ANALYSIS

Maximizing Recoveries in Bankruptcy

One of the many impacts of the COVID-19 pandemic is, and will continue to be, an increase in business bankruptcies. This will affect creditors in many ways, including unpaid debts, loss of business and “preference” claims—actions by a trustee to recover amounts the debtor paid to creditors within 90 days prior to bankruptcy. The principal avenue of recovery for creditors in bankruptcy, of course, is filing a claim against the debtor for the amount owed. This can include claims for work done prior to the bankruptcy as well as during the bankruptcy. However, bankruptcies, especially larger commercial bankruptcies, take time, and so any payout on a creditor claim can take several months or years. Thus, in this alert we also discuss a way to monetize a claim without having to wait until the bankruptcy is resolved.

Bankruptcy Stay

Bankruptcy filings are governed by the federal Bankruptcy Code. There are two primary types of business bankruptcies, both of which act to stay collection efforts against the debtor. The first is a Chapter 11 reorganization, where the entity typically stays in business and develops a plan to repay creditors, often out of future earnings. The second is a Chapter 7 liquidation, where the entity goes out of business, and a trustee is appointed to liquidate all assets. Any payments on claims in a Chapter 7 liquidation are typically paid in a lump sum after all assets have been liquidated.

Claim Filing Process

For creditors to be able to participate in distributions in a bankruptcy, they are required to file a claim evidencing their debt. This is termed a “proof of claim,” and it preserves the creditor’s right to share in distributions paid to creditors, subject to objections the debtor may have to the claim. The bankruptcy court will notify creditors of the deadline by which claims have to be filed and also where to file, and will also provide a proof of claim form. The form is short and basic, and relatively easy to complete. The deadlines are strict, though, and failure to file a timely claim can cause a loss of the right to share in distributions.

Types of Claims

The three primary types of claims in bankruptcy are unsecured, priority and secured.

Unsecured claims are for goods or services provided prior to bankruptcy where the creditor has no collateral securing the debt. These are paid only after priority and secured claims against the debtor are paid in full. The payout on these claims depends on the case, but almost always will be less than full payment, and sometimes may be pennies on the dollar, or no payout at all.

Priority claims are for work provided either right before or during a bankruptcy. There is priority for debts related to goods (not services) delivered to a debtor within 20 days prior to bankruptcy. There is also priority for goods or services provided for a debtor during a bankruptcy. The bankruptcy court will notify creditors of the date by which priority claims have to be filed and provide a claim form. This date is typically later in the bankruptcy than the unsecured claim deadline. Priority claims are significant because they must be paid in full in a Chapter 11 or Chapter 7 before unsecured creditors can be paid anything. The rationale for affording these claims priority is to encourage creditors to continue to work with a debtor that might be on the eve of bankruptcy or that is in bankruptcy and continuing to try to operate.

Secured claims are those where the creditor has collateral that secures the amount owed by the debtor, such as a mortgage on real estate or a security interest in equipment. The claim form the court sends out for unsecured claims is also to be used for secured claims.

Claim Sales

As indicated, business bankruptcies take time to resolve, so any payout on a creditor claim can take months or years. There is, however, a way to monetize a claim without having to wait until the bankruptcy is resolved. Started in the 1990s, there is an industry of entities, primarily investment banks and funds, that purchases claims out of bankruptcy. They pay a lump sum in cash at the time of sale in exchange for assignment of the claim to them. In exchange, the buyer is entitled to receive any distributions paid on the claim out of the bankruptcy.

This option is typically only available for claims believed to be undisputed (e.g., trade claims), and also only for unsecured and priority claims. There is also a dollar threshold below which claims buyers typically will not purchase. This is because buyers incur certain costs in connection with documenting a claim sale, and so it is not economical for them to buy smaller claims where the payout is likely to be minimal.

Claim Sale Process

When a buyer seeks to buy a claim, it offers to pay a percentage of the claim amount, and in so doing, expects to get paid a higher percentage payout from the bankruptcy. Buyers conduct due diligence to determine what the expected payout on claims will be. Buyers are sophisticated and often are able to predict payouts with a reasonable degree of certainty.

If there is no or a minimal expected payout in a bankruptcy, or buyers cannot tell with a reasonable degree of certainty, they likely will not get involved. If a buyer does get involved, in most cases the payout on the claim from the bankruptcy to the buyer is higher than what the buyer pays, although not always. Sometimes buyers misjudge the situation and receive less from the bankruptcy than they paid for claims.

When a buyer gets involved, they make a proposal to buy, typically early in the bankruptcy. Buyers are able to contact creditors from the information shown in the debtors’ bankruptcy pleadings or from proofs of claim the creditors file. The proposal will identify the percentage to be paid on the claim and include a draft agreement to memorialize the sale. The percentage to be paid can be as high as 90%, but more likely is a fair amount less, and in some cases can be pennies on the dollar.

Benefits to Selling

The immediate benefit to selling a claim is, of course, a cash payment at the time of sale, but there are other benefits. The creditor can avoid the uncertainty of what the payout may or may not be from the bankruptcy. A sale also allows the creditor to avoid further delay in payment associated with resolution of the bankruptcy. Finally, a sale also allows the creditor to avoid spending further time and/or fees monitoring the bankruptcy.

Sale Negotiations

When a buyer makes a proposal, the creditor typically has no idea whether the proposal is fair or not. Often, there is more than one buyer involved in a bankruptcy, and so the offer a creditor receives typically is close to a market rate (i.e., the rate other buyers are paying). However, there are no guarantees, and sometimes an initial offer is a fair amount below the market rate. Early in a bankruptcy, it is difficult to determine what the payout from the bankruptcy might be. However, creditors can conduct their own due diligence to attempt to determine the amount and thereby decide if the proposal is fair. This can include reviewing the bankruptcy documents or conferring with other creditors.

When a creditor receives an offer, the creditor can just ignore the offer. Some do so because they are willing to wait, and they believe the bankruptcy payout is going to be more than what the buyer is offering. However, we have seen several instances where the bankruptcy payout is less than what the creditor could have sold the claim for early in the case. Thus, especially where the creditor has a large claim, we recommend some consideration of an offer.

Another option upon receiving a proposal is for the creditor to sell the claim for the initial amount proposed. We do not typically recommend this, however, as buyers are often willing to pay more than the initial proposed amount.

A further option is that the creditor can attempt to negotiate a higher percentage payout. Buyers typically are only willing to pay a few cents on the dollar more than the initial offer. However, depending on the claim amount, that can lead to a material increase in recovery. This can be accomplished by asking the buyer for its best offer, or by conducting a mini “auction” of the claim, whereby the creditor asks all involved buyers for their highest bid. If other potential buyers are not readily apparent, the bankruptcy docket should reflect what other buyers are involved in the case. Experienced counsel can also quickly find out if others are involved.

Finally, another strategy is for the creditor to defer any sale decision until later in the case, especially if the offer is not significant. Payouts often increase later in a case. However, there is no guarantee of that, and so there is risk that a proposal that had been on the table early in the case will not be there later.

Claim Sale Agreements

With any sale, the buyer will require the seller to sign a sale agreement. The buyer will provide a form agreement, and the creditor should carefully review it. The creditor should ensure the agreement reflects the correct payment amount and percentage, and that payment is to be made within a fixed number of days after the claim is sold. It is also important that the creditor ensure it is not taking on new liabilities under the agreement. After a claim is sold, the debtor can still object to it, and so all sale agreements will provide that if that occurs, the buyer may assign the claim back to the seller, and the seller must return the monies it received. That is standard, including that the creditor will have to pay nominal interest on the amount to be returned. However, some buyers seek to include more onerous provisions, such as requiring the seller to indemnify the buyer from all losses related to an objection to or disallowance of the claim, including attorney’s fees, and listing the interest to be paid on returned monies at a more than nominal rate. Creditors should carefully analyze and likely resist those types of provisions.

In closing, keep these points in mind when an entity with which your company does business files bankruptcy. Make sure to file timely and proper claims for all amounts owed, whether incurred before or during the bankruptcy. Also, to the extent claims buyers are involved in the bankruptcy, consider a sale as an avenue for “cashing out” of the bankruptcy.