In the latest issue of The Wright Toolbox:
- The Automatic Stay in Bankruptcy – An Overview – read now
- Preference Actions in Bankruptcy – “Zombie Claims” – read now
The Automatic Stay in Bankruptcy – An Overview
When a bankruptcy case is filed, in any chapter of bankruptcy – 7, 11, 13, etc., something called the automatic stay comes in to effect. The automatic stay is set forth in the Bankruptcy Code at 11 U.S.C. §362. As its name suggests, the stay arises automatically and immediately by operation of law, no order of the court or issuance of a notice is required to bring it into existence. The automatic stay is applicable to all entities and persons. The words “entity” and “person” are defined in the Code very broadly as any person, estate, trust, government, corporation or unincorporated company or association. Thus, courts, governmental agencies like the IRS, banks, and all creditors are subject to the stay.
There are several well recognized purposes of the automatic stay. The first is to provide relief to the debtor from the pressure and harassment of creditors and to give the debtor a “breathing spell” to focus on rehabilitation or reorganization. The stay also protects property that may be necessary for reorganizing and providing a “fresh start.” The stay is intended to promote one of the primary goals of the bankruptcy process which is equality of distribution. It preserves the status quo and prevents the “disorganized dismemberment” of the debtor by creditors chaotically running all over the country to various courthouses to obtain independent relief to the detriment of other creditors and the debtor.
To accomplish the purposes of the bankruptcy process, the scope of the stay has intentionally been made very broad in the Code. It applies to the commencement or continuation of any judicial proceeding or other action or proceeding against the Debtor that was or could have been commenced prior to the filing of bankruptcy. The stay applies to the enforcement of a judgment or lien against the Debtor or against the property of the Debtor’ s bankruptcy estate that arose prior to the filing of the Debtor’ s bankruptcy case, including any act to obtain possession of or control over the Debtor’ s property. It applies to any attempt to create, perfect or enforce any lien against the Debtor’ s property, which includes the filing of a UCC financing statement. The stay also applies to any act to enforce a setoff right against any debt owed to the Debtor that arose before the bankruptcy case was filed. Regarding the scope of the automatic stay, it has been observed that the stay is extremely broad and applies to almost any type of formal or informal action taken against the Debtor or the property of the estate.
The automatic stay remains in force until property subject to the stay is no longer property of the estate or the earliest of: (i) the time the case is closed; (ii) the time the case is dismissed; or (iii) the time a discharge is granted or denied. The stay may also be lifted by the Bankruptcy Court upon motion by an interested party.
There are limited exceptions to the automatic stay. The Code provides that the stay does not apply to criminal actions, paternity suites, domestic support, custody or divorce matters, domestic violence, certain police powers and other limited matters. The stay also may not apply if the debtor has recently filed a bankruptcy case under certain circumstances. The automatic stay does not generally apply to separate related entities of the Debtor who are not in bankruptcy, such as directors, officers, affiliates, partners, etc. However, such entities could seek protection under 11 USC §105 – injunctive relief. Actions on claims that arose after the commencement of a case are not stayed, however enforcement of any resulting judgment would typically be stayed.
If the automatic stay is violated, such action is either void or voidable depending on the nature of the violation. Further, under the Code in the event of a willful violation of the stay an individual may recover actual damages, costs, attorneys’ fees and in appropriate circumstances punitive damages. Moreover, a violation of the stay can be punished under the Bankruptcy Court’ s contempt powers. It has been held that standing to assert a claim for willful violation of the automatic stay is not limited to the Debtor or trustee and could be asserted by any creditors who have suffered damages because of a violation.
Preference Actions in Bankruptcy – “Zombie Claims”
When a party you are dealing with goes into bankruptcy it can be a major headache, but the preference powers under the Bankruptcy Code can be a real nightmare for your bottom line. Under the bankruptcy preference powers, a trustee or debtor in possession (“DIP”), is able to reach back in time, prior to the bankruptcy filing, and void, undo or set aside certain prior transactions and force a party who has received preferential payments to disgorge and return such funds. The really scary part is that the trustee can wait for over two years from the bankruptcy filing to assert preference actions. So, let’s look at an example: On January 1, 2019 you provide $50,000 worth of goods and services to a customer, the terms were payment in 30 days, but the customer didn’t pay for three months, then 70 days later the customer files chapter 7 bankruptcy, in February 2021 the trustee in the bankruptcy case files a preference action against your company seeking the return of the $50,000 payment you received in 2019. In the absence of any defenses, the transaction you thought was long dead, has now come back to life and you could be forced to return $50,000 – oh and the Debtor keeps the goods and services.
In general, a “preference” exists when a payment or other transfer is made to a creditor and not to others prior to a bankruptcy filing. Such favoritism or preferential treatment in close proximity to the filing of bankruptcy is prohibited by the Bankruptcy Code. The purpose of the preference powers is to promote equality of distribution among creditors by ensuring that all creditors of the same class will receive the same pro rata distribution share of debtor’s estate. Thus, the preference powers are designed to put all creditors on a relatively level playing field with respect to use of a debtor’s assets that may have been available prior to bankruptcy and “during the debtor’s slide into bankruptcy.” The elements of a preferential transfer are a transfer of an interest of the debtor in property (1) to or for the benefit of a creditor; (2) for or on account of an antecedent debt owed by the debtor before such transfer was made; (3) made while the debtor was insolvent; (4) made on or within 90 days before the date of the filing of the petition; and (5) that enables such creditor to receive more than such creditor would receive if the case were a case under chapter 7 of the Bankruptcy Code and the transfer had not been made.
It should be noted that in establishing the elements of a preference action, the Debtor’s or creditor’s intent or motive is not material. It is the effect of the transaction, rather than the Debtor’s or creditor’s intent, that is controlling. As noted above, the Bankruptcy Code generally provides that a preference action must be commenced within 2 years after the filing of bankruptcy. For the purposes of a preference action, the trustee has the burden of proving the elements by a preference by a preponderance of the evidence.
Fortunately, the Bankruptcy Code provides a number of defenses to help fight off these zombie claims. The three most well-known defenses are (1) contemporaneous exchange for new value; (2) ordinary course of business and (3) subsequent new value. The contemporaneous new value defense (§ 547(c)(1) of the Bankruptcy Code) provides that a trustee may not avoid a transfer to the extent the transfer was intended by the Debtor and creditor to be a contemporaneous exchange for new value given to the Debtor. So, in our earlier example, if the $50,000 worth of goods and services were paid for at the time they were delivered, the contemporaneous exchange of new value defense would apply. The new value defense is grounded in the principle that the transfer of new value to the Debtor will offset the payment made by the Debtor, and the Debtor’s estate will not be depleted to the detriment of other creditors.
The ordinary course defense (§ 547(c)(2) provides that the trustee may not avoid a transaction as preferential if the transfer was made in payment of a debt incurred by the Debtor in the ordinary course of business or financial affairs of both the Debtor and the transferee, and such transfer was made in the ordinary course of the business or financial affairs of the Debtor and transferee or was made according to ordinary business terms. The ordinary course defense is intended to protect recurring, customary credit transactions that are made and paid in the ordinary course of business. To establish the ordinary course defense, the question will be was the debt incurred in a typical, arms-length commercial transaction that occurred in the marketplace or as part of routine operations. Once it is established that the debt was incurred in the ordinary course, then it must be proven that either the transfer: (1) was made in the ordinary course of business of both parties or (2) it was made according to ordinary business terms.
Finally, the elements of the subsequent new value defense (§ 547(c)(4) are: (1) a creditor extends new value, (2) the new value provided is unsecured and (3) the new value is not repaid to the debtor after the preferential transfer. The subsequent new value exception was devised as a solution for the unsecured creditor with a running account who would otherwise find the last 90 days of payments avoided by the trustee in bankruptcy.
If you are faced with claims that have come back from the dead and that won’t seem to die, give us a call, we know how to kill these claims so that they stay dead for good.