Creditors Rights in Bankruptcy: How to Keep from Losing Your Shirt
Anyone operating in the apparel industry knows that manufacturers and retailers frequently go out of business, creating uncertainty for creditors. Oftentimes significant disputes can arise when a phalanx of creditors eye the leftover assets of the disappearing entity seeking to divvy up what is left and secure payment of outstanding claims. The rights that inure to creditors including priority of payment in a bankruptcy proceeding largely flow from the nature of the claim — whether secured or unsecured — and the bankruptcy proceeding of the insolvent entity. The below provides a short overview of what a creditor can expect once a debtor seeks bankruptcy protection.
The rights and potential for recovery of creditors varies based on the bankruptcy petition filed by the debtor. Most commercial debtors will either file a Chapter 7 or Chapter 11 bankruptcy. In a Chapter 7 bankruptcy, the debtor surrenders all assets to the bankruptcy trustee who is then empowered to liquidate the assets, subject to secured claims, to satisfy outstanding debts. However, in a Chapter 11 the debtor seeks to “reorganize” by shedding certain debts and obligations to continue as a going concern following bankruptcy. In either case, creditors should be proactive in protecting their rights in the bankruptcy proceeding.
At the filing of any type of bankruptcy petition, an “automatic stay” is triggered which prevents creditors from taking any action to collect debts from a debtor. It is critical that upon the institution of a bankruptcy proceeding that creditors immediately cease from any attempts to collect debts or seek payment from a debtor as violating the automatic stay could subject the creditor to severe sanctions. Upon a bankruptcy filing, a creditor should promptly file a proof of claim asserting their status as a creditor and the amounts due and owing. In filing a proof of claim a creditor must provide all documentation to the court supporting their entitlement to payment including contracts, invoices, and any documents which can bolster a right to payment. Bankruptcy actions have very specific deadlines which must be met by creditors to ensure potential payment of claims.
A critical issue in bankruptcy is the priority of the claim held by the creditor which will dictate the order in which claims are paid in a bankruptcy proceeding out of the assets of the debtor estate. Generally speaking, secured claims, defined as claims which are collateralized by an asset of the bankruptcy estate, have a superior priority over those claims which are unsecured. Subject to restrictions, and depending on the chapter under which the bankruptcy was filed, a secured creditor with a perfected security interest can seek to recoup amounts due through liquidation of the secured collateral. A secured creditor may file a motion with the court seeking to lift the automatic stay to permit the creditor to levy upon the collateral to satisfy debts. In the event of a Chapter 11 bankruptcy, the creditor may be entitled to “adequate protection payments” which help protect the secured creditor’s interest in the collateral.
An unsecured creditor faces a tougher road to payment of debts. Generally, unsecured claims are the lowest in priority and only paid after administrative costs and certain unsecured claims provided “priority” by statute. In most liquidations, little to no assets are left to satisfy unsecured creditors rendering it difficult or impossible for unsecured creditors to recover debts. Although a creditor holding an unsecured claim should still file a proof of claim and vigorously pursue its rights in the bankruptcy, there is little question that regardless of the type of bankruptcy filed the chance of recovery on the debts is a riskier proposition. Therefore, whenever practical, manufacturers furnishing products to retailers should retain a security interest in the inventory to protect themselves in the event of a bankruptcy filing by the retailer.
As the bankruptcy case proceeds, creditors must continue to play an active role in the proceedings to safeguard their potential right to payment. Whenever appropriate, creditors have the right to object to motions or plans filed by the debtor, particularly if the relief sought by the debtor will have a negative impact on a creditor’s ability to obtain payment of outstanding debts. Creditors can continue negotiations with the debtor and its counsel during bankruptcy which also could lead to some payment of claims. Finally, if the bankruptcy is dismissed, which can occur for a variety of reasons such as the debtor failing to comply with all bankruptcy requirements, creditors who are able to quickly identify the dismissal and resume collection efforts immediately may be better situated to obtain payment of their debts.
As navigating the bankruptcy landscape can be a complex undertaking, it is important for creditors to engage experienced bankruptcy counsel to ensure proper registering of their claims in the bankruptcy proceeding and prevent creditors from running afoul of bankruptcy rules which could lead to hefty penalties for an offending creditor.
Joshua S. Bauchner, Esq. ([email protected]) is a shareholder of Ansell Grimm & Aaron (www.ansellgrimm.com), where he serves as Co-Chair of the Litigation Department. Anthony D’Artiglio, Esq. ([email protected]) is a litigation associate with the firm. They may be reached at at (973) 247-9000.
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