Bankruptcy in the COVID-19 Economy: Debtor and Creditor Considerations

April 27, 2020 by

Despite a $2 Trillion relief package for small businesses, one of the most popular provisions of the relief package (Paycheck Protection Program (PPP) Loans) ran out of funds. Congress has approved another $484 Billion to replenish the PPP program and provide other aid to small businesses, but some businesses may still be left out of funding. Also, with mounting unemployment rates, many individuals may also be running out of time. As the world and the United States prepare to reopen the economy, creative maneuvering to maintain solvency may soon be over. However, as individuals and small businesses take a look at finances and project recovery timelines, they may need to consider bankruptcy protection. The bankruptcy code and the bankruptcy courts exist to help debtors and creditors reach otherwise elusive resolution. The following are a few things to consider, from both the debtor’s and creditor’s perspective, when evaluating whether bankruptcy is the right choice.

For debtors, bankruptcy offers the protection of an automatic stay, a formal venue to negotiate with creditors, discharge of certain debts (including tax debts) to provide a fresh-start, and the opportunity to litigate specific claims as an overall recovery plan.

  • Automatic Stay.  Section 362(a) contains a list of actions stayed by the filing of a bankruptcy petition. This provides immediate relief to a debtor from certain collection actions that might otherwise put them out of business. For example, actions or attempts to collect claims against the debtor are generally prohibited after the petition date; as well as most acts to create, perfect, or enforce additional liens. However, there are exceptions and creditors can request relief from the automatic stay, so it isn’t complete protection and may need to be defended.
  • Bankruptcy Discharge.  Although many debts are discharged in bankruptcy, some debts are specifically excluded from the bankruptcy discharge for public policy reasons (e.g. child support). Even tax debts, which are involved in around 40% of all bankruptcies, can be discharged in certain situations. Dischargeability will depend on specific facts. However, if a debt can be discharged it provides the fresh start contemplated by the Bankruptcy Code. The cost of a discharge usually involves a certain amount of loss of property and can have a significant negative impact on credit reports and the debtor’s ability to borrow in the future.
  • Negotiation of Debts.  Many individuals and businesses are probably already engaging in extensive negotiations over amounts due. However, at some point negotiations may become unproductive and certain debts may be unresolvable without outside help. If the debtor and creditor cannot agree to terms then, perhaps, the Bankruptcy Code’s balance between adequate protection and debt relief can provide the necessary forum for resolution. This is especially true if multiple creditors are involved and individual negotiations would involve a lot of time and cost. If few creditors are involved, it might be worth trying to negotiate outside bankruptcy court. Creditors may be more willing, in this environment, to offer favorable terms to avoid defending their claims in bankruptcy.
  • Adversary Proceedings on Specific Disputes.  An adversary proceeding is the bankruptcy court’s version of a civil complaint. By rule a debtor, creditor, or the bankruptcy trustee can initiate an adversary proceeding for something that cannot be done by motion in the main bankruptcy case. For a debtor this can include such things as determining the validity, priority, or extent of a lien or other interest in property or to determine dischargeablity of a debt. A debtor may also want to subordinate any allowed claim or interest. Also, under Section 505(a) of the Bankruptcy Code, a debtor can use bankruptcy court as a forum to determine a tax liability – with some exceptions. The success of such actions will be dependent on the specific facts, legal standards, and certain exceptions that apply to the relief under the Bankruptcy Code. It is worth noting that all adversary cases are tried to the bankruptcy judge, not a jury.

For creditors, the reality is that COVID-19 will increase bankruptcy filings and cause creditors to defend the amounts owed to the best of their ability to protect their own financial stability. As debtors exercise rights under the Bankruptcy Code, creditors can use the Bankruptcy Code to take steps to ensure they receive adequate protection of their claims.

  • Automatic Stay.  Although the automatic stay offers a lot of relief to debtors, it is not without its limits. There are specific exceptions outlined in the Bankruptcy Code. A creditor can also file a motion for relief from the automatic stay for cause, including lack of adequate protection of an interest, or based on equity or effectiveness of property for the reorganization. The decision of when to seek relief from the stay is often a strategic weighing of the timing, risk of declining collateral value, and when and whether adequate protection payments, discussed below, are sought. Creditors must, however, be careful not to violate an automatic stay because they could be subject to damages, including attorney’s fees
  • Bankruptcy Discharge.  Section 727 of the Bankruptcy Code provides reasons for a creditor to object to a debtor’s discharge. Most of the reasons are punishments for debtors who fail to be forthcoming with information. For example, if the facts indicate concealed or transferred property within a year of the filing, destroyed records, failure to keep adequate records, unexplained loss of assets, or false statements, the discharge may be denied. This challenge requires the filing of an adversary proceeding, discussed below.
  • Adequate Protection Payments.  Adequate protection payments are primarily designed to compensate secured creditors for post-petition declines in the value of their collateral. Creditors will need to show the valuation of the collateral securing their interest if they seek these payments and this can be a time and cost intensive endeavor. As an alternative, parties may seek a consensual cash collateral order, if they can agree, for relief that may not fit within the strict provisions governing adequate protection payments.
  • Adversary Proceedings on Specific Disputes.  Creditors brought into bankruptcy by debtors can use adversary proceedings to affirmatively seek relief for their claims or object to discharge of claims. For example, actions can be filed to recover money or property, object to or revoke a discharge, revoke an order of confirmation of a bankruptcy plan, and/or obtain injunctions or other equitable relief. Just like debtors, the success of an adversary proceeding depends on the specific facts and the legal standards applicable to the action the creditor wishes to take. However, it provides creditors with the ability to actively defend their claims or prevent a debtor from receiving undeserved relief.

The Bankruptcy Code is complex and, obviously, involves more than those featured in this article. However, Brown Fox has created a special taskforce within the firm to counsel clients considering bankruptcy relief, attempting to negotiate terms to avoid bankruptcy, or defending their claims in bankruptcy. The task force includes experienced attorneys from the litigation and tax practice areas. If you have questions about your own specific factual situation, please reach out to Joshua Smeltzer, Eric Wood, or David Denton.

Joshua D. Smeltzer
joshua@brownfoxlaw.com

Joshua D. Smeltzer is a tax attorney with over fifteen years of experience representing individuals, corporations, and formerly the U.S. Government in a variety of tax matters. Mr. Smeltzer uses the knowledge gained inside the government to represent and advise clients on potential tax risks, navigating the IRS labyrinth during audit examinations, arguing at the IRS Office of Appeals, and litigation in the federal courts. He also advises individual and corporate clients on a variety of tax compliance issues in an effort to avoid tax disputes from occurring.

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Eric Wood
eric@brownfoxlaw.com

In an era with few, true business trial lawyers, Eric Wood has tried dozens of cases in both state and federal court and argued appeals in Texas and U.S. Circuit Courts of Appeals. He is a tireless and creative litigator who has represented clients in all kinds of business disputes for more than 15 years.

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David Denton
david@brownfoxlaw.com

David Denton brings the discipline of an Ironman triathlete to his work as a trial attorney, with broad experience in civil litigation and labor & employment matters. He has advocated for clients in both state and federal court for almost twenty years. Mr. Denton lives in Prosper with his wife, Jennifer, and two children. David enjoys competing in triathlons, fishing with his kids, and coaching their sports teams.

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