stay which enjoins nearly all collection attempts. Creditors should understand:

• • The scope of the stay sweeps broadly, forbidding activities beyond attempts to collect (e.g., lien perfection is stayed).
  • Even inadvertent violations of the automatic stay can result in harsh sanctions.
  • Relief from the stay can be sought when appropriate.

The Claims Process

Submitting a proof of claim is crucial. Creditors should know that:

• • Claims must be filed before the court-mandated “bar” date—failure to do so typically waives the claim.
  • Classification of claims as secured, priority unsecured, or general unsecured dictates the likelihood of recovery.

 Executory Contracts and Unexpired Leases

Debtors in bankruptcy have the option to assume or reject most executory contracts and unexpired leases. Creditors with counterparties in bankruptcy should note:

• • Assumption of a contract generally requires curing all monetary defaults and providing adequate assurance of future performance, which can be significant points of leverage for the non-debtor party.
  • Rejection of a contract results in it being treated as breached by the debtor, and often triggers a deadline for filing a proof of claim for damages caused by the breach.
  • If contract is terminated before the bankruptcy is filed, this choice is taken out of the debtor’s hands, a key consideration for counterparties to a contract or lease with a party that might be facing an imminent bankruptcy. 

Avoidance Actions

The Bankruptcy Code grants the debtor or trustee power to reverse certain transactions made prior to bankruptcy and recover funds for the estate.

• • Preferences: Payments made by debtor to a creditor within 90 days before a bankruptcy filing (one year if made to an insider) may be deemed preferential and clawed back. However, robust defenses exist and are often applicable, depending on the specific facts surrounding the payment and (often) the history of payments between the creditor and debtor.
  • Constructive Fraudulent Transfers: If the debtor, while insolvent, sold or transferred assets and did not receive “reasonably equivalent value,” the transfer can often be unwound. Under the Bankruptcy Code, the lookback period is two years, but state fraudulent transfer laws with longer periods may also apply.

Practical Advice for Navigating Bankruptcy

When facing financial uncertainty, consider the following points:

1. 1. Get Expert Guidance

The inherent complexity and time-sensitive nature of bankruptcy proceedings is best navigated with experienced counsel that can help you formulate and execute a sound legal strategy. Effective bankruptcy counsel will help you understand your options and obligations.

1. 2. Be Proactive and Engage Early

Notify counsel at the first sign of a counterparty’s significant financial distress. Early involvement can open up opportunities for pre-bankruptcy planning and positioning that might be impossible after the filing.

1. 3. Diligently Document Everything

Thorough record-keeping is frequently the deciding factor in establishing a claim or defense, maximizing recovery and preventing liability.

This article summarizes aspects of the law and does not constitute legal advice. For legal advice for your situation, you should contact an attorney.