Personal

Claims Against the Company
A conscientious business owner should be informed about the consequences of an inability or failure to repay creditors. Most businesses will struggle at one time or another to stay current on their payments to creditors or deal with other cash flow issues. Knowing one’s rights and responsibilities in this situation can minimize the stress of an undoubtedly stressful situation.

Some creditors are in a better legal position to ensure they are repaid than other creditors. Creditors who have obtained a security interest in the assets of the company (or in the assets of the company’s owners) have legal rights in those assets. The most common kind of security interest is a purchase money lien. A company, needing funding to purchase the equipment that it will use to manufacture its product, goes to a bank and obtains a loan. The bank wisely insists that before it will make the loan, the business must provide some collateral, usually including the very equipment that will be purchased with the loan proceeds. The bank requires the borrower to sign both a note (the document that reflects the business’s obligation to repay money) and a security agreement (the document that gives the bank rights with respect to the collateral). If the business owns real property, the bank will often take a security interest in the real property as well (in the form of a deed of trust or mortgage on the property). Having obtained a security interest, the bank is in a better position to ensure that the business repays the loan.

Security agreements, collateral pledges, deeds of trust, and mortgages are all forms of consensual liens—that is, they reflect security interests created with the consent of the borrower. Creditors can also obtain security interests without the borrower’s consent, if a statute provides a mechanism for doing so. Liens arising by statute are generally known as statutory liens. In Utah, a judgment recorded in the real property records of a county creates a judgment lien on the real property located in the county and owned by the judgment debtor. U.C.A. § 38-5-1. Utah statutes also allow for contractors to obtain statutory construction and preconstruction liens. U.C.A. § 38-1a-101 et seq. Federal tax liens often arise under statute, particularly for the non-payment of trust fund taxes like payroll taxes. More obscure statutory liens also exist, for repairmen, storage companies, providers of livestock feed, shipping companies, and attorneys (who can obtain a statutory lien on the recovery in a lawsuit). See generally U.C.A. § 38-2 et seq. Courts can also impose equitable liens, which require a showing of “a debt or duty owed by one party to another and a res to which the obligation may be fastened.” Telluride Global Dev., LLC v. Bullock (In re Telluride Global Dev., LLC), 380 B.R. 585, 595–96 (B.A.P. 10th Cir. 2007).

No discussion of security interests would be complete without some mention of the Uniform Commercial Code. Virtually every state has enacted some form of this model law, including Article 9a, dealing with secured transactions, which Utah has enacted at U.C.A. § 70A-9a. The statutes found in this chapter of the Utah Code explain in detail the things creditors must do to create, perfect (that is, make enforceable against others), and enforce security interests. Basically, once a security interest is created, it is enforceable as between the creditor and debtor (the security interest is at that point said to have “attached” to the collateral). U.C.A. § 70A-9a-203. But in order to make the security interest enforceable against all the world, a creditor must give notice of his security interest in the proper place and proper way (a creditor must “perfect” his security interest). U.C.A. § 70A-9a-301. Failure to follow the most minute details of the Uniform Commercial Code can render a security interest invalid against third parties without notice. See Rushton

Standard Indus. (In re C. W. Mining Co.), 2009 Bankr. LEXIS 2372,
*44 (Bankr. D. Utah 2009) (avoiding a security interest where financing statements listed the debtor as “CW Mining Company” instead of its registered organizational name, “C.W. Mining Company”). The Debtor’s registered organization name is “C. W. Mining Company” (periods after the letters and spaces between). The Financing Statements each list the Debtor’s name as “CW Mining Company” (no periods included). The Financing Statements failed to properly list the Debtor’s registered organization name. Debtors should be aware that once a creditor has attached and perfected his security interest, his security interest extends not only to the collateral pledged, but also to the identifiable proceeds of that collateral. U.C.A. § 70A-9a-315. Also, a security interest generally2 follows the collateral when it is sold, meaning buyers should take care to ensure that outstanding security interests are extinguished when buying used goods. Id.

For example, consider an excavating company, Digger Co., which owns a backhoe. When Digger Co. purchased its backhoe, it borrowed the funds to do so from Big Bank, and gave Big Bank a security interest in the backhoe. Big Bank perfected its security interest. Eventually, Digger Co. decided that it had too many backhoes, and decided to trade the backhoe with Unvigilant Digging, Inc., in exchange for a skid loader. Unvigilant Digging, Inc. delivers the skid loader to Digger Co., and takes possession of the backhoe. Digger Co. stops making payments to Big Bank, and puts the skid loader to work. When Big Bank starts trying to figure out how to collect the balance of its loan, it might pursue Unvigilant Digging, Inc., because its security interest continues in the backhoe. Big Bank might also assert its security interest in the skid loader, which constitutes the proceeds of the backhoe in the hands of Digger Co.

Generally, when a business is struggling to pay its debts, it has already encumbered all its assets with liens. Secured creditors seeking repayment in these circumstances generally proceed first against their collateral, then compete with unsecured creditors in the chase to find unencumbered assets, including unencumbered cash, that could be used to satisfy their claims against the company.

Most creditors, even secured lenders, are far more interested in getting the cash they are owed than recovering their collateral. When a debtor misses a note payment, the creditor will usually begin by begging, pleading, or demanding payment. They may even offer accommodations (like deferral of a few payments) to allow the borrower time to get things in order and resume making regular payments. Only when these efforts fail do they begin to consider more drastic remedies. Eventually, a secured creditor will generally declare the note to be in default, accelerate the balance of the debt (almost all notes include a provision requiring a borrower to immediately repay the full loan balance upon an event of default, like missed payments), and commence collection efforts. Creditors with properly perfected security interests have the right to proceed directly against their collateral—that is, they may take steps to repossess their collateral without judicial involvement, so long as they do not breach the peace. If a secured creditor cannot retake possession of his collateral without breaching the peace, he must seek assistance of a court. A writ of replevin, issued by a court, instructs the sheriff to take possession from the debtor of goods in which the creditor has a special property interest (for example, pledged collateral). Utah R. Civ. P. 64 and 64B.

Unsecured creditors have fewer remedies available to them. Typically, they must first reduce their claims to judgment, by proving up their claims in court. If the amount owed is less than $10,000.00, a creditor may proceed by filing an affidavit in small claims court. If the amount in controversy exceeds $10,000.00, a creditor may proceed in county district court. Ultimately, assuming a debtor has no defenses to a creditor’s claims, and the creditor presents sufficient evidence to prove the bona fides of his claim, the court will enter a judgment in favor of the creditor. A judgment liquidates the amount of the debt and memorializes the debt in a way that will allow creditors to seek repayment using judicial processes. A judgment will often not ensure ultimate repayment, however, because most debtors do not have sufficient unencumbered assets to simply satisfy a judgment. Instead, obtaining a judgment usually marks the beginning of collection efforts, which may or may not yield recoveries sufficient to justify the expense of pursuit.

Judgment in hand, a creditor may ask a court to issue various writs to take possession of assets to satisfy the judgment. Utah R. Civ. P. 64.

 

A writ of attachment allows a judgment creditor to seize property in the possession of the judgment debtor to satisfy the judgment. Utah R. Civ. P. 64C. A writ of execution is available to seize property in the possession or under the control of a debtor, and sell that property to satisfy the judgment. Utah R. Civ. P. 64E. A writ of garnishment is available to seize property owned by or owed to the debtor while the property is in the hands of a third party, in satisfaction of a judgment. Utah R. Civ. P. 64D. In rare circumstances, usually involving a debtor attempting to avoid a creditor’s collection efforts, a creditor may succeed in obtaining a writ prior to the entry of a judgment (a “prejudgment writ”). Prejudgment writs are available only upon a showing of a substantial likelihood of success in the underlying claim, among other required proof. Utah R. Civ. P. 64A.

 

Claims Against the Owners or Managers of the Company
Often, entrepreneurs are asked to personally guarantee company debts. Contractual guarantees are by far the most common way that individuals can be held liable for company debts. In Utah, there are two types of guarantees, guarantees of payment and guarantees of collection. A guarantee of payment requires the guarantor to pay the obligations of the borrower, even if the creditor has not made demand upon the borrower. A guarantee of collection requires only that the guarantor pay the borrower’s obligations after the lender has made demand upon the entity that is principally liable for the debt. See Strevell-Patterson Co.

Francis, 646 P.2d 741, 743 (Utah 1982). Guarantees are subject to the statute of frauds—that is, they must generally be documented in a signed writing to be enforceable. U.C.A. § 25-5-4(1)(b).
Because guarantees are so ubiquitous in the context of small business commercial lending, discussion of the rules in the absence of personal guarantees is relatively unimportant. However, trade creditors often fail to obtain contractual guarantees, and tort victims have no opportunity to contract for a business owner’s personal liability for company debts. Therefore, there are circumstances when the general rules of owner liability for company debts are not overridden by the contractual guarantees so often given by business owners.

Owners of properly-formed businesses are generally not personally liable for claims owed by the company. U.C.A. § 48-3-304. This limited

 

liability is a fundamental advantage of corporate organization as discussed more fully in this book. See generally Jones & Trevor Mktg. Inc. v. Lowry, 2012 UT 39 (Utah 2012) (“Ordinarily, a corporation is regarded as a legal entity, separate and apart from its stockholders. The purpose of such separation is to insulate the stockholders from the liabilities of the corporation, thus limiting their liability to only the amount that the stockholders voluntarily put at risk.”(internal citations omitted)). The protection afforded to the owners of a properly-formed business is often referred to as the corporate veil. Despite the general protection afforded by the corporate veil, there are theories of liability that can be employed against business owners to seek to hold them personally liable for company debts.

Piercing the corporate veil (or invoking the alter ego doctrine) refers to the action of a court to abandon the protections afforded to most company owners. “If a party can prove its alter ego theory, then that party may ‘pierce the corporate veil’ and obtain a judgment against the individual shareholders even when the original cause of action arose from a dispute with the corporate entity.” Jones & Trevor Mktg., 2012 UT 39 at ¶ 13. As the Utah Court of Appeals has stated:

 

To disregard the corporate entity under the equitable alter ego doctrine, two circumstances must be shown: (1) Such a unity of interest and ownership that the separate personalities of the corporation and the individual no longer exist, but the corporation is, instead, the alter ego of one or a few individuals; and (2) if observed, the corporate form would sanction a fraud, promote injustice, or result in an inequality. … Certain factors which are deemed significant, although not conclusive, in determining whether this test has been met include: (1) undercapitalization of a one-man corporation; (2) failure to observe corporate formalities; (3) nonpayment of dividends;

siphoning of corporate funds by the dominant stockholder;
nonfunctioning of other officers or directors; (6) absence of corporate records; (7) the use of the corporation as a façade for operations of the dominant stockholder or stockholders; and (8) the use of the corporate entity in promoting injustice

 

or fraud. … The rationale used by courts in permitting the corporate veil to be pierced is that if a principal shareholder or owner conducts his private and corporate business on an interchangeable or joint basis as if they were one, he is without standing to complain when an injured party does the same.

 

Colman v. Colman, 743 P.2d 782, 786 (Utah App. 1987). The list of factors to be considered in Colman is not exclusive, and other authorities have noted up to twenty relevant factors that may be considered in determining whether to pierce the corporate veil. See 114 Am. Jur. 3d. Proof of Facts 403, § 10 (2010). Whatever the factors, the key for individuals seeking to avoid personal liability for their business’s debts is to honor the corporate form: organize properly (with the advice of counsel); capitalize the company with adequate working capital; hold corporate board and shareholder meetings; keep minutes at those meetings; pay fair salaries to owners working as management; pay dividends to all shareholders; and honor all distinctions between the corporation and its owners. By doing so, business owners give Courts a reason to honor the corporate veil. Veil piercing is a fairly extreme remedy that courts do not take lightly, Jones & Trevor Mktg., 2012 UT 39 at ¶ 15, but if corporate formalities are ignored in ways that strike courts as unfair, owners are at risk.

 

Aside from veil piercing, owners, officers and managers of companies should be aware that their personal conduct can lead to personal liability if they participate in tortious conduct of the business. Tortious conduct is conduct involving a breach of a duty owed to an aggrieved individual. Even though “an officer or director of a corporation is not personally liable for torts of the corporation or of its other officers and agents merely by virtue of holding corporate office, [one] can [] incur personal liability by participating in the wrongful conduct.

… [B]oth limited liability members and corporate officers should be treated in a similar manner when they engage in tortious conduct.” d’Elia v. Rice Dev. Inc., 2006 UT App 416

 

at ¶¶ 38 and 43. Corporate officers or members face personal liability when they participate in a corporation’s tortious acts.

 

Owners, officers and directors may also face personal liability for receiving improper distributions from the company. U.C.A. § 48-3-406. A company may not make distributions to owners if such distributions would render the company unable to pay its debts as they come due, or otherwise render the company insolvent. U.C.A. § 48-3-405. Officers and directors may also be held personally liable for allowing or authorizing improper company distributions. U.C.A. § 48-3-406.

 

Fraudulent Transfers
Another common way principals of a company can become personally liable to creditors of the company is by receiving a fraudulent transfer. Suppose a small excavating company realizes that it is drowning in debt. The owner-operator of the company doesn’t want to lose a particular backhoe, which is owned free and clear of any liens or other encumbrances. Rather than allow creditors to get a judgment against the company and execute on the backhoe, the owner-operator decides to transfer the backhoe to himself personally (or to a family member) so that executing creditors of the company cannot seize the backhoe. The company sells the backhoe, worth $20,000, to the owner-operator for

$1,500. Obviously, this transaction is not fair to the business’s creditors, who had access to equipment worth $20,000 to satisfy their claims, but now have access to only $1,500 in cash. State law will not allow this inequitable transaction to stand.

Utah, like the vast majority of states, has enacted the Uniform Fraudulent Transfer Act. U.C.A. § 25-6-1. The Uniform Fraudulent Transfer Act gives creditors harmed by a transfer such as the one described in the previous paragraph a cause of action against the person or entity that received the transfer from the business. There are two basic types of fraudulent transfers: actually fraudulent transfers, requiring a showing that the transferor intended to defraud his creditors; and the far-more- common constructively fraudulent transfer, requiring a showing of certain inequitable circumstances justifying recovery, regardless of the transferor’s actual intent.

 

To avoid a transfer that was made with actual intent to hinder, delay, or defraud creditors, a creditor must either prove the intent of the transferor (who is unlikely to admit his intent), or prove that there are sufficient indicia of fraud to convince the court of the transferor’s intent. The Uniform Fraudulent Transfer Act provides a non-exclusive list of certain indicia of fraud (often called the “badges of fraud”), including whether:

the transfer or obligation was to an insider;
the debtor retained possession or control of the property transferred after the transfer;
the transfer or obligation was disclosed or concealed;
before the transfer was made or obligation was incurred, the debtor had been sued or threatened with suit;
the transfer was of substantially all the debtor’s assets;
the debtor absconded;
the debtor removed or concealed assets;
the value of the consideration received by the debtor was reasonably equivalent to the value of the asset transferred or the amount of the obligation incurred;
the debtor was insolvent or became insolvent shortly after the transfer was made or the obligation was incurred;
the transfer occurred shortly before or shortly after a substantial debt was incurred; and
the debtor transferred the essential assets of the business to a lienor who transferred the assets to an insider of the debtor.

 

U.C.A. §25-6-5(2). When a sufficient showing of some or all of these elements is made, a court should determine that the transfer was made with actual intent to defraud creditors, and the transfer may be “avoided,” or undone. Alternatively, the court may allow the complaining creditor to seize the transferred asset (or other assets of the transferee) to satisfy the claim against the company. U.C.A. § 25-6-8. Note that it is the fraudulent intent of the transferor, and not the intent of the transferee, that determines whether the creditor may recover. However,

 

if a transferee has taken in good faith and paid reasonably equivalent value, the transfer may not be avoidable. U.C.A. § 25-6-9.

As stated above, it is far more common that a creditor seeking to avoid a fraudulent transfer will present evidence that the transfer was “constructively fraudulent” rather than actually fraudulent. To prove a constructively fraudulent transfer, a plaintiff must prove that the transfer was made in exchange for less than “reasonably equivalent value” and at a time that the debtor was insolvent (or that the debtor became insolvent as a result of the transfer). U.C.A. §§ 25-6-5 and 25-6-6. Much of the litigation in this area centers on what constitutes reasonably equivalent value. In the example above, $1,500 is obviously not reasonably equivalent value for a backhoe worth $20,000, but what if the owner had paid $15,000 for the company’s backhoe? $17,500? Judge Clark of the United States Bankruptcy Court for the District of Utah examined this question in In re Richardson, 23 B.R. 434 (Bankr.

D. Utah 1982). He rejected use of any fixed percentage as a cutoff for reasonably equivalent value, finding that “[i]n some cases, no less than 100 percent of fair market value may be a reasonable price.”

A few other points about fraudulent transfers bear mentioning. Note that if a company is not insolvent, and does not become insolvent by transferring away an asset, then the transfer is not avoidable regardless of the value of the asset transferred. So in the excavating example above, if the company is doing well financially and can afford to dispose of a $20,000 backhoe in exchange for only $1,500 (without putting its creditors in jeopardy), it is free to do so. Transfers are more likely to be avoided if made to an insider. Also, the ways to measure insolvency vary depending on whether the creditor seeking to avoid the transfer only became a creditor after the transfer, or was a preexisting creditor at the time of the transfer. The intricacies of this distinction are beyond the scope of this book, but can be understood by examining U.C.A.

§§ 25-6-5 and 25-6-6. Finally, the explanations above deal with the transfer of a backhoe, but the transfer of a lien on backhoe for less than reasonably equivalent value would be no different. Indeed, the term transfer is defined broadly to include “every mode, direct or indirect, absolute or conditional, or voluntary or involuntary, of disposing of or partying with an asset or an interest in an asset…” U.C.A. § 25-6-2(12).

 

Commercial

Introduction
Unfortunately, some businesses eventually fail, and others come so close to failing that they need to be restructured in bankruptcy in order to survive. There are several different types of bankruptcy cases, but this book will address only the three most common: chapter 7, chapter 11, and chapter 13. A chapter 7 bankruptcy is often called a liquidation, because the basic premise of the case is that the business or individual filing chapter 7 anticipates the liquidation of essentially all its assets, leaving either an inoperable (and usually defunct) business, or an individual ready to have a fresh start freed from her pre-bankruptcy debts. A chapter 11 bankruptcy is often called a reorganization, because the basic premise of the case is the restructuring of a business’s assets and liabilities in order to emerge from bankruptcy leaner, meaner, and better equipped to handle the company’s modified debt burden going forward. Chapter 11 debtors strike a new deal with their pre- bankruptcy creditors, hoping to repay a portion of their old debt over time. Chapter 11 proceedings are also occasionally used to liquidate businesses, particularly where there is some ongoing business to wind down before an eventual liquidation. Finally, a chapter 13 bankruptcy is often called a wage-earner’s bankruptcy, because only individuals with regular income are eligible to file chapter 7. 11 U.S.C. § 109(e). Chapter 13 case mechanics are mostly beyond the scope of this book, but some understanding is important for businesses dealing with consumer debtors who file chapter 13. Businesses are not eligible to be chapter

debtors, nor are individuals with personal debts exceeding certain limits (currently $1,149,525 in secured debts and $383,175 in unsecured debts as of 2015). 11 U.S.C. § 109(e). Occasionally, an individual will file a chapter 11 petition for eligibility reasons or in order to take advantage of more robust provisions for creditor treatment available in chapter 11.

Bankruptcy is a matter of federal law, and bankruptcy cases are filed in a federal bankruptcy court. U.S. Constitution, Art. I, Section 8, Clause 4 (“The Congress shall have Power to … establish … uniform Laws on the subject of Bankruptcies throughout the United States.”). Although federal law provides the framework for a bankruptcy case, the bankruptcy code incorporates state law for many substantive questions. The vast majority of bankruptcy cases are commenced with the filing of a voluntary petition by the debtor itself, though there is a procedure for a certain minimum number of creditors to join together to file an involuntary bankruptcy case. 11 U.S.C. § 303. A debtor may oppose an involuntary petition, but it often will instead allow the case to proceed, and convert it to chapter 11 in order to try to rehabilitate the business.

The Bankruptcy Estate
The commencement of a bankruptcy case creates an estate, which is a separate legal entity from the debtor. 11 U.S.C. § 541. At the filing of the petition, all interests of the Debtor in property become assets of the bankruptcy estate. Id. In a chapter 7 case, a trustee is appointed to oversee liquidation of the estate’s assets; in a chapter 11 case, the management of the debtor, at least initially, remains in control of the estate, and manages the assets for the benefit of creditors. In this role the debtor’s management is known as the debtor-in-possession. Management can control (to some extent) the bankruptcy process as debtor-in-possession, but often creditors grow restless and seek appointment of a chapter 11 trustee (or conversion of the case to chapter 7). If management has engaged in unethical behavior, fraud, or gross mismanagement, the appointment of a trustee is highly likely. 11 U.S.C. § 1104. Creditors often successfully assert gross mismanagement; their first piece of evidence is the fact that a bankruptcy filing was necessary.

Creditors evaluating their likely recoveries from a bankruptcy estate should be mindful that individual debtors are allowed certain exemptions under state law (incorporated by federal law, see 11 U.S.C.

§ 522), which allow an individual debtor to retain some assets from the bankruptcy estate. In Utah, the exemptions are modest: $30,000 (or $60,000 for a couple) in a homestead; $3,000 in a motor vehicle, qualified retirement accounts, unemployment and disability benefits, basic home furnishings, a year’s supply of provisions, and de minimus amounts for animals, books, musical instruments, and tools of the trade.

U.C.A. § 78B-5-505 and 506.

Automatic Stay
Usually a creditor’s first exposure to a bankruptcy case involves the automatic stay. Under any chapter, the filing of a bankruptcy petition generally stays all collection efforts, giving the debtor a breathing spell during which essentially no creditors can improve their position vis-à- vis one another. The automatic stay arises automatically (surprise!) with the filing of a bankruptcy petition, and stays the commencement or continuation of litigation that could have commenced pre-petition; the enforcement of any prepetition judgment; all acts to take possession of the debtor’s property or property of the bankruptcy estate; all acts to create, perfect, or enforce a lien on the Debtor’s property; all acts to collect prepetition debts from the debtor; and the setoff of mutual debts owing to the debtor. 11 U.S.C. § 362(a). In other words, any legal thing a creditor could do to improve his position in his collection efforts is automatically stayed for a period lasting anywhere from approximately 90 days to several years, or until a creditor obtains permission (known as “relief from stay”) from the bankruptcy court to proceed.

All business owners should have a basic understanding of the consequences of the automatic stay, because acts taken in violation of the automatic stay are void. Franklin Sav. Ass’n v. Office of Thrift Supervision, 31 F.3d 1020, 1022 (10th Cir. 1994). This means that if somebody engages in any kind of transaction involving assets of the estate, they are at risk that the transaction may be undone (and they may find themselves on the short end of attempts to be made whole). For instance, a bank agreeing to refinance a mortgage with a bankrupt debtor, by proceeding without considering and seeking relief from the automatic stay, could lose its security interest in the home, and find that it has become an unsecured creditor. See Hopkins v. Suntrust Mortg., Inc., 441 B.R. 656, 667 (Bankr. D. Idaho 2010). Furthermore, individuals injured by a willful violation of the automatic stay are entitled to damages, including punitive damages. 11 U.S.C. § 362(k).

If a creditor desires relief from the automatic stay, he may proceed to ask the bankruptcy court to modify or lift the automatic stay. This relief is most often sought by secured creditors, who have rights in the collateral that has become property of the bankruptcy estate. One way to obtain relief is to show that there is cause for relief from stay. 11 U.S.C. § 362(d)(1). The most common type of cause justifying relief from stay is that a secured creditor’s interest in the collateral is not “adequately protected,” meaning that the creditor faces a risk that during the pendency of the automatic stay, his collateral may depreciate or become insufficient (perhaps due to the ongoing accrual of interest) to ensure that the creditor can preserve his secured status as it existed on the petition date. Alternatively, a secured creditor can obtain relief from stay by showing that there is no equity in the property that could benefit the estate, and the collateral is not necessary for an effective reorganization. 11 U.S.C. § 362(d)(2).

Oftentimes, creditors who are oversecured by a significant margin cannot obtain relief from stay, and must instead essentially wait for the bankruptcy process to play out. In a complex chapter 11 case, that may take many months, and even years. But the oversecured creditor has few options other than to wait, enjoy the ongoing accrual of interest, and monitor its collateral while the debtor figures out how to restructure and resume payments.

Bankruptcy Schedules, the Meeting of Creditors, and Debtors Examinations
The fresh start obtained by a debtor in bankruptcy is offered in exchange for a debtor’s willingness to “open his cloaks” and allow his creditors a full and complete view of his financial condition. This unfettered look at the debtor’s finances is accomplished in three ways. First, the debtor is required to file statements and schedules that list his assets, identify his creditors, set forth his budget, and disclose his recent relevant transactions. Fed. R. Bankr. P. 1007. These schedules are typically filed with the bankruptcy petition, but may also be filed within the two weeks following the filing of the petition. Soon thereafter, the case trustee or the United States Trustee will convene a meeting of creditors. 11 U.S.C. § 341. Creditors are welcome to attend this meeting, where the debtor is placed under oath (outside the presence of the bankruptcy judge), and the trustee and creditors are given an opportunity to ask a few questions and learn the basics about the debtor’s financial condition. If further investigation is required, a debtor’s examination can be used to explore in more depth all issues surrounding the debtor-creditor relationship and the debtor’s financial condition. Fed. R. Bankr. P. 2004. Creditors should be mindful of the opportunity to use these three tools to better understand the opportunities for recovery in a particular case. Debtors should be mindful that there are significant consequences for making a false statement in connection with a bankruptcy case. 18

U.S.C. §§ 152 and 157 (noting that bankruptcy fraud carries a penalty of up to five years in federal prison).

The Bankruptcy Discharge
Individuals file bankruptcy in the hopes of discharging at least a portion of their debt. A bankruptcy discharge allows a bankruptcy debtor to extinguish his personal liability on a debt (note that the debt itself is not extinguished, only the debtor’s liability on the debt; third parties liable with the debtor continue to be liable for the debt). The rules about how and when a bankruptcy discharge is entered vary greatly between chapter 7, 11, and 13 cases.

In chapter 7 cases, only individual chapter 7 debtors are eligible to obtain a discharge. 11 U.S.C. § 727(a)(1). Businesses that file chapter 7 do not obtain a discharge because the assets are liquidated and the business becomes defunct. The chapter 7 discharge is typically entered about 100 days after the case is filed. Several circumstances can minimize the effect of the bankruptcy discharge, either by excepting certain debts from the discharge, 11 U.S.C. § 523; or by denying a debtor’s discharge entirely, 11 U.S.C. § 727. A great deal of the litigation in bankruptcy court is brought to determine whether a particular debt should be excepted from discharge, and whether a debtor has engaged in conduct that precludes entry of a discharge all together.

Congress has determined that certain debts should not be dischargeable in bankruptcy. Principal among these are most tax obligations, most domestic support obligations, debts incurred by fraud, debts arising from willful and malicious injury, debts arising from defalcations while acting in a fiduciary capacity, and student loan debts (except in extreme circumstances). 11 U.S.C. § 523. However, in order to establish that a particular debt is of a kind to be excepted from discharge, there is often a very short fuse (60 days from the first date set for the meeting of creditors) for filing a complaint on such question. Fed. R. Bankr. P. 4007.

Congress has also determined that certain behavior should disqualify a debtor from obtaining a bankruptcy discharge. Grounds for denial of a chapter 7 discharge include: concealing assets with intent to hinder, delay, or defraud creditors; failing to maintain adequate books and records; failing to explain a loss or deficiency of assets; making a false oath or account in connection with a bankruptcy case; failing to wait six to eight years after one’s most recent bankruptcy discharge; and refusing to obey any lawful order of the court. Again, the time for objecting to discharge is short, running 60 days from the first date set for the meeting of creditors. Fed. R. Bankr. P. 4004.

In a chapter 11 case, a debtor must propose and confirm a plan of reorganization in order to discharge its prepetition debts. Effectively, the debtor proposes a new contract with its creditors, and if it is able to garner enough support for the new contract, it discharges its old debt in exchange for a promise to perform under the plan (the new contract). There are many requirements for confirmation of a chapter 11 plan, the most important of which are: the “best interests of creditors” test, which requires that the plan deliver to creditors at least as much as they would have received in a chapter 7 liquidation; and the “absolute priority rule,” which requires that no interest-holders receive anything of value (including interest in the reorganized debtor or the exclusive opportunity to invest in the reorganized debtor) under the plan unless senior creditors are paid in full. 11 U.S.C. §§ 1123 and 1129. There are many more confirmation requirements that are beyond the scope of this text. If the court confirms the plan, the effect of confirmation is the discharge of the debtor’s prepetition obligations. 11 U.S.C. § 1141.

In a chapter 13 case, the quid pro quo of the debtor’s discharge includes the commitment to pay all of one’s disposable income over a three to five year period to satisfy the prepetition claims of creditors. Because a debtor cannot “earn” his discharge without making plan payments over time, the chapter 13 discharge of debts does not occur until plan payments are complete. Once all payments required under the plan have been made (and a few other requirements met), the debtor receives her discharge.

Claims
When a debtor files his bankruptcy schedules, he includes a list of all the people or entities to whom he owes money. Notice is then sent to these individuals, either instructing them to file a proof of claim by a certain deadline, or informing them that there is no immediate need to file a claim, because it is unlikely that the estate will recover any assets that could be used to satisfy creditor claims. It is very important that creditors desiring to participate in the bankruptcy timely file a proof of claim with the bankruptcy court, because failure to do so may preclude one’s opportunity to share in the assets of the estate or in the plan payments proposed by the debtor. (However, one should note that filing a proof of claim may submit one to the jurisdiction of the court where the bankruptcy case is pending.) A form for filing a proof of claim is available in the forms library on the website of the United States Bankruptcy Court for the District of Utah (www.utb.uscourts. gov). When filing the proof of claim, attach all documents that would help the Court determine the bona fides of the claim.

In some cases, major claims are disallowed because some minor requirement (like the deadline to file claims) is overlooked. A significant exception to the requirement to file a proof of claim arises only in chapter 11 cases, where, if the debtor in its schedules admits that the claim owing to a certain entity is not contingent, disputed, or unliquidated, and if the debtor schedules the claim in the appropriate amount, then the scheduled claim can be deemed allowed.

If proper documentation and exhibits are attached to the proof of claim when filed, the claim may be deemed allowed so long as the trustee does not object. Whenever a claim is based on a written document, redacted copies of the document should be attached to the proof of claim to substantiate the loss.

One of the questions the proof of claim form asks is whether the claim asserted is a secured or unsecured claim. In bankruptcy, secured claims are not as broad as the concept outside of bankruptcy. For instance, suppose a bank has a third position trust deed on a piece of real property worth $500,000, but the first and second mortgage holders are owed $600,000. Outside of bankruptcy, the bank still holds a secured claim, and if the homeowner wants to sell the property, she’s going to have to get a release from the bank (which the bank may willingly give once they realize the amounts owed to the 1st and 2nd trust deed holders). In bankruptcy, the bank would not be a secured creditor, because the inquiry is not whether a lien is noted on title (it is), but instead whether there is any equity in the collateral that could be used to repay the claims of the particular creditor. 11 U.S.C. § 506(a).

Secured creditors may determine that it is not in their interest to file a proof of claim. Security interests generally pass through bankruptcy unaffected, so a secured creditor may decide to rely on his lien to protect him from the debtor’s default. The creditor’s recourse against the collateral survives the bankruptcy, while the creditor’s recourse against the debtor is discharged. Of course by choosing not to participate, the secured creditor waives any right to share in whatever funds the trustee is able to recover and distribute to creditors. However, in some circumstances a prudent creditor may determine that the likelihood of any repayment from the estate is a benefit insufficient to outweigh the burden of submitting oneself to jurisdiction in a far-flung locale.

Some claims are also entitled to priority over general unsecured claims. 11 U.S.C. § 507. Common priority claims include:

the administrative expenses of the bankruptcy professionals (11
U.S.C. §507(a)(2));

the actual and necessary costs of preserving the bankruptcy estate (see 11 U.S.C. § 503(b));
domestic support obligations (11 U.S.C. § 507(a)(1));
wages, salaries, and benefits earned within 180 days of the bankruptcy petition (11 U.S.C. § 507(a)(4) & (5));

 

recent taxes (11 U.S.C. § 507(a)(8)); and
damages arising from injury caused by an intoxicated driver (11
U.S.C. § 507(a)(10)).

Priority claims are entitled to payment in full before general unsecured claims receive any distribution from the bankruptcy estate.

Trustee’s Powers
One of the Trustee’s jobs in a bankruptcy case is to maximize the assets available for distribution to creditors. The Bankruptcy Code gives the Trustee (or debtor-in-possession) authority to recover some assets transferred prepetition, in order to further the goal of equal distribution among similarly situated creditors.

Trustees often seek to recover preferential payments, or “preferences.” 11 U.S.C. § 547. A preference is a payment made to or for the benefit of a creditor, made within 90 days (or one year if the creditors is an insider of the debtor) before the bankruptcy filing, while the debtor was insolvent, for or on account of antecedent debt, that enables the creditor to receive more than is otherwise would have received on account of the debt. 11 U.S.C. § 547(b). Creditors who receive preferential payments have several defenses, including contending that the creditor extended new value to the debtor after the transfer, that the transfer was a contemporaneous exchange, that the transfer was made in the ordinary course, or that the payment was too small to meet certain statutory minimums. 11 U.S.C. § 547(c).

The typical example of an avoidable preference involves a business that is owed $20,000 for goods sold some time ago. The creditor begs and pleads for payment, and finally the struggling debtor makes an $8,000 payment 30 days before filing bankruptcy. The trustee then sues the creditor to recover the preferential payment. Because the debtor was insolvent when the payment was made, the payment was made on account of antecedent debt, within 90 day before the bankruptcy, and enables the creditor to recovery more than he would have otherwise gotten in a chapter 7 bankruptcy, the payment constitutes a preference. The creditor business tries to raise defenses, but none are availing, because this was old debt, the payment was beyond the ordinary course of business, and there was no new credit extended post-payment. The business must return the $8,000 to the Trustee, who then uses the money to pay claims. This often strikes the creditor as remarkably unfair, in light of the fact that even if it had kept the $8,000, it would still be owed an additional $12,000. However, the policy behind the statute is that this creditor, who happened to be able to grab a payment on the eve of bankruptcy, should not be able to jump in front of other creditors who were not so fortunate.

Bankruptcy trustees also make use of additional avoiding powers. Trustees can avoid unperfected liens (security interests not properly recorded in the appropriate state or county offices), 11 U.S.C. § 544, and fraudulent transfers (as addressed in Chapter 30, supra), 11 U.S.C.

§ 548. All these powers are wielded for the benefit of creditors, allowing the trustee to attempt to maximize the assets available to liquidate and distribute for the benefit of creditors.

Chapter 13 Bankruptcy
While businesses are not eligible to be chapter 13 debtors, a basic understanding of chapter 13 is important for any business that deals with consumers, because such businesses are often creditors in chapter 13 cases. The concept of a chapter 13 case is far different from other chapters. The goal of a chapter 13 debtor is to keep his property and repay his prepetition creditors over time at least the value of what they would have received if the debtor had filed a chapter 7 case. Consumer debtors often choose to file chapter 13 in an effort to save their home from foreclosure, though their efforts are not always successful. A chapter 13 plan sets forth the debtor’s ability to make payments over 3-5 years, and the distribution of such payments to various classes of creditors, including secured creditors, priority unsecured creditors, and general unsecured creditors. The chapter 13 trustee’s job is much different than that of a chapter 7 trustee; a chapter 13 trustee is mostly a payment administrator and compliance officer, ensuring that a chapter 13 plan complies with the bankruptcy code (and objecting when it doesn’t), and that all payments are made and distributed as required under the plan (and asking the court to dismiss the case when they aren’t).

Changes to the bankruptcy code made in 2004 force some families out of chapter 7, leaving chapter 13 as their only viable alternative to obtain a discharge. If a debtor’s debts are primarily consumer debts, he will be ineligible to file chapter 7 if he earns more than the median income for a similarly-sized family in his state, 11 U.S.C. § 727(b), and has disposable income sufficient to repay a statutorily-set percentage or amount of the claims against him. This test has come to be known as the “means test.”

The process for confirming a chapter 13 plan involves proposing a plan that promises to pay all of one’s projected net disposable income over time to the trustee. Projected disposable income is determined by filling out forms similar to tax forms, with allowance for certain reasonable expenses. Unlike in a chapter 11 case, creditors do not vote on whether to accept or reject the chapter 13 plan; instead, the court determines whether the plan complies with the requirements of the bankruptcy code. The debtor commences making payments to the trustee within 30 days of the case filing, and continues making monthly payments while the details of the plan are negotiated. If the debtor succeeds in making all payments required under the plan, the debtor receives a discharge upon plan completion. Most debtors fail to make it through their plans, because having committed all their disposable income to the plan, they are ill-equipped to deal with unforeseen circumstances and job loss. While they could petition the court to modify the plan to deal with such circumstances, often the urgency that necessitated the filing is attenuated, and debtors fail to follow through with their plan payments. A completed chapter 13 plan is somewhat rare.