chalos

Introduction

At the heart of any substantive discussion about U. S. bankruptcy law are at least two (2), conflicting, perhaps even diametrically opposed, issues. The first is reconciling the use of insolvency law to benefit both the insolvent and its creditors. The second is finding a way to distribute the debtor’s inadequate assets among competing meritorious claims. Simply stated, such problems arise from the fact there are not enough assets in a bankruptcy proceeding to satisfy everyone. On one hand, bankruptcy is a way out of trouble for hopelessly troubled debtors. On the other hand, it is an efficient means of collecting obligations. Unfortunately, however, what often times is “escape” to a debtor may be viewed as a “swindle” to a creditor.

The U. S. Congress historically has given favored treatment to a variety of creditor groups. In recent years, these favored groups have included, inter alia, labor unions, retirees, the victims of drunk (or drugged) drivers, government agencies that guarantee student loans, consumers who buy on layaway plans, ex-spouses, landlords, shopping mall operators, farmers, and the Federal Reserve System. There is sometimes little logic, other than political logic, behind the rationale as to who is granted a favored position. Moreover, there is little consistency in the favors granted. For example, some tax claims are protected by giving them priority and by making them non-dischargeable in some, but not all, forms of bankruptcy. Wage claims are given a priority but are dischargeable. Drunk driving claims are given no priority, but are not dischargeable. Student loan claims have no priority but are sometimes dischargeable and sometimes not. Labor contracts are protected in an entirely different way: unlike most other contracts, the debtor must honor them except in limited circumstances. Why a particular creditor is given favored treatment is only part of the mystery. Why it is given one form of favored treatment and not another is often equally baffling.

Historical Analysis of the U. S. Bankruptcy Code

Laws governing financial relationships and maritime transactions have common roots in the Roman times and the English legal system.¹Although the United States Constitution provided Congress with the power to create uniform bankruptcy laws,² federal legislation modeled on English law was not enacted until 1800.³ Temporary Bankruptcy laws were enacted and subsequently replaced in 1800-1803, 1841-1843, and 1867-1878.⁴ Bankruptcy laws during the 19th century were created periodically to meet the various needs of the expanding market economy. Ultimately, the 1878 Act was replaced with the enactment of the first permanent bankruptcy law, the Bankruptcy Act of 1898.⁵

Following a depression in the 1890’s, the 1898 Act created both voluntary and involuntary forms of bankruptcy, and provided a new means of collection for lenders and a “fresh start” for debtors.⁶ This Act was amended by the Chandler Act of 1938⁷ as a reaction toeconomic problems resulting from the 1929 stock market crash. These amendments provided for the treatment of business and individual reorganization.

By the 1960’s, dissatisfaction with the Act intensified, and in 1970, the Burdick Commission for Bankruptcy Law Reform was created. Its findings led to the enactment of The Bankruptcy Reform Act of 1978,⁸ the Bankruptcy Code and numerous jurisdictional and procedural rules. Among the many issues addressed by the U. S. Bankruptcy Code are: (1) creation of independent bankruptcy court with nationwide jurisdiction to deal with all matters arising under bankruptcy laws; (2) Presidential appointment of bankruptcy judges; (3) abolition of filing of bankruptcy proceedings as grounds for default; and (4) establishment of a broad “automatic stay” combined with the new concept of adequate protection of creditors.

Subsequently, in 1982, jurisdictional provisions of the Bankruptcy Reform Act were deemed “unconstitutional” by the U. S. Supreme Court in Northern Pipeline Constr. Co. v. Marathon Pipe Line Co⁹ (hereinafter “Marathon“). Specifically, the U. S. Supreme Court was concerned with the Act’s grant of jurisdiction to bankruptcy judges to rule on state law issues. Following almost two (2) years of Congressional attempts to resolve the problematic provisions, the Bankruptcy Amendments and Federal Judgeship Act of 1984, a/k/a BAFJA, was enacted in 1984.¹⁰ Some of the significant changes from BAFJA include: the resting of jurisdiction in Title 11 bankruptcy cases with the district courts; the appointment of bankruptcy judges by the court of appeals for a fourteen year term in “bankruptcy unit” of each district court; and the diminution power and status of the bankruptcy judges. In 1994, the Bankruptcy Reform Act was enacted, creating a Bankruptcy Review Commission to investigate problems and formulate recommendations for needed reforms.¹¹

In brief, it is fair to say that the U. S. Bankruptcy Code is fundamentally a politically motivated document which, like most statutes, represents a series of “horse-trades” among legislators. For those so inclined, it is possible to trace many of these historical “horse-trades,” as the legislative history of the U. S. Bankruptcy Code is fairly well reported and complete.

General Overview of U. S. Bankruptcy Law

One of the central concepts of bankruptcy law is a “fresh start,” whereby a debtor who has surrendered non-exempt assets to the trustee receives another chance to succeed.  However, as stated above, the U. S. Bankruptcy Code has traditionally afforded special status to “property” interests such as mortgages, security interests, and leasehold rights, and, as such, a debtor cannot claim a “fresh start” free of property interests unless their holders have so agreed or have been fully compensated.¹² Accordingly, the “fresh start” label is somewhat misleading. Moreover, in theory, although private companies are prevented from discriminating on the basis of the debtor’s bankruptcy, lenders can, in reality, (and often do) refuse to provide credit or restrict such lending to conform to discriminating terms.¹³ Nevertheless, bankruptcy proceedings are, generally speaking, intended to be for the benefit of both debtors and creditors. As stated above, debtors are intended to benefit from discharge and the fresh start, and the creditors from the presumably efficient and even-handed administration and distribution of the debtor’s non-exempt property.

In virtually all bankruptcy cases, most creditors play a passive role. Simply stated, besides filing a “proof of claim” in hopes of later receiving a potential distribution, the typical creditor does nothing. The reason for this is simple economics; the bankruptcy value of the typical claim is negligible. Most times, creditors who have already given up hope of collection are rarely interested in paying “good money after bad” to participate in the bankruptcy proceeding. In most cases, only creditors with priority secured claims will have claims with any potential “real value. ”

Commencement of the Bankruptcy Case

Bankruptcy cases are commenced by the filing of a bankruptcy petition in the proper form, with the proper fee, in the proper district. The petition may either be voluntary (that is, filed by the debtor) or involuntary (that is, filed by the creditors). There are detailed requirements for each type of petition, and detailed eligibility requirements for each “Chapter” filing, as detailed below. For your guidance, we note that not all persons and/or entities are eligible for relief under all Chapters. Nor are involuntary petitions always permitted. There is a general requirement that the debtor must have a significant nexus with the United States. Individual and business entities must either reside in, or have a domicile, place of business, or property in the United States.¹⁴ There is no requirement, however, that the debtor be a United States citizen.

The filing of the petition constitutes an “order for relief,”¹⁵ and no further action is required for the case to begin. The filing of a bankruptcy petition has many other implications. Perhaps most notably, the filing of a bankruptcy petition triggers the “automatic stay” of other proceedings against the debtor and serves to determine many time limits, such as the ninety (90) day preference period, the fraudulent transfer period, and the time the debtor has to file various documents with the court.

The eligibility of a person or entity to be either a voluntary or an involuntary debtor under the Code varies from Chapter to Chapter. The main eligibility rules relating to voluntary filings are as follows:

Chapter 7 (Liquidation) Virtually any individual or business entity may be a voluntary debtor in a Chapter 7 proceeding. The only exceptions are (1) railroads, (2) most domestic financial institutions, (3) most foreign financial institutions¹⁶ and (4) governmental units.¹⁷ Each of the exclusions reflects the fact that there are other methods for dealing with their insolvencies. For example, there are state and federal institutions and structures, such as the FDIC, to deal with the most insolvent financial institutions. There is a special subchapter in Chapter 11 of the Bankruptcy Code for railroads; and Chapter 9 of the Code deals with insolvent municipalities.

Chapter 9 (Adjustment of Debts of a Municipality)Chapter 9, which is rarely used, is available only to amunicipality, and only under limited circumstances. The debtor must have been authorized to be a debtor under the law of the state that created it, must be insolvent, and must “desire to affect a plan to adjust” its debts.¹⁸ In addition to those requirements, the debtor must have either (1) have obtained creditor agreement to the filing, (2) have failed to obtain creditor agreement after good faith negotiation, (3) be unable to negotiate with its creditors or (4) reasonably believe that a creditor may attempt to obtain a preference.¹⁹

Chapter 11 (Reorganization) The eligibility requirements of Chapter 11 are virtually the same as those for Chapter 7. There are only two (2) differences. First, a stockbroker or commodity broker is eligible for Chapter 7 but not for Chapter 11.²⁰ Second, a railroad, which is not eligible for Chapter 7, is eligible for Chapter 11.²¹Note, however, that railroad reorganizations are subject to a somewhat different set of Chapter 11 rules.

Chapter 12 (Adjustment of Debts of a Family Farmer with Regular Annual Income)With the possible exception of Chapter 9, Chapter 12 has the most complex eligibility requirements under the Code, and is available only to “afamily farmer with regular income. “²² A family farmer with regular income is defined as a “family farmer whose annual income is sufficiently stable and regular to enable such family farmer to make payments under” a Chapter 12 plan.²³ Generally speaking, to qualify for Chapter 12 protection, an individual (or individual and spouse) must be engaged in farming operations and must have no more than $1,500,000 in debt. Generally, at least eighty percent (80%) of those debts must arise from the farming operation and more than fifty percent (50%) of the income must come from the farming operation. Corporations and partnerships may also qualify for Chapter 12, but only if they are controlled by a single family.

Chapter 13 (Adjustment of Debts of an Individual with Regular Income) Chapter 13 eligibility is also somewhat restricted, but by no means as much asChapter 12 eligibility. Several requirements must be met including, but not limited to, the debtor must be either an individual or an individual and spouse. Corporations, partnerships, and other legal entities are not permitted to file under this Chapter.

Petition and Schedules

Along with the petition, the debtor must file a number of other documents. All of these documents are standard forms provided in the Bankruptcy Rules and Forms. The main purpose of filing such other documentations is to provide the court, the trustee, and the creditors with information about the debtor’s financial situation. These documents include, among other things, a list of creditors, along with various “schedules” of assets, obligations, and other pertinent information. Generally, the schedules to be filed are the following:

Schedule A -All real property interests of the debtor other than leasehold interests and any encumbrances.

Schedule B -All personalproperty other than leases orexecutory contracts. Encumbrances on theproperty are not included on Schedule B.

Schedule C – All property that the debtor claims as exempt.

Schedule D – F -All Secured, Priority, and General Unsecured Claims.

Schedule G – Executory contracts and unexpired leases.
Schedule H – Co-obligors of the debtor.
Schedule I and J – Current income and expenses (for individual Debtors only).

The Automatic Stay

“Automatic stay” refers to the stay of all civil actions involving the debtor, debtor’s property and/or property of the bankruptcy estate. Pursuant to section 362 of the Code, the filing of a bankruptcy petition operates as a stay of nearly all non-criminal actions against the debtor, debtor’s property and/or property of the estate.²⁴ The stay functions to further bankruptcy law’s goal of orderly reorganization of the debtor’s property by giving the debtor and the liquidating trustee “breathing room” to organize the assets of the estate. In certain limited circumstances, a creditor can move to have the stay lifted.

There are, of course, numerous implications of the automatic stay. The stay blocks the commencement or continuation of any judicial or administrative action against the debtor that was or could have been initiated before the commencement of the case.²⁵ The stay also prohibits any action to obtain possession of the estate; to obtain possession of property from the estate; or to exercise control over the property of the estate. ²⁶ Any action to create, perfect, or enforce any lien against property of the estate is also stayed pending bankruptcy actions.²⁷

Although the automatic stay affects numerous proceedings, there are some limitations on its application. The stay ceases to exist once the bankruptcy case is over (or property is abandoned), and does not apply to collection of alimony, maintenance, or support from property that does not belong to the estate.²⁸ Certain governmental actions are also immune to the prejudicial effects of the automatic stay.²⁹

While the automatic stay may adversely impact the substantive rights of the creditors, the purpose of the automatic stay is merely procedural. The automatic stay is intended as a form of procedural protection under which the debtor can prepare and present a proposed plan free from unauthorized creditor pressure.

Enforcement of the Stay

The great majority of U. S. courts have held that actions in violation of the automatic stay are entirely void, even if the party taking the action had no notice of the stay. Even actions taken by the government, such as a foreclosure sale, may be entirely without legal effect. The fact that the action taken may have been entirely innocent and in good faith may be a defense against sanctions, however, does not protect the underlying action itself.

Claims and Interests

In addition to the debtor, rights in the property of the bankruptcy estate are classified as either “claims” or “interests. “A “claim” refers to either (i) a debt owed or potentially owed; or (ii) a right against the debtor to an equitable remedy that arises from the breach of contract. The term “interest” also has two (2) meanings: it can refer to a right to specific property of an estate or a right to the remainder of the estate after all claims have been satisfied.³⁰

Claims can either be “secured” or “unsecured. “A secured claim exists where the claimant is owed a debt and has collateral securing the debt. An unsecured claim, however, exists where there is merely a debt and the creditor has no interest in any debtor property in the event that the debt is not paid. The distinctions between secured debt, unsecured debt and equity are not created by the Bankruptcy Code. Rather, the Code largely, but not entirely, preserves the traditional common-law priority structure, which is founded upon the basic principle that debt always precedes equity, and that secured debt precedes unsecured debt.

Allowance of Claims

The broad definition of “claim” in Code section 101 is somewhat narrowed by section 502. Generally speaking, for a claim to be given status in the bankruptcy, and for its holder to exercise rights based on the claim, the claim must be “allowed. “In most cases, claims are allowed perfunctorily. Claims are “deemed allowed” if a Proof of Claim is filed and a party in interest (such as the debtor, the trustee, or another creditor) fails to object. If there is an objection, the court, after notice and an opportunity for a hearing, determines the amount of the claim (if any) to be allowed.

Exemptions and Redemption

Some property is “exempt,” meaning that it is not subject to seizure. Other property is subject to “redemption,” meaning that the debtor has the right to purchase it for a lump sum from lien holders. “Exemptions” are based upon the principle that no individual should be totally deprived of the basic necessities of life, no matter how severe his/her financial troubles. Exemptions are primarily governed by state law. Due to the high degree of variety among state exemptions, the Bankruptcy Code added federal exemptions (but authorizes individual states to “opt out” and thereby limit their residents to state-mandated exemptions). In addition to state and federal exemptions, section 522(b)(2) of the Bankruptcy Code provides debtors exemptions for property protected under the non-bankruptcy federal law.³¹ The debtor is permitted to choose between federal exemptions within section 522(d) of the Bankruptcy Code or the federal non-Bankruptcy Code exemptions and the law of the debtors domicile state.³² However, if the domicile state of the debtor has “opted out” of federal exemptions, the debtor must use state exemption provisions.³³

In the few states that have not opted out, the debtor can choose federal exemptions instead of state exemptions. Federal exemptions consist of a “homestead” exemption,³⁴ a “wildcard” exemption,³⁵ and various specific exemptions. Under the homestead exemption a debtor can exempt up to $17,425 in qualifying property. Qualifying property includes, for example, real property that the debtor or his dependent use as a residence; personal property the debtor or his dependent use as a residence; an interest in a cooperative that the debtor or his dependent use as a residence; or a burial plot for the debtor or his dependent. The debtor is also provided with a wildcard exemption of $925 plus up to $8,725 of any unused homestead exemptions which can be used for anything. Additionally, the numerous specific exemptions are aimed at the protection of particular pieces of property up to a pre-determined value. In the event the property is worth more than the cap and the debtor cannot subsidize the remaining portion, the property is sold and the debtor will receive the portion of the proceeds equal to the corresponding exemption amount.³⁶

State exemptions are generally divided into three categories: homestead exemptions, specific exemptions of tangible property, and specific exemptions of income equivalents. Although the homestead exemption protects the value of the debtor’s home, the exemption amount is relatively small and usually only allows for the debtor to keep a portion of the proceeds from selling his house. The specific exemptions in tangible personalty are capped at a low amount, while exemptions covering earned income substitutes can be more generous.³⁷ The third exemption option for debtors is the alternative federal exemptions. Any debtor who either chooses or is compelled to use the state exemptions is also entitled to these alternative federal exemptions. However, many of the alternative federal exemptions are included in the state exemptions ³⁸ so that the alternative federal exemptions, ostensibly, have little effect.

In most circumstances, the debtor must claim exemptions by filing a list of exemptions with the bankruptcy court. Pursuant to bankruptcy procedural rules, this list of exemptions should be filed with the debtor’s schedule of assets.³⁹ If the debtor fails to file the exemptions, a dependent of the debtor is given thirty (30) days from the time required for filing such schedules to file the list.⁴⁰ Exemptions, however, only provide protection for unencumbered property. Any liens on exempt property remain unaffected.⁴¹

“Redemption” refers to the debtor’s right to “redeem” property from a lienholder, whereby a debtor can buy out the lien and become the property owner. Although many states include rights of redemption, the Bankruptcy Code additionally includes a right of redemption for individual Chapter 7 debtors trying to hold on to encumbered but exempt or abandoned personal property.⁴²Redemption eligibility is only possible with property that is either exempt under Bankruptcy Code section 522 or has been abandoned by the trustee to the lien holder.

Discharge and Reaffirmation

The main bankruptcy goal of nearly all debtors is discharge. Discharge is also the primary distinguishing feature of bankruptcy, and what most clearly separates bankruptcy proceedings from state insolvency proceedings. Simply stated, discharge means that those obligations not satisfied through or in conjunction with the bankruptcy proceeding cease to be binding on the debtor. A creditor may take no action to collect discharged debts from the debtor. In this regard, although the debtor may feel and/or otherwise have a moral obligation towards discharged debts, it has no legal obligation to pay them.

Non-Dischargeable Debts

Section 523 lists a number of debts which are not dischargeable in most bankruptcies. These non-dischargeable debts have little in common beyond the obvious fact that U. S. Congress has found them to be unworthy of discharge. Whether these debts actually will be paid is, at best, speculative, as practically speaking, most non-dischargeable debts are seldom recovered.

At present, there are more than a dozen types of debt that are classified non-dischargeable under section 523. The most noteworthy non-dischargeable debts are:

Taxes: A number of tax obligations are non-dischargeable, including those given priority under section 507, some of those for which a return was filed late or not at all, and those for which the debtor filed a fraudulent return or otherwise evaded. In addition, if the debtor borrows money to pay a non-dischargeable tax obligation it owes to the United States, the debtor’s obligation on the loan is itself non-dischargeable.

Fraud: Generally, debts arising from fraudulent actions by the debtor to obtain property, money, services, or credit are non- dischargeable. The same is true with regard to fraudulent actions to obtain an extension, renewal, or refinancing of credit; thus, the debt may be non-dischargeable either because it was initially obtained by fraud or because the lender was induced to extend the due date by fraud. The statutory provision is written broadly, to encompass many actions that have been labeled “fraud. “These include false pretenses, false representations, and actual fraud In addition, the debt will be non-dischargeable if the debtor used a written statement that contains a materially false representation of the debtor’s financial condition or an insider’s financial condition if (1) the creditor reasonably relied on it and (2) the debtor “caused to be made or publishes with intent to deceive. ” This last provision is often used to block discharge of a loan made in reliance on a false financial statement; the most litigated aspect of the exception is that the statement must be materially false. Minor errors not clearly relevant to the decision to lend
are not enough.

Unscheduled Debts: Under some circumstances, debts not scheduled by the debtor are not discharged. Generally speaking, this applies only if the creditor did not have timely notice of the proceeding; if it did, and failed to file a proof of claim, the debt owed to it is discharged.

Fraud by a Fiduciary: Debts arising from the debtor’s fraud or defalcation while acting in a fiduciary capacity, as well as debts arising from the debtor’s embezzlement or larceny, are not dischargeable.

Alimony, Maintenance and Support; Other Related Obligations: Generally speaking, obligations of the debtor to provide alimony, maintenance, or support of a spouse, former spouse, or child are non-dischargeable. This provision reflects a general policy of preventing bankruptcy from becoming a haven for those who are unwilling to provide for their present or prior families, and who thereby increase the support burdens places on the taxpayer. To be non-dischargeable, these obligations must arise in connection with a separation agreement, divorce decree, or other order of a court of record.

Intentional Torts: A debt arising from a “willful and malicious injury” by the debtor is non-dischargeable. This provision has been read rather broadly to encompass generally any obligation arising from an intentional tort.

Fines, Penalties, and Forfeitures: Most fines, penalties, and Forfeitures owed to governmental units are non-dischargeable. Those fines that are compensation for pecuniary loss, and certain tax penalties, are excluded from this rule and are thus dischargeable unless made non-dischargeable under another provision.

Education Loans: An outcry about alleged bankruptcy abuse by students who had received government-backed student loans led to the enactment of what is now section 523(a)(8). That section restricts, although it does not entirely prohibit, the bankruptcy discharge of student loans made, insured, or guaranteed by the government. These loans are not dischargeable unless (1) the loan first became due more than seven (7) years before the bankruptcy or (2) excepting the loan from discharge would impose undue hardship on the debtor and the debtors’ dependents. The undue hardship exception to non-dischargeability has generated a mass of litigation, most of it fact specific. Courts are most likely to find undue hardship if the debtor’s income is at or near the federal poverty line, especially if there are other circumstances, such as health problems. Some courts have gone so far as to say that even poverty-level income is not enough to demonstrate undue hardship if the debtor has the capacity to make more money but is refusing to do so. Other courts have been more lenient, requiring only that the debtor need only demonstrate “modest” income an a “no-frills” budget.

DUI Debts: Politics also played a significant role in theenactment of section 523(a)(9). It makes non-dischargeable any obligation for death or personal injury that is caused by the debtor’s operation of a motor vehicle while unlawfully intoxicated on alcohol, drugs, or “another substance. “Perhaps surprisingly, this provision has engendered little litigation.

Debts Undischarged in Prior Proceedings: Under section 523(a)(10), a debtor may not obtain discharge for an obligation that either was or could have been scheduled in a prior bankruptcy proceeding, if the debtor either waived discharge or (with a few exceptions) was denied discharge. The primary effect of this provision is to prevent a debtor who was denied discharge because of misconduct in one proceeding from obtaining discharge in a subsequent proceeding.

Fraud on Depository Institutions: As part of its reaction to the collapse of a large part of the American financial industry in the late 1980’s. Congress added two (2) non-dischargeable obligations. The first of these relates to certain obligations arising out of any act of fraud or defalcation while acting in a fiduciary capacity with respect to any depository institution or insured credit union. This provision appears to be wholly redundant to section 523(a)(4), which more generally makes debts arising from fraud by a fiduciary non-dischargeable.

Failure to Maintain Capital Requirements: The second addition to section 523 that arose from the collapse of banks and thrift institutions is section 523(a)(12), which applies to debtors for “malicious or reckless” failure by the debtor to fulfill its commitment to a Federal depository institution regulatory agency (such as the F. D. I. C. to maintain the capital of a financial institution.

Criminal Restitution Orders: Finally, the 1994 Amendments added certain criminal restitution Orders as non-dischargeable debts.

Effect of Discharge

Discharge has a number of direct and indirect effects on the debtor and the debtor’s obligations. The discharge voids any judgment based on the debtor’s liability for a discharged debt.⁴³ It operates as an injunction against any action to collect, recover, or offset any discharged debt as a personal liability of the debtor.⁴⁴ There are also special rules that deal with the effect of the discharge on community property.⁴⁵

Preferences

One of the more controversial powers given in the Bankruptcy Code is the power of the trustee (or debtor in possession) (hereinafter “DIP”), to avoid certain pre-petition transactions as “preferences. “Generally speaking, a preference occurs whenever a debtor favors one creditor over another in paying out its limited resources. In bankruptcy, some, but not all, preferences may be avoided. Avoidance means that the transferee is forced to return the transferred property or its value.

The Code’s primary preference provision is section 547. “Preferences” are defined in section 547 (b). In short, preference is a transfer (i) of property, (ii) to or for the benefit of a creditor, (iii) on an antecedent debt, (iv) made while the debtor was insolvent, (v) made during the preference period (usually the ninety (90) days before the bankruptcy, but one (1) full year for insiders of the debtor), and (vi) that enables to creditor to receive more than it would get in a Chapter 7 liquidation of the debtor.⁴⁶

Preference law is not self-executing. The trustee/DIP must take action to recover the alleged preferential transfer. This is normally done by an “adversary proceeding” in the bankruptcy court.⁴⁷ If the creditor has submitted itself to the jurisdiction of the bankruptcy court (as, for example, by filing a proof of claim) there is no right to a jury trial.⁴⁸ The trustee/DIP carries the burden of persuasion as to all elements of the preference; however, there is a rebuttable presumption that the debtor was insolvent during the ninety (90) days prior to the filing of the petition.⁴⁹ The creditor carries the burden of persuasion as to the applicability of any exception to the avoidance rules.⁵⁰

Preference Period

Section 547 does not avoid all transfers that prefer one creditor over another. Transfers that are relatively remote from the filing of the bankruptcy traditionally have been left untouched. Under the current version of the Code, the preference period generally extends backninety (90) days.⁵¹

Exceptions to Avoidance

The U. S. Bankruptcy Code provides that preferential payments may not be treated as a recoverable transaction in eight (8) specific circumstances.⁵² Most notably, preferential payments may not be treated as recoverable where the payments are made as part of the parties’ “ordinary course of business. “Specifically, section 547 of the U. S. Bankruptcy Code provides, in pertinent part, the following:

The trustee may not avoid under this section a transfer – …
(2) to the extent that such transfer was –

in payment of a debt incurred by the debtor in the ordinary course of business or

• financial affairs of the debtor and the transferee;
• made in the ordinary course of business or financial affairs of the debtor and the transferee; and
• made according to ordinary business terms.⁵³

The “ordinary course of business” defense was established as a matter of policy “to induce creditors to continue dealing with a distressed debtor so as to kindle its chances of survival without a costly detour through, or a humbled ending in, the sticky web of bankruptcy.”⁵⁴ However, in order to successfully establish an ordinary course of business defense, a creditor is required to meet the burden of proving each element of the defense by a preponderance of the evidence.⁵⁵ For your guidance, we note that neither the U. S. Bankruptcy Code nor the implementing case law specifically defines the terms “ordinary course of business” or “ordinary business terms. “In fact, “there is no precise legal test which may be applied to determine whether the requirements of section 547(c)(2) have been met. “⁵⁶The U. S. Bankruptcy Court has expressly acknowledged that “few issues in Bankruptcy Law are as unsettled as is the question of how one defines the ‘ordinary course of business’ and ‘ordinary business terms’ for purposes of11 USC 547(c)(2). “⁵⁷

Generally speaking,”subjective inquiries will be made as to whether the payment of a debt was made in the ordinary course of business of the debtor and the transferee. “⁵⁸In determining whether or not payments were ordinary, the court will look at “several factors, including timing, the amount and manner a transaction was paid and the circumstances under which the transfer was made. “⁵⁹ Additionally, in determining “ordinary business standards,”courts generally will make an objective determination as to whether “the subject payments were ordinary in relation to the prevailing standards in the creditor’s industry. ” ⁶⁰ Notwithstanding, most courts look most heavily to the ongoing payment practices of the parties.⁶¹Even quite long time lags between the due date of the obligation and its payment may be excused, if it truly reflects an established practice between the parties.⁶²Sporadic and irregular payments may indeed be ordinary course if they are consistent with the parties’ mode of dealing.⁶³ Also of great significance are the actions of the creditor. It is interesting to note that if the creditor exerts pressure on the debtor to make payments, most courts hold that the payments are not in ordinary course.⁶⁴

Additionally, the Code provide an exception for “substantially” contemporaneous exchanges for new value.⁶⁵This exception protects transfers to the extent they were intended by the debtor and the creditor to be a contemporaneous exchange for new value and were in fact substantially contemporaneous.⁶⁶The legislative history of section 547(c)(1) indicates that Congress had in mind the technical preference problem created when the debtor pays by check. As you may be aware, payment by check is not complete until the check is paid by the bank on which it is drawn.

International Bankruptcy

Insolvency is not a problem limited to the United States. Courts around the world, must deal with it. In today’s world of international business, and globalization, this inevitably creates problems of overlapping legal systems and legal rules. As there is no overriding sovereignty to force any one nation’s courts to defer to another’s, either in procedural or substantive matters, the resolution of these problems is left to the vagaries of international law and the hopeful application of “comity.” .

In reality, most issues are resolved by what is colloquially known as the “grab” rule. Generally, the courts of any given country will grab whatever assets are within its borders, and thus subject to its sovereignty, administer them. This often means that the multinational insolvent will be administered piecemeal, in multiple proceedings, with duplicated expenses and inconsistent results. Although it is widely recognized that the grab rule is inefficient, many U. S. bankruptcy commentators opine that it is likely to remain predominant. The most fundamental reason for this is that there is a wide divergence among countries concerning their respective bankruptcy policy. Indeed, in the eyes of many, U. S. bankruptcy laws are absurdly tilted toward debtors and necessarily result in huge and unnecessary costs to creditors.

The United States Bankruptcy Code has made at least a minor attempt to deal with transnational bankruptcies without employing the grab rule. Under section 304, a representative appointed in a foreign insolvency proceeding⁶⁷ may petition for an ancillary proceeding in U. S. Bankruptcy Court. An ancillary proceeding is not a full-blown bankruptcy case; rather, it is a way of facilitating the foreign court’s proceeding by requesting assistance in the administration of assets located within the U. S.

Conclusion

In nearly every bankruptcy, there are far more claims than there are assets. In metaphorical terms, in a bankruptcy, there is no such thing as a “free lunch. “In fact, most times, there is hardly any lunch, and in some cases, there is nothing to eat at all (except, perhaps, for the bankruptcy lawyers). Nevertheless, in the bankruptcy proceeding, there is only so much to go around, and although the available assets are insufficient, it is all there will ever be. The foregoing text is only intended to provide a basic understanding of U. S. bankruptcy proceeding. However, should you or your colleagues have any specific questions or comments, we stand ready to respond to any specific questions/comments you may have. For your guidance, the author of this paper can be reached by telephone at:(+1 516 714 4300); via E-mail (gmc@chaloslaw. com) or AOH at (+ 1 516 721 4076).

Rule B of the Supplemental Rules for Certain Admiralty and Maritime Claims (hereinafter “Rule B”) permits a claimant having an in personam claim against a defendant that is cognizable in admiralty to attach the goods or chattels of the defendant, or the latter’s credits or effects in the hands of garnishees, within the district, when the defendant cannot be found in the district. A Rule B attachment permits the assertion of jurisdiction over a defendant’s property located within the district even though the court has no in personam jurisdiction over the defendant. Attachment is not necessarily dependent on the existence of a maritime lien or preferred mortgage lien, but necessitates merely an in personam claim against the defendant that falls within U.S. admiralty jurisdiction.

The attachment is not restricted to maritime property (ships, cargo, freight, bunkers), but may be taken against any goods or chattels of the defendant located within the jurisdiction of the federal district court seized of the claim, as well as the credits or effects of the defendant in the hands of third parties. Hence, it is used to seize both tangible and intangible assets, including, notably, bank accounts.

Because Rule B jurisdiction is in personam, if the defendant makes a general appearance in the action and the plaintiff’s claim is allowed, the judgment is enforceable against all of the defendant’s property, and not only against the property seized as in the action in rem. If the defendant fails to appear, however, the plaintiff’s judgment is enforceable only against the value of the property attached. In addition, the defendant can choose to make a “special” or “limited” appearance, and merely appear for the purpose of seeking to vacate the attachment. By making a special or limited appearance, the defendant does not subject all of its assets to the jurisdiction of the court.

For maritime actions involving a writ of attachment pursuant to Rule B of the Supplemental Rules of Maritime Attachment, the procedure begins with the filing of a verified complaint. This sort of action is entitled to priority, in recognition of the fact that there is often the need to act quickly, before the moveable assets which are the subject of the seizure request can be removed from the jurisdiction of the court. In fact, the Rules also reflect that “exigent circumstances” may exist which require expedited consideration and handling of the initial application to the court.

Once the verified complaint is filed, the procedure routinely provides for ex parte issuance of the requested writ of attachment pursuant to Rule B. Although ex parte, these procedures pass constitutional muster because of the safeguard in Rule E enabling the defendant or any person claiming an interest in the property to seek a hearing immediate after the property is seized. At the Rule E hearing, the plaintiff is the party who has called for the seizure of the property in question and thus has the burden to show why the attachment should not be vacated. That the plaintiff has carried the burden has been defined as a preliminary determination, and the form of evidence that may be considered is within the discretion of the court.

While Rule B requires the presence of property within the jurisdiction of the court, the Rule also requires that the “defendant cannot be found within the district.” The defendant may be considered “found” in the district, by conducting regular business and maintaining offices, but may not defeat a Rule B attachment by designating, after suit has been filed, an agent in the district for service of process. Once an appearance has been filed by the claimant of the property subject to Rule B attachment, additional Rule B writs may be disallowed in the same action, since the purpose of Rule B, that is, to secure that appearance, is no longer served. The more traditional view, however, is that the relevant period for determining if the defendant is “found within the district” by its presence and activities is at the time of the attachment. The authorities are split as to whether the presence of a vessel husbanding agent, prior to the attachment, is alone sufficient to defeat Rule B process. Mere presence of an agent for service of process in the district, in the absence of ongoing business activities of the defendant, is not sufficient to defeat a Rule B attachment.

If the attachment is upheld following a hearing pursuant to Rule E, the amount of security may be resolved by agreement of the parties or by the court. In the absence of agreement, the Rules require the court to fix the principal of the bond or stipulation at an amount sufficient to cover the amount of the plaintiff’s claim “fairly stated with accrued interest and costs. . . .” The Rule provides for a maximum of “twice the amount of the plaintiff’s claim or the value of the property on due appraisement, whichever is smaller.” Despite the plain “whichever is smaller” language of the Rule, some courts explicitly “err on the high side” in setting the bond. The court has latitude in setting the amount of the bond, which properly includes accrued interest and costs. A plaintiff may attempt to re-arrest or re-attach property, after accepting security, only on a showing of fraud or misrepresentation, or mistake by the court in setting initially the amount of security.

The experienced litigant frequently accepts a P & I club letter of undertaking as security standing in place of a vessel or other property, and enabling its release, or in lieu of arrest in the first place; but the courts will not force a plaintiff to accept a letter of undertaking in lieu of a bond. Club letters may reserve the right to challenge the propriety of the arrest, or the amount of the security, after the property is released. A number of courts will not revisit the fact or amount of security until trial, if it has been provided by agreement, and without the involvement of the court in setting its amount. Where the court has determined the amount of security, on the other hand, the Rule expressly provides for a reduction in the amount of security “for good cause shown.

If the court requires security for the benefit of a plaintiff, it is often met with a request for counter security by the opposing party. The Rules specifically provide, in limited circumstances, that a person who has provided security for attachment in the initial action, may file a counterclaim and seek security on the counterclaim. In practice, the requirement of counter security is conservatively applied, and any request for counter security must be based on something more than a claim for wrongful attachment, for which courts routinely deny the request. In ruling on motions for counter security, courts often invoke general equitable principles and the policy against imposition of burdensome costs on a plaintiff that might, otherwise, prevent it from bringing suit.

In conclusion, while we trust the foregoing is self-explanatory, we stand ready to respond to any and all inquiries you, your colleagues and/or your clients may have. Of course, any specific substantive liability analysis will necessarily depend on the facts and circumstances of the underlying incident. We are available to assist in any way we can, and for your convenience, George M. Chalos, Esq. can be contacted either at the above details, or on a 24/7 basis on his mobile telephone (+1 516-721-4076). Additionally, if more convenient, Mr. Chalos can be contacted via Email at gmc@chaloslaw.com.

On Jun 25, 2009, the US Supreme Court, In a narrow 5-4 majority decision authored by one of its perceived judicial conservatives ( Mr. Justice Thomas), handed down  an important decision in the matter of Atlantic Sounding Co. v. Townsend, 557 U.S._______  (2009)- in the jurisprudentially volatile area of punitive damages under US maritime law.

The narrow issue was whether an injured seaman may recover punitive damages for his employer’s willful failure to pay maintenance and cure. The seaman, who was employed onboard a tug boat, slipped and fell on the deck injuring his shoulder and elbow. The tug owner refused to pay maintenance and cure. The seaman filed the usual injured seafarer’s lawsuit (i.e.: alleging claims sounding in Jones Act negligence; general maritime law unseaworthiness; and maintenance and cure). The employer filed a separate complaint in Federal court seeking a declaration of non-liability for maintenance and cure. The seaman counterclaimed for punitive damages predicated on the employer’s failure to pay maintenance and cure. The two (2) cases were consolidated.

Subsequently, the employer moved to dismiss the punitive damages claim. The district court denied the motion but certified the question for interlocutory appeal to the Eleventh Circuit Court of Appeals. The Court of Appeals upheld the decision of the District Court that the seaman was entitled to claim punitive damages. There were conflicting decisions on the issue among the circuits so the U.S. Supreme Court granted certiorari.

The US Supreme Court upheld the seaman’s right to seek punitive damages predicated on the employer’s refusal to provide maintenance and cure. The Court rejected arguments that the punitive damages claim for was precluded by its earlier decision in Miles v, Apex Marine Corp., 498 U.S. 19 (1990) in conjunction with the Congressional judgment expressed in the enactment of the 1920 Jones Act. In relevant part Miles had held that, though the general maritime law recognized a wrongful death cause of action for the death of a seaman, the damages recoverable could not include items for loss of society and future earnings that were unavailable under the Jones Act and the Death on the High Seas Act statutory causes of action. In this case the Court holds that “…unlike the facts presented by Miles, the Jones Act does not address maintenance and cure or its remedies. It is therefore possible to adhere to the traditional understanding of maritime actions and remedies without abridging or violating the Jones Act. “The availability of punitive damages for maintenance and cure actions is entirely faithful to these “general principles of maritime tort law” and no statute casts doubt on their availability under general maritime law”. The Court also rejected the contention that the Jones Act replaced the common law remedies available to seamen for maintenance and cure, and upholds seaman’s rights to use in this regard both, statutory and general maritime law remedies, though these may be overlapping.

The Court further noted that American jurisprudence has permitted punitive damages ever since the colonial era, indeed before the ratification of the US Constitution. Punitive damages remained a feature of U.S. common law at least since 1784 and have been part of the (judge-made) general maritime law since the 1800’s. There is no question then that a seaman is entitled to pursue punitive damages for the denial of his maintenance and cure rights “unless Congress has enacted legislation departing from this common-law understanding”. The purpose of the Jones Act is remedial in nature, and meant to augment the rights of seamen, not to decrease them. “Limiting recovery for maintenance and cure to whatever is permitted by the Jones Act would give greater pre-emptive effect to the Act than is required by its text, Miles, or any of [the]  Court’s other decisions interpreting the statute..”

This case is part of the wider ongoing debate over the availability of punitive damages under the general maritime law of the United States and the effect that Acts of Congress are thought to have in this area. One view is that where Congress has acted, related legal issues are also governed by a form of indirect preemption. This is, in effect, at the core of the dissenting opinion authored by Mr. Justice Alito, which was joined by the Chief Justice and Associate Justices Scalia and Kennedy. However, the majority decision notes that Congress has had occasion to actually enact statutory restrictions expressly addressing general maritime law claims in certain instances and, accordingly, knows how to restrict the traditional remedy of maintenance and cure when it wants to. Thus, the availability of punitive damages under the General Maritime Law of the United States, whether in maintenance and cure actions or in other maritime claims areas,  should not be considered restricted under Congressional enactment,  unless the enactment restricts the availability expressly and specifically.

To read the US Supreme Court’s decision in Atlantic Sounding Co. v. Townsend, please click here.

For more information on the US Supreme Court’s decision, please do not hesitate to contact us at:  info@chaloslaw.com.

On June 4, 2009, the New York Court of Appeals, in response to a certified question presented by the United States Court of Appeals for the Second Circuit, issued an opinion in Koehler v. The Bank of Bermuda that will significantly impact the enforcement of foreign judgments in New York. Specifically, the Court held that a New York court with personal jurisdiction over a defendant and/or a garnishee holding a defendant’s property may be ordered to turn over out-of-state property (including property located abroad) regardless of whether the defendant is a judgment debtor or a garnishee.

In reaching its decision, the Court looked to the Civil Practice Law and Rules of the State of New York (CPLR) Article 52, specifically § 5225, which provides that a New York Court may issue a judgment ordering a party to deliver property in which the judgment debtor has an interest to a judgment creditor for payment of the debt. The Court noted that unlike the pre-judgment remedy of attachment, post-judgment enforcement requires only jurisdiction over persons – notover property. CPLR article 52 contains no express language limiting its application to property contained within the State, leading the Court to conclude that “the Legislature intended CPLR article 52 to have extraterritorial reach.”

The full effect of this decision are yet to be seen. However one thing is clear: the NY Court of Appeal’s holding permits any party with an unsatisfied arbitration award or judgment (for any claim, including both maritime and non-maritime matters) to seek to enforce that award against a judgment debtor that is registered to do business in New York or otherwise has property in the possession of a garnishee which is subject to personal jurisdiction in New York. In Koehler, the Bank of Bermuda was ordered to send property from Bermuda to NY to satisfy a judgment, despite lack of jurisdiction over both the Plaintiff and Defendant in the underlying claim matter.

To read a copy of NY Court of Appeals decision in Koehler v. The Bank of Bermuda, click here.

For more information concerning this decision and its potential application in any particular matter, please do not hesitate to call on us at info@chaloslaw.com.

On October 16, 2009, the Second Circuit Court of Appeals issued a decision severely limiting the scope of the type of property that may be attached pursuant to Rule B. In The Shipping Corporation of India Ltd. v. Jaldhi Overseas Pte Ltd., the Court, in sum and substance, held that “electronic fund transfers (“EFTs”) being processed by an intermediary bank are not property subject to attachment under Rule B.”  The Court relied on New York State law, which prohibits the attachment of EFTs in possession of an intermediary bank. Citing the New York Uniform Commercial Code, the Court stated that neither the originator nor the beneficiary of an EFT hold title to the funds in the account at an intermediary bank. Accordingly, the Court found that since EFTs are no longer considered property of either the originator of the beneficiary, they cannot be “defendant’s property” subject to Rule B attachment. In so holding, the Court expressly overruled its 2002 decision in Winter Storm Shipping Ltd. v. TPI.

The Second Circuit’s decision emphasizes the burden that Rule B has placed on the federal courts and international banks operating within the Southern District and suggests that the attachment of EFTs has “threatened the usefulness of the dollar in international transactions.”  The decision stresses the threat posed by the “explosion” of maritime attachments to, inter alia, New York’s position as the center of international banking and finance. The Court stated that, in attempting to avoid Rule B attachments, many potential Rule B defendants conduct their cross-border transactions in a currency other than U.S. Dollars, causing a reduction in the use of the dollar as the preferred currency of international commerce. In addition, the Court cited to The Clearing House Association’s (whose members consist of all major NY garnishee banks) amicus curiae brief, which detailed the large volume of maritime cases filed between October 1, 2008 and January 31, 2009 and the resulting burden that has been placed on the banks and the District Court Judges. The Court’s focus on the aforementioned reasoning and its weak legal rationale for reaching its conclusion suggests that this was a result-driven decision and that the Court has succumbed to intense pressure from the garnishee banks to put an end to Rule B attachments of EFT transfers transiting through New York.

At present, it is unclear what the implications of the Second Circuit’s decision will be. It is likely that defendants in Rule B actions whose EFTs have been attached will bring motions to vacate, which the Judges sitting in the Southern District Court may well be amendable to grant. In Rule B actions that are not challenged but where plaintiffs have restrained funds, it is unclear whether the Court will require these funds to be released (or not).

This decision does not prevent Rule B actions from being commenced, where the defendant has property in the Southern District (other than EFTs, such as bunkers, freight or bank accounts) and cannot be “found.”

Finally, it should be noted that while pre-judgment attachment of EFTs appears to no longer be permissible following the Jaldhi decision, the New York Court of Appeals decision in Koehler v. Bank of Bermuda Ltd., 2009 NY Slip Op. 04297 (June 4, 2009) provides an important post-judgment option for parties wishing to enforce foreign judgments and/or arbitration awards. In that matter, the Court of Appeals held that a New York court with personal jurisdiction over a defendant and/or a garnishee holding a defendant’s property may be ordered to turn over out-of-state property  including property located abroad), regardless of whether the defendant is a judgment debtor or a garnishee. The full effect of this decision in the maritime context still remains to be seen, but according to Koehler, any party with an unsatisfied judgment or arbitration award for any claim may seek to enforce its award against a judgment debtor that has property in the possession of a garnishee subject to personal jurisdiction in New York or against the debtor, itself, that is registered to do business in New York. Read more on the Koehler decision.

Read a copy of the Second Circuit Court of Appeals decision in Jaldhi