Article Texas Lawyer

7 Concepts Every In-House Lawyer Needs to Know About Bankruptcy

By now, the statistics are well-known throughout Texas: domestic crude oil prices have fallen over 50 percent since mid-2014; domestic natural gas prices have fallen over 50 percent over the same period. With prices so depressed, over 30 Exploration & Production companies filed for Chapter 11 bankruptcy protection in 2015, and more than 20 to date have filed in 2016.

Given the current levels of distress, it is critical for in-house lawyers to understand key bankruptcy concepts to ensure that they are ready to act should they learn that one of their business partners is itself seeking bankruptcy protection. Here are 7 concepts every in-house lawyer needs to know about bankruptcy.

1. Your business partner may reorganize or liquidate—Chapter 7 vs. Chapter 11. A corporate debtor may file its petition under Chapter 7 or Chapter 11 of the Bankruptcy Code. In Chapter 7, a debtor ceases its operations and its assets are liquidated by a court-appointed trustee. That trustee will convert the debtor’s assets to cash and distribute the proceeds among the debtor’s creditors based on the types of claims a creditor has.

In contrast, Chapter 11 allows a debtor to propose a Chapter 11 plan, which may provide for a sale, reorganization, or liquidation. Typically, the plan is heavily negotiated among the debtor and its creditors and ultimately must be approved by the bankruptcy court. This process can be lengthy and the debtor must demonstrate that every creditor’s recovery under the proposed plan is better than the value of its recovery in a hypothetical Chapter 7 liquidation. Following approval and confirmation of the plan, a Chapter 11 debtor typically emerges as a going concern. The vast majority of large E&P companies that have sought bankruptcy protection have filed for Chapter 11 and have used the process to reorganize around a plan of reorganization.

2. Who comes to the party?—Key Players in a Chapter 11 Case. A Chapter 11 case brings with it plenty of different constituencies: the bankruptcy judge, unions, employees, landlords, Federal and state regulatory authorities, equity holders, post-petition debtor-in-possession lenders, etc. There are a few places where the debtor’s business partners may slot in, depending on the circumstances.

If the debtor owes you money, you may hold a “claim” against the debtor. Your ability to recover on account of that claim will depend on a number of factors. For example, if your claim is not secured by a lien or other security interest in the debtor’s property or otherwise is not a priority claim under the Bankruptcy Code, your claim may be accorded general unsecured status. Understanding your rights as a creditor of a debtor in bankruptcy may involve complicated questions of state and Federal law. Answering those questions also can be worth the time and investment as they can be critical to the outcome of obtaining a 100 percent recovery, receiving cents on the dollar, or even no recovery at all.

Another potential creditor role is service on the creditors’ committee. The Office of the U.S. Trustee—a department within the Justice Department that works to ensure the integrity of the bankruptcy system across the country—is tasked with forming a creditors’ committee to represent the interest of all unsecured creditors in a case. Typically, each of a debtor’s 20 to 50 largest (by claim amount) general unsecured creditors is solicited by the U.S. Trustee for participation on the unsecured creditors’ committee. The debtor typically pays the costs and expenses of the creditors’ committee’s retained legal and financial advisors.

As a trade vendor, you may be deemed a “critical vendor,” in which case the debtor may seek court authority to pay you all pre-filing amounts in exchange for your agreement to continue providing goods and services. This may also be true if you can assert liens against the debtor’s property pursuant to state statutes. Note, however, if you accept payment of your prepetition claim, you likely will not be selected to serve on any creditors’ committee.

3. Your pending lawsuit against the debtor may be stayed—The Automatic Stay. Commencing a Chapter 11 case triggers an automatic stay, a key protection afforded to debtors. The stay is designed to afford the debtor the opportunity to focus on the bankruptcy proceeding rather than on litigating its financial obligations to its creditors. Thus, the automatic stay stops pending lawsuits and other actions to collect prepetition debts or take control of the debtor’s assets.

While the automatic stay is in place, willful attempts to collect may be sanctionable. Therefore, if your business has a lawsuit pending against the debtor at the time it files Chapter 11, including enforcement of any judgments, your case will be stayed until the bankruptcy proceeding concludes unless the bankruptcy court grants you relief from the stay.

There are a number of strategies that may be employed to address issues associated with the automatic stay and related pre-filing claims, including an understanding of any debtor-purchased insurance that may be available to satisfy your claim as well as the appropriate venue (i.e., bankruptcy court versus state court) in which the underlying dispute may be (or should be) brought.

4. You need to ask the court to get paid what you are owed—The Proof of Claim. If your company is owed money from a debtor, you will need to file a “proof of claim” form with the bankruptcy court in which you register your claim, indicating the type, amount and basis for such claim. The proof of claim form can be accessed on the bankruptcy court’s website and you may need to attach all relevant documents.

At the beginning of a bankruptcy case, the court will issue a “bar date” order, which sets forth a deadline for filing proofs of claims. It is imperative that you file your proof of claim prior to this deadline.

5. Your contract with the debtor may be “rejected”—Executory Contracts. In the bankruptcy context, an executory contract is a contract between a debtor and a non-debtor party where both parties owe material obligations to the other. Real estate leases and sales agreements like supply contracts would almost always be an executory contract. In Chapter 11, the debtor has the unilateral right to examine all of its executory contracts and unexpired leases to determine whether it wishes to rid itself of unprofitable agreements. The court is deferential to a debtor’s “business judgment” in evaluating a request to assume or reject such agreements.

If the debtor elects to reject the contract, it is treated as if the debtor breached the contract on the day it filed and its contractual counterparty receives a general unsecured claim for damages arising from the debtor’s rejection (assuming, of course, that the counterparty properly files its proof of claim). If the debtor elects to assume or assume and assign the contract, it is required to “cure” the contract by paying existing defaults.

The debtor typically has until plan confirmation to decide whether to assume or reject executory contracts. Up until that time, the non-debtor counterparty is required to perform its obligations under the executory contract, even if the debtor has not paid outstanding prepetition amounts.

6. Your payment from the debtor prior to filing may be clawed-back—Preference Actions. Debtors can recover certain payments to creditors made within a certain time prior to filing—one year for “insiders” and 90 days for everyone else. These “preference actions” are only available when the payment in question would enable the recipient to receive more by virtue of the transfer than it would have received in a hypothetical liquidation of the debtor.

The purpose of this protection is to prevent a debtor from favoring one creditor over another by paying certain creditors, while others remain unpaid. With the preference action, the debtor may seek to claw-back such payments so that they can be redistributed on a pro rata basis to all of the debtor’s creditors. The statute of limitations on preference actions is two years from the petition date.

There are credible defenses that creditors can raise to preference actions, including that the payment was made in the ordinary course of business, that the payment constituted a contemporaneous exchange for value, or that the creditor provided subsequent new value after the payment at issue.

7. Your issue may not be decided by the bankruptcy judge—Core v. Non-Core Proceedings. The United States Congress has granted bankruptcy judges jurisdiction over “core proceedings.” These are proceedings or issues that are entirely related to the bankruptcy case. Non-core proceedings, in contrast, are issues arising in a bankruptcy case that are not technically bankruptcy matters. The distinction is critical because a bankruptcy judge may not enter a final order in a non-core proceeding absent consent of the parties. If the parties withhold consent, the bankruptcy judge is required to submit proposed findings of fact and conclusions to the Federal district court in the jurisdiction where the bankruptcy court sits.

Big fights can arise in bankruptcy proceedings over whether or not a particular issue is core versus non-core. Certain issues are obvious: for example, matters concerning estate administration, creditors’ claims, and motions to terminate the automatic stay are core because they are entirely related to the bankruptcy case. But, other issues are no as clear-cut. Whenever there is a dispute, the bankruptcy judge must determine issue by issue whether the court has jurisdiction over it.

This overview illustrates the complex legal issues that can arise in a bankruptcy proceeding. To maximize your potential recovery and minimize business distribution, in-house counsel, working with skilled bankruptcy counsel, should endeavor to anticipate how these issues could play out if a particular business partner filed for bankruptcy.