August 31, 2018
Author: Gerald H. Suniville
Organization: Fabian VanCott
I. INTRODUCTION AND OVERVIEW
The loan payment is substantially overdue. The debtor tells you the check is in the mail. Then, without warning, the Notice of Commencement of Bankruptcy Case is in your mailbox. What is a creditor to do?
First, don’t (completely) despair. Not everything is (necessarily) lost. There are rights and remedies available to creditors, both secured and unsecured, that may assist a creditor in recovering some or part of its claim.
No two bankruptcy cases will be the same and the approach a creditor will or should take to protect its claim will depend upon a wide variety of variables. The following written materials are intended to assist the creditor in understanding the debtor’s bankruptcy case and the rights and remedies that may be invoked by a creditor to protect and enforce its claim.
Experience shows that in most cases the very provocation for seeking some form of debtor relief is the real or imagined threat of legal or non-judicial interference with the untrammeled right to possession and use of real or personal property by a creditor asserting its security interests in the property following a default by the purchase or obligor.
Regardless of the Chapter under which relief may be sought, the omnipresent “automatic stay” becomes operative upon filing, and the tug-of-war begins between the creditor and the debtor. Chapter 7 cases have relatively simple solutions, generally turning on valuation, and usually result in either abandonment or reaffirmation, whichever is best suited to the “fresh start” granted the debtor.
Chapter 11, however, because of its goal of maintaining the status quo while permitting the reorganization, or debt restructuring process to go forward, has endless varieties of defenses, moves and strategies. Some of these complications are: (i) whether the secured asset is the sole asset of the debtor; (ii) whether there is any basis for a successful reorganization within a reasonable time; (iii) whether rents or income produced by the secured assets are essential to continued operations or a plan of reorganization; (iv) whether relief from the stay or failure to get relief is truly significant; (v) whether optional relief, e.g., abstention, dismissal or conversion, appointment of an examiner or trustee, is available; (vi) whether a creditor’s plan might emerge as a consequence of a debtor’s inability to propose or effectuate its plan; (vii) whether the secured claimant is a senior or junior lienholder; and (viii) whether the debtor is a person, partnership or corporation. Such is the often stormy course of reorganization proceedings.
B. Types of Bankruptcy Cases
a. Chapter 7. Chapter 7 is the principal bankruptcy remedy for an individual or business burdened with excessive debt and whose income is insufficient to provide a meaningful repayment plan. Under Chapter 7, a trustee is appointed with the duty to collect and liquidate the debtor’s non-exempt assets and close the estate as expeditiously as is compatible with the best interests of creditors. 11 U.S.C. § 704(a)(1). A person who files a Chapter 7 petition and invokes the protection of the Bankruptcy Code assumes certain duties and responsibilities which that law imposes. In re Martin, 30 B.R. 24, 26 (Bankr. E.D.N.C. 1983). Generally, the debtor has a duty to aid in the honest administration of the estate in all of its aspects. Goldie v. Cox, 130 F.2d 695, 708 (8th Cir. 1942). The first duty of a Chapter 7 debtor is to file with the court a list of creditors, a schedule of assets and liabilities, a schedule of current income and current expenditures, and a statement of financial affairs. 11 U.S.C. § 521(a)(1). Second, the debtor is required to cooperate with the trustee as necessary to enable the trustee to perform his duties in the case. 11 U.S.C. § 521(a)(3). Third, the debtor must surrender to the trustee all property of the estate, and any recorded information, including books, documents, records and papers, relating to the property of the estate. 11 U.S.C. § 521(a)(4). Fourth, under the 1984 Amendments, the debtor is required to file with the court a statement of intention with respect to the retention or surrender of property securing consumer debt and to perform his or her intention within 30 days unless extended by the court.
11 U.S.C. § 521(a)(2). Fifth, the debtor may be required to attend a hearing on discharge. 11 U.S.C. § 524(d). Sixth, the debtor must obey any lawful order of the Bankruptcy Court, other than an order to respond to a material question or to testify. 11 U.S.C. § 727(a)(6)(A).
For an individual debtor, the purpose of Chapter 7 is to provide the debtor with a fresh start, free of excessive debt. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) made significant changes which have affected debtors who file, or plan to file, a petition for Chapter 7 bankruptcy. After BAPCPA, individual debtors who have the means to pay their debts are required to enter into a repayment plan under Chapter 11 or 13 rather than having their debts cancelled under Chapter 7. (BAPCPA § 102). In essence, BAPCPA replaced the presumption in favor of granting Chapter 7 relief with a presumption that abuse exists if the debtor’s current monthly income exceeds an amount determined by an IRS-crafted “means test.” (BAPCPA § 102(a)(2)). Debtors who pass the means test can file for a Chapter 7 bankruptcy and be reasonably assured that their petition will not be dismissed for abuse. Failing to undergo a means test, or failing to pass a means test, could result in a Chapter 7 petition being dismissed for abuse, or with their consent, converted into a petition for Chapter 11 or 13. (See BAPCPA § 101-102).
b. Chapter 13. For consumer debtors, the basic alternative to Chapter 7 liquidation is Chapter 13. The purpose of Chapter 13 is to enable an individual, under Bankruptcy Court supervision and protection, to develop and perform under a plan for the repayment of that individual’s debts over an extended period. In some rare cases, the plan will provide for full payment of creditors’ claims. In most others, it may offer creditors a percentage of their claims in full settlement. During the repayment period, creditors may not harass the debtor or seek to collect their debts. They may only receive payments under the plan. Under Chapter 13, the debtor submits all or a portion of his future income to the standing Chapter 13 Trustee, who disburses such funds to creditors in satisfaction of their claims. The fundamental objectives of Chapter 13 are:
(i) to permit the debtor to protect his assets, by developing a plan of repayment rather than liquidating them;
(ii) providing discharge relief to the debtor conditioned upon payment under the plan of all debts, partially or in full;
(iii) protection of the debtor’s credit standing;
(iv) enabling the debtor to avoid the stigma of Chapter 7 by being able to meet his or her financial obligations; and
(v) providing a greater return to creditors than in a Chapter 7 liquidation.
c. Chapter 11. Usually a financially troubled business will attempt to work out its problems with creditors outside of bankruptcy. But when an out-of-court arrangement fails to give the business the time and relief it needs to preserve its assets, the business may look to the reorganization process available under Chapter 11. The basic purpose of a reorganization under Chapter 11 of the Bankruptcy Code is to restructure the business’ finances so that it may continue to operate, provide its employees with jobs, pay its creditors, and produce a return for its equity security holders. The premise of a business reorganization is that it is more economically efficient to reorganize than to liquidate, because it maintains the going-concern value of the business and preserves jobs and assets.
The procedure under Chapter 11 is relatively simple in its basic outlines. When a petition is filed, all creditor actions against the debtor and its assets are automatically stayed. The automatic stay gives the debtor a “breathing spell” in order that it may bring its creditors together for discussion, explanation of its financial problems, and negotiation. Creditors are prevented from acting unilaterally to gain an advantage over other creditors or to pressure the debtor into action.
Normally, the management of a Chapter 11 debtor is left in possession to operate the business. But the Bankruptcy Court is permitted to order the appointment of a trustee upon request of a party if the protection afforded by a trustee is needed. A trustee would be needed, for example, in cases where the current management of the debtor has been fraudulent or dishonest, or has grossly mismanaged the business. If a trustee is appointed, the management is ousted and the trustee is put completely in control of the business.
The Bankruptcy Judge who presides over the Chapter 11 case is not involved in the day-to-day administration of the business, but acts only in a judicial capacity to resolve any controversies which arise. See generally In re Curlew Valley Associates, 14 B.R. 506 (Bankr. D. Utah 1981). The United States Trustee requires the debtor to submit monthly financial reports and other periodic reports concerning progress and developments in the case.
During a Chapter 11 case, the business of the debtor continues to operate. Most transactions conducted in the ordinary course of business do not require court approval. The discretion to act with regard to ordinary business matters without prior court approval is at the heart of the administrative powers of the debtor-in-possession under §§ 1107(a) and 1108. See In re DeLuca Distributing Co., 38 B.R. 588, 591 (Bankr. N.D. Ohio 1984). As one court has stated, “[t]he touchstone of ‘ordinariness’ [under § 363(c)(1)] is thus the interested parties’ reasonable expectations of what transactions the debtor in possession is likely to enter in the course of its business. So long as the transactions conducted are consistent with these expectations, creditors have no right to notice and hearing. . . .” In re James A. Phillips, Inc., 29 B.R. 391, 394 (S.D.N.Y. 1983).
But matters not in the ordinary course of business, such as incurring secured debt or the sale of substantial assets, require authorization from the Bankruptcy Court after notice to creditors.
A business reorganization case under Chapter 11 contemplates the formulation of a plan of reorganization for the debtor. The plan determines how much creditors will be paid, and in what form, (i.e., cash, property, or securities), whether the stockholders will continue to retain any interest in the company, and in what form the business will continue. See generally In re Tri-L Corp., 65 B.R. 774, (Bankr. D. Utah 1986). The plan may propose to alter the legal, equitable, or contractual rights of both secured and unsecured creditors. See 11 U.S.C. § 1123. Usually a plan is the product of lengthy negotiations with creditors.
The Bankruptcy Court requires that the plan be accepted by certain percentages of the creditors and equity security holders before it may be confirmed and put into operation. Before creditors are allowed to vote on the plan, however, a disclosure statement must be approved by the Bankruptcy Court as containing information of a kind and in sufficient detail to enable creditors to make an informed decision whether to accept or reject the plan. 11 U.S.C. § 1125(b). See generally In re Jeppson, 66 B.R. 269, 288-93 (Bankr. D. Utah 1986). Debtors are allowed to continue soliciting acceptances of plan subsequent to the filing of bankruptcy so long as the solicitation is in accordance with applicable non-bankruptcy law and creditors were solicited prior to bankruptcy in compliance with applicable non-bankruptcy law. (11 U.S.C. § 1125 as amended by BAPCPA § 408).
II. EFFECT OF DEBTOR’S FILING
A. Automatic Stay
Probably no section of the Bankruptcy Code has had more judicial interpretation than 11 U.S.C. § 362, which enjoins and prevents the initiation or continuation of any act, action or proceeding against the debtor or his property. The automatic stay of 11 U.S.C. § 362(a) is a self-executing, pervasive statutory injunction that operates nationwide, without notice, the moment the debtor files a bankruptcy petition. In re A.H. Robins Co., Inc., 63 B.R. 986, 988 (E.D. Va. 1986). Actions taken in violation of the stay are generally void, or at the very least, may be avoided.
a. Scope of Stay. 11 U.S.C. § 362(a)(1)-(8). The automatic stay operates as an injunction against:
(i) the commencement of continuation, including the issuance or employment of process, of a judicial administrative, or other action or proceeding against the debtor that was or could have been commenced before the commencement of the case, or to recover a claim against the debtor that arose before the commencement of the case;
(ii) the enforcement, against property of the estate, of a judgment obtained before the commencement of a case;
(iii) any act to obtain possession of property of the estate or of property from the estate to exercise control over property of the estate;
(iv) any act to create, perfect or enforce any lien against property of the estate;
(v) any act to create, perfect, or enforce against property of the debtor any lien to the extent that such lien secures a claim that arose before the commencement of the case;
(vi) any act to collect, assess, or recover a claim against the debtor that arose before the commencement of the case;
(vii) the setoff of any debt owing to the debtor that arose before the commencement of the case against any claim against the debtor;
(viii) the commencement of continuation of a proceeding before the United States Tax Court concerning a corporate debtor’s tax liability of a debtor who is an individual for a taxable period ending before the date of the order for relief under this title.
B. Relief from Automatic Stay and Adequate Protection
a. Section 362(d) provides in pertinent part as follows:
(d) On request of a party in interest and after notice and a hearing, the court shall grant relief from the stay provided under subsection (a) of this section, such as by terminating, annulling, modifying, or conditioning such stay—
(1) for cause, including the lack of adequate protection of an interest in property of such party in interest; or
(2) with respect to a stay of an act against property under subsection (a) of this section, if –
(A) the debtor does not have an equity in such property; and
(B) such property is not necessary to an effective reorganization.
(3) with respect to a stay of an act against single asset real estate under subsection (a), by a creditor whose claim is secured by an interest in such real estate, unless, not later than the date that is 90 days after the entry of the order for relief (or such later date as the court may determine for cause by order entered within that 90-day period) or 30 days after the court determines that the debtor is subject to this paragraph, whichever is later …
(4) with respect to a stay of an act against real property under subsection (a), by a creditor whose claim is secured by an interest in such real property, if the court finds that the filing of the petition was part of a scheme to delay, hinder, and defraud creditors that involved either --
(A) transfer of all or part ownership of, or other interest in, such real property without the consent of the secured creditor or court approval; or
(B) multiple bankruptcy filings affecting such real property.
C. Violations of the Stay
The debtor’s basic remedy for a creditor’s violation of the automatic stay is the civil contempt sanctions, the purpose of which is to compensate the debtor for injuries suffered at the hands of the creditor who knowingly disregards the stay and takes actions against the debtor of the debtor’s property. See generally In re Reed, 11 B.R. 258 (Bankr. D. Utah 1982). Assessment of compensatory damages for violations of the stay has been the most common exercise of the civil contempt power by bankruptcy judges since the enactment of the Code.
Section 549(c) protects good faith purchasers of real property as well as purchasers of real property at a judicial sale where such real property is located in a county other than the county in which the case was commenced unless a copy of the petition was filed in the office of such county in which conveyances of real property are recorded.
Section 362(k)(1) provides that “[a]n individual injured by any willful violation of a stay provided by this section shall recover actual damages, including costs and attorneys’ fees, and, in appropriate circumstances, may recover punitive damages.”
D. Relief from the Automatic Stay Respecting Whether the Debtor has Equity in the Property, and Whether the Property is Necessary to an Effective Reorganization
The Bankruptcy Code allows a court to terminate, annul, modify or condition the automatic stay if “with respect to a stay of an act against property, . . . (A) the debtor does not have equity in such property; and (B) such property is not necessary to an effective reorganization.” 11 U.S.C. §362(d)(2)(A), (B). Before the court can grant a secured creditor’s motion to lift the automatic stay, it must be shown not only that the debtor lacks equity in the property, but also, that the property is not necessary to an effective reorganization. See In re Alyucan Interstate Corp., 12 B.R. 803, 811 (Bankr. D. Utah 1981).
If it is clear that without the use of property, there will not be an effective reorganization, the property is necessary to an effective reorganization. See, e.g., In re Sunstone Ridge Associates, 51 B.R. 560 (D. Utah 1985). In the District of Utah, the “necessity test” was first enunciated by Bankruptcy Judge Mabey in Koopmans 22 B.R. 395, 407 (Bankr. D. Utah 1982):
Accordingly, property in which the debtor has no equity is necessary to an effective reorganization whenever it is necessary, either in the operation of the business or in a plan, to further the interest of the estate through rehabilitation or liquidation. This test, in large measure, will turn upon the facts of each case. The property may be important to the liquidation of other property, as for example a warehouse or refrigerator which, although overencumbered, may be needed to store inventory or groceries pending sale. The property standing alone may have no equity, but when sold as package, may bring a better price for other assets, as for example, working for watches yet to be assembled, or contiguous parcels of real property. Or the property may be sold for the direct benefit of junior lienors and the indirect benefit of unsecured creditors. Indeed, it may have no equity but may deserve the protection of the state because, in order to continue operations, its value has been appropriated to supply adequate protection for others or pledged to secure postpetition credit.
The “necessity” test was later elaborated upon by Judge Winder in In re Sunstone Ridge Associates, as follows:
In a one-asset case such as this one, the necessity test is almost tautological. A company with only one asset is always going to need that asset in any effective reorganization. From the evidence in the record, it is clear that there will be no reorganization in this case without the disputed property. The bankruptcy court’s findings that the property was not necessary to an effective reorganization were based on a feasibility test. * * *
Because this court holds that applying a feasibility test under §362(d)(2) is in error, the order lifting the automatic stay is vacated.
Id. at 563. There is some uncertainty in this district concerning the Sunstone Ridge test. The Tenth Circuit dismissed an appeal from Sunstone Ridge as moot and vacated Judge Winder’s published decision. However, in an unpublished opinion, In re Ralsu, Inc., Senior District Judge Anderson appears to have adopted the Sunstone Ridge analysis. In re Martin, 761 F.2d 472 (8th Cir. 1985), involved farming debtors in North Dakota who sought to sell grain mortgaged to a creditor and to use proceeds to fund their 1984 farming operations. The District Court refused to allow the debtors to use the proceeds as cash collateral and overturned the bankruptcy court’s rulings allowing such use of proceeds. The District Court held that the first lien on 1984 crops was not adequate protection of the creditor’s security interest. The debtor offered the secured party a first lien on future crops as well as crop insurance guaranteeing a 75-percent return in the event of crop failure. On appeal, the Eighth Circuit held that a lien on future crops to the extent the crops were not otherwise encumbered, may provide adequate protection. The Court of Appeals remanded and directed the bankruptcy court to make several factual determinations: (1) establish the value of the secured creditor’s interest;
(2) identify the risks to the secured creditor’s value resulting from the debtor’s request for use of cash collateral; and (3) determine whether the debtor’s adequate protection proposal protects the value as nearly as possible against risks consistent with the concept of indubitable equivalence. Id. at 477.
In re Martin is notable for its expansive and flexible interpretation of adequate protection. As in South Village and Alyucan, the court in Martin has placed a greater emphasis upon the restructuring and reorganizing purposes of Chapter 11, thus, injecting a more debtor-oriented approach to the analysis of adequate protection.
E. Drop Dead Agreements
Frequently, litigation between a secured creditor and a Chapter 11 debtor respecting relief from the automatic stay and adequate protection will be resolved by a court approved stipulation and settlement agreement. These documents will generally provide that in the event the agreement is breached by the debtor the automatic stay is terminated without further order of the court or notice to the debtor. On their face the stipulation and order are self-executing, but, are they really?
Notwithstanding the inclusion of a drop-dead clause and a subsequent perceived breach, some courts have ruled that they retain jurisdiction to reconsider stipulated relieffrom-stay orders, if the equities of the case mandate reconsideration. See In re Primer,Inc., 26 B.R. 556 (Bankr. E.D. Pa. 1982). The problem becomes more complex if the secured lender, in reliance upon the provision, and without advising the court of the breach, engages in self-help to secure possession of the property. This could lead to state court litigation and the reassertion of exclusive bankruptcy court jurisdiction by the debtor or other creditors. However reassuring they may seem, “drop dead” clauses are inherently unpredictable, particularly without careful refinement and implementation.
To avoid the pitfalls of self-help, before the “drop dead” language becomes operative, the stipulation should make provision for notification to the debtor, at the very least, of the breach and its consequences, by affidavit and a notice filed with the court. Thereafter, a reasonable time should be granted for the debtor to cure or take other action, including an opportunity to move for relief from the proposed action by the secured creditor.
A second solution where the stipulation itself does not give a procedural safeguard, would be for the injured secured creditor to file with the court a motion seeking an order implementing the “drop dead” language and asserting the grounds for relief.
III. SALES OF PROPERTY
A. Relevant Statutory Provisions
11 U.S.C. § 363 provides, in pertinent part, as follows:
* * *
(b)(1) The trustee, after notice and a hearing, may use, sell, or lease, other than in the ordinary course of business, property of the estate.
* * *
(c)(1) If the business of the debtor is authorized to be operated under section 721, 1108, 1304, 1203, 1204 or 1304 of this title and unless the court orders otherwise, the trustee may enter into transactions, including the sale or lease of property of the estate, in the ordinary course of business, without notice or hearing, and may use property of the estate in the ordinary course of business without notice or a hearing.
(2) The trustee may not use, sell, or lease cash collateral under paragraph (1) of this subsection unless –
(A) each entity that has an interest in such cash collateral consents; or
(B) the court, after notice and a hearing, authorizes such use, sale, or lease in accordance with the provisions of this section.
B. Sales of Property Under the Bankruptcy Code
Section 363 of the Bankruptcy Code defines the rights and powers of the trustee with respect to the use, sale, or lease of property, including property of the estate, and the rights of third parties that have an interest in the subject property. Section 363 is applicable to cases under Chapters 7, 22 and 13.
The power of the Bankruptcy Courts to sell assets, either free and clear of liens or subject to liens, has long been recognized. See COLLIER ON BANKRUPTCY, ¶ 363.01 at 363-6 (15th ed. 1990).
Section 363 does not create property interests, but rather defines the rights and powers of the trustee regarding the use, sale, or lease of property of the estate. Section 363, subparts “b” and “c” provide a distinction between a sale of property outside the ordinary course of business (subsection b(1)) or property sold within the ordinary course of the debtor’s business (subsection c(1)). As an example, sales of property in the ordinary course of business would be the sale of property by a retail business where such property is ordinarily sold as part of such business. For instance, the sale of produce by a debtor grocery store presumably would be in the ordinary course of business. Such sales, however, may trigger other important sections of the Bankruptcy Code, including issues involving adequate protection and use of cash collateral.
Subsection (c) governs the use, sale or lease of property in the ordinary course of business in cases in which the trustee or debtor-in-possession have been authorized to operate the business. In In re Phillips, Inc., 29 B.R. 391 (Bankr. S.D.N.Y. 1983), the court construed the phrase “ordinary course of business” as follows:
The touchstone of “ordinariness” is thus the interested parties’ reasonable expectations of what transactions the debtor-in-possession is likely to enter in the course of its business. So long as the transactions conducted are consistent with these expectations, creditors have no right to notice or hearing, because their objections to such transactions are likely to relate to the bankrupt’s chapter 11 status, not the particular transactions themselves. Where the debtor-in-possession is merely exercising the privileges of its chapter 11 status, which include the right to operate the bankrupt business, there is no general right to notice and hearing concerning particular transactions. To preclude such transactions, interested parties might apply to the bankruptcy court for relief from the stay, 11 U.S.C. § 362(d)(1), or for conversion or dismissal of the chapter 11 petition, 11 U.S.C. § 1112(b). Id. at 394.
Sales under subsection (b) are sales outside the ordinary course of business. These sales require notice and hearing. The notice provisions of Rule 2002 generally are sufficient, unless a creditor requests that all notices be mailed to him.
Where the purchaser is a secured creditor with respect to the asset purchase, he may offset the price to the extent of his equity only. See In re Valley Building Supply, Inc., 39 B.R. 131 (Bankr. D. Vt. 1984).
In the event there is a doubt as to whether the sale is within the ordinary course of business or outside the ordinary course of business, prudent practitioners are cautioned to view the sale as a sale outside the ordinary course of business and provide notice and schedule a hearing. Generally, a sale of substantially all of the assets of the debtor’s estate or other substantial bulk sale transfers will probably be deemed to be outside the ordinary course of business and thus the procedures of subsection (b)(1) govern the disposition of such property.
Many courts have authorized the sales of substantially all of the assets of the debtor prior to the preparation and filing of a debtor’s disclosure statement and plan, particularly where the assets are perishable or where they are rapidly decreasing in value. See In re Boogaart of Florida, Ina., 5 CBC 2d 1441 (Bankr. S.D. Fl. 1981); In re WHET, Inc., 12 B.R. 743 (Bankr. D. Ma. 1981). But see In re White Motor Credit Corporation, 4 CBC 2d 1562 (Bankr. N.D. Oh. 1981) wherein the court held that Section 363 does not authorize the sale of all or substantially all assets of the estate in a Chapter 11 reorganization case.
C. Sales Free and Clear of Liens
Section 363(b) of the Bankruptcy Code provides that the debtor-in-possession or trustee may use, sell or lease property of the estate other than in the ordinary course of business after notice and a hearing. A sale of property other than in the ordinary course of business must be in the best interest of the estate and its creditors. In re WHET, Inc., 12 B.R. 743, 752 (Bankr. D. Mass. 1981). The “best interest” test depends upon “the consideration paid and all other relevant factors.” In re Ancor Exploration Co. 30 B.R. 802, 808 (N.D. Okla. 1983).
The following factors are often relevant to the court’s inquiry: (1) the proportionate value of the asset to the estate as a whole; (2) the amount of time that has elapsed since the filing; (3) the likelihood that a plan of reorganization will be proposed and confirmed in the near future; (4) the effect of the proposed disposition on future plans of reorganization; (5) the proceeds to be obtained from the disposition compared to the appraised value of the property; and (6) whether the asset is increasing or decreasing in value. In re Lionel Corp., 722 F.2d 1063, 1071 (2d Cir. 1983).
BAPCPA amended § 363(b)(1) to provide that, if the debtor in connection with offering a product or service discloses to an individual a policy prohibiting the transfer of “personally identifiable information” about individuals to persons that are not affiliated with the debtor, and if such policy is in effect on commencement of the case, then the trustee is prohibited from selling or leasing such information unless (1) the sale or lease is consistent with such policy or (2) after appointment of a “consumer privacy ombudsman” in accordance with § 332, the court approves such sale or lease giving “due consideration” to the facts, circumstances, and conditions thereof and finding that no showing was made that the sale or lease would violate applicable non-bankruptcy law. (Bohn at 5-6).
Under § 363(f), the trustee may sell property free and clear of any interest (including a lien) only if: (1) applicable non-bankruptcy law would permit a sale of such property free of the interest; (2) the other entity consents; (3) the interest is a lien and the sales price is greater than the aggregate value of all liens on such property; (4) the interest is a bona fide dispute; or (5) the entity could be compelled in a legal or equitable proceeding to accept a money satisfaction of its interest. Section 363(e) provides that on request of an entity that has an interest in property proposed to be sold, the Bankruptcy Court shall prohibit the sale unless that entity’s interest is given adequate protection. Most often, adequate protection in a sale free and clear of liens will be to have those liens attach to the proceeds of the sale.
BAPCPA further amended § 363 by adding a new § 363(o) which provides that a purchaser of an interest in a “consumer credit transaction that is subject to the Truth in Lending Act” or any interest in a “consumer credit contract” pursuant to § 363 remains subject to all claims and defenses that are related to such consumer credit transactions or such consumer credit contract, to the same extent as such purchaser would be subject to such claims and defenses of the consumer had such interest been purchased at a sale or other than under § 363. (Bohn at 6).
A trustee generally should not conduct § 363 sales of fully secured property where there is no potential equity for unsecured creditors and with the trustee enhancing his or her compensation without any corresponding benefit to the estate. In re Lambert Implement Co., Inc., 44 B.R. 860, 862 (Bankr. W.D. Ky. 1984). Where the trustee sells property free and clear of liens, and the secured creditors bids in the property and sets off his claim against the purchase price pursuant to § 363(k), the trustee is entitled to a commission pursuant to § 326(a) based upon the total sale price provided (i) the particular property has been justifiably administered in the bankruptcy case, and (ii) the trustee has properly performed services in connection with the property. The practice of trustees selling fully encumbered property simply to increase their commissions has been properly condemned. In re K. C. Machine & Tool Co., 816 F.2d 238, 246 (6th Cir. 1987). “[C]reditors might be justified in thinking that the sale by trustee was not for their interest, but was had for the purpose of enabling [the trustee] to collect commissions on the entire value of the property. . . .”
By enacting § 544(b) of the Code, Congress gave Bankruptcy Courts the power to order the trustee to abandon property of the estate at the request of a party in interest if the property is burdensome or valueless and of no benefit to the estate. If the trustee elects to sell property that has no equity for the estate, absent his consent or an effective waiver the secured creditor cannot be surcharged for the trustee’s commission and costs under § 506(c) unless (i) the costs are reasonable and necessary, (ii) the costs were incurred for the purpose of preserving or disposing of the property, and (iii) the costs do not exceed the benefit actually conferred upon the secured creditor. See In re AFCO Enterprises, Inc., 35 B.R. 512, 514 (Bankr. D. Utah 1983).
It should be noted that where the estate possesses no substantial ownership rights in the property and any disputes with respect to such property are between third parties, the court lacks authority to order a sale. See Missouri v. U.S. Bankruptcy Court, 647 F.2d 768, 4 CBC 2d 306 (8th Cir. 1981), cert. denied,454 U.S. 1162 (1982). Section 363(m) protects a good faith purchaser of property of the estate should the sale be challenged on appeal. Since such protection is limited to good faith purchasers, a court order confirming the sale should make an affirmative holding on this issue. In re Abbotts Dairies of Pa., Inc., 788 F.2d 143 (3rd Cir. 1986). Unless an appealing creditor first seeks a stay of the consummation of the sale, the appeal court is precluded from setting the sale aside. See Matter of Cada Investments, Inc. 664 F.2d 1158 (9th Cir. 1981). The only exception to this rule is where the order of sale is expressly conditioned upon the appeal. In re Sako Local Development Corp., 19 B.R. 119 (BAP 1st Cir. 1982).
IV. EXECUTORY CONTRACTS AND UNEXPIRED LEASES
A. Relevant Statutory Provisions.
11 U.S.C. § 365 dealing with executory contracts and unexpired leases provides in pertinent part as follows:
(a) [With some exceptions,] the trustee, subject to the court’s approval, may assume or reject any executory contract or unexpired lease of the debtor.
(b)(1) If there has been a default in an executory contract or unexpired lease of the debtor, the trustee may not assume such contract or lease of the debtor, at the time of assumption of such contract or lease, the trustee—
(A) cures, or provides adequate assurance that the trustee will promptly cure, such default other than a default that is a breach of a provision relating to the satisfaction of any provision (other than a penalty rate or penalty provision) relating to a default arising from any failure to perform nonmonetary obligations under an unexpired lease of real property, if it is impossible for the trustee to cure such default by performing nonmonetary acts at and after the time of assumption, except that if such default arises from a failure to operate in accordance with a nonresidential real property lease, then such default shall be compensated in accordance with the provisions of this paragraph;
(B) compensates, or provides adequate assurance that the trustee will promptly compensate, a party other than the debtor to such contract or lease, for any actual pecuniary loss to such party resulting form such default; and
(C) provides adequate assurance of future performance under such contract or lease.
(2) Paragraph (1) of this subsection does not apply to a default that is a breach of a provision relating to –
(A) the insolvency or financial condition of the debtor at any time before the closing of the case;
(B) the commencement of a case under this title;
(C) the appointment of or taking possession by a trustee in a case under this title or a custodian before such commencement; or
(D) the satisfaction of any penalty rate or provision relating to a default arising from any failure by the debtor to perform nonmonetary obligations under the executory contract or unexpired lease.
(3) For the purposes of paragraph (1) of this subsection and paragraph (2)(B) of subsection (f), adequate assurance of future performance of a lease of real property in a shopping center includes adequate assurance—
(A) of the source of rent and other consideration due under such lease, and in the case of an assignment, that the financial condition and operating performance of the proposed assignee and its guarantors, if any, shall be similar to the financial condition and operating performance of the debtor and its guarantors, if any, as of the time of the debtor became the lessee under the lease;
(B) that any percentage rent due under such lease will not decline substantially;
(C) that assumption or assignment of such lease is subject to all the provisions thereof, including (but not limited to) provisions of such as a radius, location, use, or exclusivity provision, and will not breach any such provisions contained in any other lease, financing agreement, or master agreement relating to such shopping center; and
(4) [I]f there has been a default in an unexpired lease of the debtor, the trustee may not require a lessor to provide services or supplies incidental to such lease before assumption of such lease unless the lessor is compensated under the terms of such lease for any services and supplies provided under such lease before assumption of such lease.
(c) The trustee may not assume or assign any executory contract or unexpired lease of the debtor, whether or not such contract or lease prohibits or restricts assignment of rights or delegation of duties, if—
(1)(A) applicable law excuses a party, other than the debtor, to such contract or lease from accepting performance from or rendering performance to an entity other than the debtor or the debtor in possession whether or not such contract, or lease, prohibits, or restricts assignment of rights or delegation of duties; and
(B) such party does not consent to such assumption or assignment; or
(2) such contract is a contract to make a loan, or extend other debt financing or financial accommodations, to or for the benefit of the debtor, or to issue a security of the debtor; or
(d)(1) In a case under chapter 7 of this title, if the trustee does not assume or reject an executory contract or unexpired lease of residential real property or of personal property of the debtor within 60 days after the order for relief, or within such additional time as the court, for cause, within such 60-day period, fixes, then such contract or leases is deemed rejected.
(3) the trustee shall timely perform all the obligations of the debtor, except those specified in section 365(b)(2), arising from and after the order for relief under any unexpired lease of nonresidential real property, until such lease is assumed or rejected, notwithstanding section 503(b)(1) of this title. The court may extend, for cause, the time for performance of any such obligation that arises within 60 days after the date of the order for relief, but the time for performance shall not be extended beyond such 60-day period. This subsection shall not be deemed to affect the trustee’s obligations under the provisions of subsection (b) or (f) of this section. Acceptance of any such performance does not constitute waiver or relinquishment of the lesson's rights under such lease or under this title.
(4) Notwithstanding paragraphs (1) and (2), in a case under any chapter of this title, if the trustee does not assume or reject an unexpired lease of nonresidential real property under which the debtor is the lessee within 60 days after the date of the order for relief, or within such additional time as the court, for cause, within such 60-day period, fixes, then such lease is deemed rejected, and the trustee shall immediately surrender such nonresidential real property to the lessor.
(e)(1) Notwithstanding a provision in an executory contract or unexpired lease, or in applicable law, an executory contract or unexpired lease of the debtor may not be terminated or modified, and any right or obligation under such contract or lease may not be terminated or modified, at any time after the commencement of the case solely because of a provision in such contract or lease that is conditioned on—
(A) the insolvency or financial condition of the debtor at any time before the closing of the case;
(B) the commencement of a case under this title; or
(C) the appointment of or taking possession by a trustee in a case under this title or a custodian before such commencement.
(f)(2) The trustee may assign an executory contract or unexpired lease of the debtor only if—
(A) the trustee assumes such contract or lease in accordance with the provisions of this section; and
(B) adequate assurance of future performance by the assignee of such contract or lease is provided, whether or not there has been a default in such contract or lease.
(g) [T]he rejection of an executory contract or unexpired lease of the debtor constitutes a breach of such contract or lease
(h)(1)(A) If the trustee rejects an unexpired lease of real property of the debtor under which the debtor is the lessor and—
(ii) if the term of such lease has commenced, the lessee may retain its rights under such lease (including rights such as those relating to the amount and timing of payment of rent and other amounts payable by the lessee and any right of use, possession, quiet enjoyment, subletting, assignment, or hypothecation) that are in or appurtenant to the real property for the balance of the term of such lease and for any renewal or extension of such rights to the extent that such rights are enforceable under applicable nonbankruptcy law.
(i)(2) If such purchaser remains in possession –
(A) such purchaser shall continue to make all payments due under such contract, but may, offset against such payments any damages occurring after the date of the rejection of such contract caused by the nonperformance of any obligation of the debtor after such date, but such purchaser does not have any rights against the estate on account of any damages arising after such date from such rejection, other than such offset;
B. Rights and Obligations Respecting Executory Contracts and Unexpired Leases
Section 365 is generally applicable in proceedings under Chapters 7, 9, 11 and 13 and contains most of the statutory material in the Code dealing with executory contracts and unexpired leases. There are, however, certain other statutory provisions which may be applicable at various stages of a bankruptcy proceeding. Section 1123(b)(2) provides that a Chapter 11 plan may allow for the assumption or rejection of any executory contract or unexpired lease under Section 365. Additionally, the amount of a claim arising from the rejection and consequential breach of an executory contract is subject to certain limitations as to the amount of such claim under Section 502. Finally, Section 1113 was added to the Code by the Bankruptcy Amendments and Federal Judgeship Act of 1984, applying only to cases commenced on or after July 10, 1984 and provides for a carefully balanced procedure for the rejection of collective bargaining agreements.
The Code does not make any attempt to define the term \"executory contract.\" The legislative history, however, noted that \"it generally includes contracts in which performance remains due to some extent on both sides.\" House Report No. 95-595, 95th Cong., 1st Sess. 347. The classic definition of executory contracts is the often-cited Countryman definition. Professor Countryman defined executory contracts as follows:
“A contract under which the obligation of both the bankrupt and the other party are so far unperformed that the failure of either to complete performance would constitute a material breach excusing performance of the other.” Countryman, Executory Contracts and Bankruptcy, 57 MINN. L. REV. 439, 460 (1973).
The Countryman definition, however, has been questioned. See In re Booth, 8 B.C.D. 19 BR. 53 (Bankr. D. Utah 1982) (the court challenged the appropriateness of the categorization of an installment land contract as an executory contract where the debtor is a vendee); In re Gladding Corp., 22 B.R. 632 (Bankr. D. Mass. 1982) (workers' compensation insurance policy held not to be an executory contract).
To avoid the uncertainty under the Bankruptcy Act as to whether a lease is an executory contract, Section 365 specifically refers to both executory contracts and leases in order that the law is clear that Section 365 applies to both. 3 COLLIER ON BANKRUPTCY, ¶ 365.02 (15th Ed. Revised 2002).
COLLIER ON BANKRUPTCY observes:
Section 365 applies only if the contract or lease is in existence at the commencement of the case. If the contract or lease has expired by its own terms or has been terminated under applicable law prior to the commencement of the bankruptcy case, there is nothing left for the trustee to assume or assign. However, the termination process must actually be completed and not be subject to reversal, a determination which will require reference to applicable state law.
Id. See In re Windmill Farms, Inc., 841 F.2d 1467, 1469 (9th Cir. 1988); In re Trigg, 630 F.2d 1370 (10th Cir. 1980) (oil and gas leases automatically terminated for nonpayment of annual rent; payments could not be reinstated by bankruptcy court in Chapter XI case). 1. Rights and Duties to Assume or Reject Under Section 365. The basic and overriding principle of Section 365 is the power of the trustee or the debtor in possession to assume or reject executory contracts and unexpired leases. This right is set forth in Section 365(a). The decision to assume or reject is one that must be made with the approval of the court. However, the mere passage of time (120 days after the order for relief is entered), if no other action is taken, will result in the automatic termination of the lease agreement. See Section 365(d)(1) and (4). Note that the deadline used to be 60 days, but BAPCPA extended the deadline to 120 days and limited the number of permitted extensions. This requires debtors with multiple leased locations to act quickly in determining whether to assume or reject a lease of non-residential real property. (Bohn at 11).
From the date of filing the petition until assumption or rejection, the executory contract is not enforceable. NLRB v. Bildisco & Bildisco, 465 U.S. 513 (1984). However, the rent or lease payments or other contractual obligation that arise postpetition shall be treated as administrative claims. See Section 365(d)(3); In re Granada, 88 B.R. 369 (Bankr. D. Utah 1988). Once an assumption of an executory contract is made, however, obligations under executory contracts are treated as administrative expense claims. In re Cost Trading Company, 11 C.B.C. 2d 790 (9th Cir. 1984). In the event the trustee or debtor in possession continues to receive benefits from the other party to an executory contract pending a decision to reject or assume, the debtor or trustee is obligated to pay for the reasonable value of these services as an administrative expense and as specified in the contract. NLRB v. Bildisco & Bildisco, supra.
The rejection of a contract or unexpired lease is treated as a breach of such contract or unexpired lease. See Section 365(g). One of the fundamental principles underlying assumption or rejection of executory contracts is that the debtor or trustee cannot assume the favorable features of the contract and reject the burdensome obligations. Assumption requires the debtor to assume the entire contract. Similarly, the contract must be rejected in its entirety, or not at all. In re Klaber Bros., Inc., 173 F.Supp. 83 (S.D.N.Y. 1959); In re Braniff Airways, Inc., 25 B.R. 216 (Bankr. N.D. Tex. 1982).
The standard that applies to assumption or rejection of unexpired leases in executory contracts is the business judgment test. The primary issue under this test is whether the rejection or assumption will ultimately benefit the general unsecured creditors by permitting a successful rehabilitation or reorganization. 2. Assumption Standards. Section 365(b) governs the trustee's rights to assume the contract or lease where there has been a default, either pre- or post-petition.
Under subsection (b), the trustee may not assume the contract or lease unless the default is cured or adequate assurance is given that he will promptly cure such default. A prepetition default, as well as one that occurs during the pendency of the case, may be cured under Section 365(b)(1). In re Luce Industries, Inc., 7 B.C.D. 78 (Bankr. S.D.N.Y.1980), rev'd on other grounds, 4 C.B.C.2d 355 (S.D.N.Y. 1981).
Section 365(b)(1) tends to strike a balance between two often conflicting interests, the right of the contracting non-debtor to get the performance it bargained for, and the right of the debtor's creditors to get the benefit of the debtor's bargain. In re Luce Industries, supra.
The adequate assurance provision of subsection (b)(1) is related to the trustee's duty to cure any default, compensate for pecuniary loss, and provide for future performance. Adequate assurance is generally decided on a case-by-case basis and generally is given a practical construction. In re Lafayette Radio Electronics Corp., 9 B.R. 993 (Bankr. E.D.N.Y. ;1981); In re Berkshire Chemical Hollars, 20 B.R. 454 (Bankr. D. Mass. 1982). The court must be reasonably satisfied that if the debtor is not going to cure immediately, it will be able to do so within a period of time deemed to be prompt. Adequate assurance requires cash or collateral that is non-speculative and sufficiently substantial so as to assure the non-debtor party that it will receive the amount in default. In re Luce Industries, supra. The assurance required, however, could fall \"considerably short of an absolute guarantee of performance.\"
If the unexpired lease is of real property in a shopping center, the adequate assurance required by the trustee under Section 365(b)(3) extends to the following: (a) the source of the rent and other consideration due under the lease; (b) that any percentage rent due will not decline substantially; (c) that such provisions as those relating to radius, location, use or exclusivity will not be substantially altered; and (d) the tenant mix or balance in such shopping center will not be substantially disrupted. See Lafayette Radio Electronics Corp., supra. These assurances for shopping center-lessors was expanded under the 1984 amendments to Section 365. Although Section 365(b)(2) permits a bankruptcy court to ignore the effect of ipso facto and forfeiture clauses; a restrictive use clause in a shopping center lease is not construed to be in this category.
See In re TSW Stores of Nanuet, Inc., 9 C.B.C. 2d 793 (Bankr. S.D.N.Y. 1983). See also Section 365(c).
When there has been a default in a lease, the trustee is entitled to services or supplies thereunder, but the trustee may not require the lessor to provide services or supplies incidental to the lease prior to assumption until such services and supplies provided by the lessor before the assumption have been paid for under the terms of the lease. See Section 365(b)(4).
3. Restrictions on Assumption and Assignment. Section 365(c)(1) applies not only to personal service contracts, but rather includes a bar to any assignment whenever the duty is not delegable. See In re Braniff Airways, Inc., 700 F.2d 935, 943 (5th Cir. 1983), reh'g denied, 705 F.2d 450 (5th Cir. 1983); In re Nitec Paper Corp., 11 C.B.C. 2d 959 (S.D.N.Y. 1984).
Similarly, the trustee cannot assume a contract binding the other party to make a loan or extend financial accommodations for the benefit of the debtor or to issue a security of the debtor. See Section 365(c)(2).
4. Time Limits for Assumption and Rejection. Section 365 was substantially amended by the Bankruptcy Amendments and Federal Judgeship Act of 1984, Pub. L. 98-333, 98 Stat. 353 (July 10, 1984), largely to alleviate the costly process of evicting lessee-debtors. See generally, Hearing on S. 2297 Before the Subcomm. on Courts of the Senate Judiciary Comm., 97th Cong., 2d Sess. (1982); Hearing on Shopping Center Tenancy Before the Subcomm. on Courts of the Senate Judiciary Comm., 98th Cong., 1st Sess. 348-418 (1983); S.Rep. No. 98-65, 98th Cong., 1st Sess. 26-43 (1983). Section 365(d)(4), added in 1984, provides that if the trustee or debtor in possession does not assume or reject an unexpired lease of non-residential real property under which the debtor is the lessee within 60 days after the order for relief, or within such additional time as the court for cause fixes, the lease is deemed rejected and the trustee must immediately surrender the property to the lessor. See generally, In re By-Rite Distributing, Inc., 47 B.R. 660 (Bankr. D. Utah 1985), rev'd on other grounds, 55 B.R. 740 (D. Utah 1985).
The purpose of Section 365(d)(4) is to compel the trustee or debtor in possession to act with dispatch, thereby reducing the parties' uncertainty about leases. See In re Southwest Aircraft Services, 53 B.R. 805, 808 (Bankr. C.D. Cal. 1985), aff'd, 66 B.R. 121 (Bankr. App. Pan. 9th Cir. 1986), rev'd on other grounds, 831 F.2d 848 (9th Cir. 1987). Congress clearly believed that it was unfair to the lessor of non-residential real property for the trustee not to make lease payments while deciding whether to assume or reject the lease: In this situation, the landlord is forced to provide current services – the use of its property, utilities, security, and other services – without current payment. No other creditor is put in this position. In addition, the other tenants often must increase their common area charge payments to compensate for the trustee's failure to make the required payments for the debtor.
The bill would lessen these problems by requiring the trustee to perform all the obligations of the debtor under a lease of non-residential real property at the time required in the lease. This timely performance requirement will insure that debtor-tenants pay their rent, common area and other charges on time pending the trustee's assumption or rejection of the lease.
130 Cong. Rec. S. 8994-95 (Daily Ed. June 29, 1984) (remarks by Senator Hatch) quoted in In re By-Rite Distributing, Inc., 47 B.R. at 664-65. The additional mandate of Section 365(d)(4), requiring immediate surrender of the property to the lessor upon rejection, emphasized the clear intent of Congress that the statute be strictly construed. Additional protections were given to commercial lessors in amendments to Section 362(b) and 541(b). The Bankruptcy Code now provides that the automatic stay does not operate as a stay \"of any act by a lessor to the debtor under a lease of nonresidential real property that has terminated by the expiration of the stated term of the lease before the commencement of or during a case . . . to obtain possession of such property.\" 11 U.S.C. § 362(b)(10). BAPCPA also amended § 362, rendering automatic stay inapplicable to the commencement or continuation of investigations or actions by “securities self regulatory organizations” (which includes security associations registered with the SEC or a national securities exchange) to enforce such organization’s regulatory power or to delist, delete or refuse to permit “quotation of any stock that does not meet applicable regulatory standards.” (Bohn at 4). Automatic stay has been rendered inapplicable to certain pension plan obligations such as withholding from wages and collections of amounts under an agreement with the debtor for the repayment of loans made by plans established by the employer (Id. at 5) and automatic stay is inapplicable to a setoff of tax refunds for pre-petition tax periods against income tax liabilities for tax periods ending prior to bankruptcy. (Id.).
Furthermore, Section 541(b)(2) states that the property of the estate does not include \"any interest of the debtor as a lessee under a lease of non-residential real property that has terminated at the expiration of the stated term of such lease before the commencement of the case . . ..\" The obvious purpose behind the amendments to Section 362(b)(10) and 541(b)(2) was to make clear that leases which were validly terminated prior to or during the bankruptcy case are indeed terminated and do not constitute property of the estate subject to the protection of the automatic stay. See Hearing on Shopping Tenancy Amendments Before the Subcomm. on Courts of the Senate Judiciary Comm., 98th Cong., 1st Sess. 391-92 Ser. No. J-98-1 (1983) (statement of Nathan B. Feinstein).
Section 365(d)(3) requires the continued performance by the trustee of the full rent obligations under the lease until the decision to assume or reject the lease is made. While Section 365 permits the trustee to assume or reject residential and personal property leases up to and until the date of confirmation, the lessee of non-residential real property must act within 60 days. 11 U.S.C. § 365(d)(4). The language of Section 365(d)(3), that the trustee shall \"timely\" perform, clearly contemplates that the trustee will pay the rent as it comes due.
In the event the debtor or trustee fails to pay the rent as it becomes due post petition, the unpaid claim is treated as an administrative claim and there is no super priority expense treatment for the unpaid rent payments. See In re Granada, 88 B.R. 369 (Bankr. D. Utah 1988).
The non-debtor party to an executory contract may obtain a court order requiring the trustee to make an election to assume or reject before the statutory deadline when delay would be inequitable. See Theatre Holding Corp. v. Mauro, 681 F.2d 102 (2nd Cir. 1982).
A request for approval of assumption or rejection is a contested matter and governed by Rule 9014. In re Summit Land Company, 13 B.R. 310 (Bankr. D. Utah 1981). When a motion is made for approval of assumption or rejection, the court should set a hearing on notice to the other party to the contract. In re Arctic Enterprises, Inc., 16 B.R. 153 (Bankr. D. Minn. 1981).
5. Ipso Facto Clauses. It is not uncommon to find in leases, contracts, and notes, provisions that specify that a default will occur should a receiver be appointed, or an obligor file bankruptcy, become insolvent, enter into an assignment for the benefit of its creditors, or other language relative to the financial condition of the obligor. Under the Bankruptcy Act of 1898, such ipso facto clauses were enforceable, and a creditor could deem an agreement in default, or indeed terminated, as a result of the obligor's financial condition or bankruptcy.
Under the Bankruptcy Code, an executory contract or unexpired lease of the debtor may not be terminated or modified, at any time after the commencement of the case, solely because of the provision in such contract or lease that is conditioned upon the insolvency or financial condition of the debtor. 11 U.S.C. § 365(b)(2).
Many real estate transaction documents include a bankruptcy or insolvency clause which generally provide that upon the filing of an insolvency proceeding or a petition in bankruptcy by a party to the transaction, that party's rights are terminated or modified in some way. Such provisions can be classified as either the automatic termination or \"ipso facto\" provision, or a clause under which forfeiture, modification or termination is at the option of the non-defaulting party. The Bankruptcy Code in Sections 541(c)(1), 363(1), 365(e) and 365(f) contain provisions that substantially restrict any post-petition enforcement of insolvency termination clauses.
Section 541(c) states that an interest of a debtor in property becomes property of the estate notwithstanding any provision respecting forfeiture, modification, or termination of a debtor's interest in property conditional upon insolvency or financial condition on the commencement of the bankruptcy proceeding or the appointment of a trustee under the Code, or of a custodian. Section 363(1) permits a trustee, or a debtor-in- possession under chapter 11, to use, sell or lease property notwithstanding provisions in a contract, a lease or under \"applicable law\" that work a forfeiture, modification or termination as a result of bankruptcy. Section 365(e)(1) precludes termination or modification of an executory contract or unexpired lease \"solely\" by reason of a termination clause, and § 365(f)(2) permits assumption or assignment of an executory contract or lease, notwithstanding an insolvency termination clause prohibiting the assignment or assumption upon insolvency in the instrument. See, e.g., In re LJP, Inc., 22 B.R. 556 (Bankr. S.D. Fla. 1982). These sections, however, do not affect or prohibit the pre-petition enforcement of such clauses or, in the case of § 365(e), post-petition enforcement that is not based \"solely\" on such a clause.
6. Insolvency Termination Clauses. Section 365(e)(1) of the Code generally renders unenforceable bankruptcy and insolvency termination clauses sought to be invoked after commencement of the bankruptcy case. Nonetheless, such clauses can generally be used since they may be effective if invoked so as to fully terminate the defaulting parties' rights in the property prior to commencement of a tenant's bankruptcy case. See, Comm. on Developments in Business Financing, Structuring and Documenting Business, Financing Transactions Under the Federal Bankruptcy Code of 1978, 35 Bus. Law 1645, 1703-04 (1980). It should be noted that § 365(e)(1) deals only with termination or modification of an executory contract or lease \"at any time after the commencement of the case.\"
7. Assignments. Generally, executory contracts and unexpired leases are assignable under Section 365(f) unless the exception of Section 365(c) applies. Matter of Fulton Air Service, Inc., 34 B.R. 568 (Bankr. N.D. Cal 1983) and cases cited therein. The primary focus of adequate assurance of future performance is the ability of the assignee to satisfy the financial obligations. This is not, however, the complete statutory requirement. Adequate assurance means assurance that the non-debtor party, usually a lessor, will get the full benefit of his bargain. In re Evelyn Byrnes, Inc., 9 C.B.C. 2d 430 (Bankr. S.D.N.Y. 1983).
8. Effect of Rejection. Rejection of executory contract or an unexpired lease under this section generally constitutes a breach as of a date immediately before the filing of the petition. 11 U.S.C. § 365(g)(1); Cf. In re Record Company, Inc., 8 B.R. 57 (Bankr. S.D. Ind. 1980).
Rejection of an unassumed contract under Section 365 is assimilated to a petition claim for the purposes of allowance. See, however, 11 U.S. C. § 502(g) with regard to limitations on the amount of such claim; In re Sun Ray Bakery, Inc., 2 C.B.C. 2d 998 (Bankr. D. Mass. 19980).
Damages resulting from the rejection of an unexpired lease of real property is subject to the limitations imposed by 11 U.S.C. § 502(b)(6). This limitation applies without regard to non-bankruptcy law, including even a judgment determining the amount of damage. In re Bus Stop, Inc., 3 B.R. 26 (Bankr. S.D. Fla. 1980).
However, if the contract or lease has been assumed before a rejection in a case under Chapter 9, 11 or 13, the breach is effective as of the time of the rejection. 11 U.S.C. § 365(g)(2)(A). The resulting damages would be administrative expenses of the case in which the rejection occurs, governed by 11 U.S.C. § 503.
If the contract or lease was assumed in a case under Chapter 11 or 13 and rejected thereafter in a case after its conversion to Chapter 7, the breach is effective as of a date immediately before conversion. The resulting damages would be administrative expenses of the superseded case.
9. Debtor as Lessor. If a trustee of a lessor-debtor rejects the lease of real property, the lessee is given the option of treating the lease as terminated or of remaining in possession for the balance of the term and any extension to which he is entitled under non-bankruptcy law. 11 U.S.C. § 365(h)(1)(A)(ii). Section 365(h) settles any conflict in pre-Code law and requires the debtor-lessor to recognize the estate for years of a lease and precludes a charge for use in occupancy rather than rent after rejection of the lease. See In re Stable Mews Associates, 35 B.R. 603 (Bankr. S.D.N.Y. 1983). If the lessee opts to remain in possession, he is authorized to setoff against the rent for the balance of the tenure under the lease the damages caused by the debtor's nonperformance after the rejection. 11 U.S.C. § 365(h)(2).
V. AVOIDANCE POWERS PERTAINING TO REAL PROPERTY TRANSFERS AND FORECLOSURES: PREFERENCES, FRAUDULENT CONVEYANCES AND THE “STRONG-ARM” CLAUSE
The so-called “avoidance” sections of the Bankruptcy Court which have specific application to, or may impact upon, the real property transfers, transactions, or foreclosures are 11 U.S.C. §§ 522, 554, 545, 547, 548 and 549.
A. Avoidance of Liens Which Impair the Debtor’s Exemption Rights
Section 522(f) provides the debtor with an important power to avoid certain liens. Section 522(f)(1) provides that:
Notwithstanding any waiver of exemptions . . . the debtor may avoid the fixing of a lien on an interest of the debtor in property to the extent that such lien impairs an exemption to which the debtor would have been entitled under Subsection (b) of this section, if such lien is –
(a) A judicial lien . . ..
The debtor may avail himself of the lien avoidance power provided by § 522(f) even if the debtor has previously waived any of his exemptions. It should be understood that a lien may be avoided by the debtor only to the extent that such lien impairs an exemption to which the debtor would have been entitled. The term “judicial lien” has a precise meaning under the Code and is defined at § 101(36) to mean a lien obtained by a judgment, levy, sequestration or other legal or equitable process or proceeding. The lien avoidance power under § 522 has no application to consensually granted security interests such as deeds of trust and mortgages, but does apply to statutory liens such as mechanics liens.
B. Avoidance Under the “Strong-Arm Clause” - § 544(a)
A trustee (or debtor-in-possession) is given the status, as of date of petition, of a hypothetical creditor who:
(a) obtains a judicial lien (defined in § 101(36)
(b) obtains a writ of execution returned unsatisfied; and
(c) is a bona fide purchaser of real property of the debtor.
The trustee’s rights under this section are governed by applicable non-bankruptcy law. In re First Capital Mortgage Loan Corp., 60 B.R. at 919 (Bankr. D. Utah 1983), aff’d no. C-86-0622J slip op. (D. Utah April 24, 1987) (per Jenkins, J.). The trustee’s status is “without regard to any knowledge of the trustee or any other creditor.” But, constructive notice, as recognized by state law, prevents exercise of these avoiding powers. In re Richardson, 23 B.R. 434, 439 (Bankr. D. Utah 1982). The trustee may act not only to avoid transfers of property of the debtor, but is granted all other rights and powers that a creditor holding a judicial lien would have after prevailing in a simple contract action. A trustee can utilize the rights of a hypothetical and actual creditor under common law and statutory law other than the Code. Those rights include the rights of a judicial lienholder, an execution creditor, a bona fide purchaser of real property, and a general unsecured creditor.
1. Judicial Lien Creditor. In most states, the holder of a judgment lien is entitled to priority over contract creditors holding unrecorded security interests and liens, but not over bona fide purchasers. In some instances, the rights of a bona fide purchaser and a judgment lien holder are coequal. In others, the rights of a judgment lien creditor are not as extensive.
2. Execution Creditor. In most states, an execution creditor is likewise entitled to priority over an unperfected security interest holder but not over a bona fide purchaser.
3. Bona Fide Purchaser of Real Property. Under § 544(a)(3), a trustee or debtor-in-possession has the rights of a bona fide purchaser of real property. Generally, a bona fide purchaser can void the title of one who has failed to record the instrument under which that person claims title, unless (i) their possession of the property can provide constructive notice under the law of that state and prevent a purchaser from being a bona fide purchaser with avoiding powers or (ii) the circumstances would otherwise give rise to the imposition of a constructive trust or equitable lien under state law.
In most states, a bona fide purchaser of real property is entitled to avoid the rights of holders of judgment liens, mechanics’ liens, materialmen’s liens, oil and gas contractors’ liens, and simple contract claims. In Saghi v. Walsh (In re Gurs), 27 Bankr. 163 (Bankr. App. Pan. 9th Cir. 1983), the Bankruptcy Appellate Panel for the Ninth Circuit held that a recorded lis pendens was binding upon the trustee and prevented him from becoming a bona fide purchaser of the real property in question. Several courts have held that, where the facts would warrant the imposition of a constructive trust under state law, the trustee or debtor-in-possession acquires only bare legal title to the property. U.S. Life Insurance Company of New York v. Lester (In re Fieldcrest Homes), 18 B.R. 678 (Bankr. N.D. Ill. 1982). Tracing is, however, required. If the debtor once held the fund or property in question as a trustee or agent, the person holding a claim to the funds or property is merely the holder of an unsecured claim, unless the funds can be traced into specific funds or property held by the trustee. In re Independence Land Title Corp., 18 B.R. at 673.
The trustee’s status as a bona fide purchaser of real property as of the filing of the bankruptcy petition generally will prevail over property rights awarded by judicial decree. In re Harms, 7 B.R. 398 (Bankr. D. Colo. 1980). In Harms, the Colorado divorce court had divided the marital property, but the wife failed to record her decreed interest. Under Colorado law, the failure to record rendered her interest worthless against a subsequent bona fide purchaser and, therefore voidable by the bankruptcy trustee. A purchaser is bound by every recorded instrument and every recital, reference or reservation contained in or fairly disclosed by any recorded instrument. A lis pendens can operate to prevent a resulting or constructive trust from being found and prevent the trustee from being able to void title through the use of the § 544(a)(3) bona fide purchaser’s rights. In re Gurs, 27 B.R. at 163. Likewise, possession can provide constructive notice under state law and thereby prevent § 544(a)(3) from voiding title. McCannon v. Marston, 679 F.2d at 13. However, if a person in possession has executed and delivered to another a deed to the property, his possession of the property will not prevent a bona fide purchaser from taking title superior to that of the person in possession. That type of possession will not impart notice of a type that will defeat the § 544(a)(3) rights of a trustee or debtor-in-possession. In re Marter, Inc., 31 B.R. 1050 (Bankr. D. Kan. 1983).
4. Transfers Voidable Under State Laws. The state law fraudulent transfer tests vary greatly. Utah, like many states, has adopted a version of the Uniform Fraudulent Transfers Act. Utah Code Ann. § 25-6-1, et seq. (1953, as amended). Section 548 of the Bankruptcy Code is a close approximation of the Act. The Utah Act provides for the avoidance of transfers made and obligations incurred without adequate consideration. Under the Act, if the debtor was left with unreasonably small assets, the transfer is voidable as to existing or subsequent creditors. If the debtor intended to incur or believed that it would incur debts beyond its ability to pay, then the transfer is voidable as to existing or subsequent creditors. Generally, Utah law provides for avoiding transfers in which the debtor had fraudulent intent and transfers for which the debtor received less than a fair consideration. If an actual unsecured creditor of the debtor could, under applicable state law, avoid a particular transfer, then the trustee can likewise avoid that transfer.
5. Avoidance of a Transfer Voidable by Creditor Holding Unsecured Claim § 544(b). This section authorizes a trustee to avoid any transfer by the debtor that is voidable under nonbankruptcy law by a creditor holding an allowed unsecured claim.
Section 544(b) does not purport to ipso facto render void any transactions between the debtor and others; it creates merely a power of avoidance that may be exercised as the trustee sees fit.
To avoid a transfer under § 544(b), the trustee must establish the existence of at least one actual, unsecured creditor holding an allowable claim against whom the transfer was fraudulent and voidable under nonbankruptcy law. Robinson v. Atlas (In re Hecht), 31 B.R. 72, 76 (Bankr. D. Vt. 1985).
C. Avoidance of Statutory Liens - § 545
Section 545 basically invalidates three types of statutory liens (defined in § 101(47)): (1) liens which first become effective upon a specific event, such as the debtor’s bankruptcy filing; (2) liens which at the time the petition is filed are not perfected or enforceable against a hypothetical bona fide purchaser; and (3) liens for rent or of distress for rent. Section 545(l) invalidates those liens which are really disguised priorities, designed to operate only in insolvency and not in competition between creditors without regard to the debtor’s insolvency:
(a) When a case under the Code is commenced.
(b) When any other insolvency proceeding concerning the debtor is initiated.
(c) When a receiver or nonbankruptcy trustee or an assignee for the benefit of creditors is appointed or takes possession.
(d) When the debtor becomes insolvent in the bankruptcy sense.
(e) When the debtor’s financial condition fails to meet a certain standard, such as equity test of insolvency.
(f) When any other creditor has an execution levy made against the debtor’s property.
A bona fide purchaser under § 545(2) is any bona fide purchaser, not, as in §§ 544(a)(3), 547(e)(1), 548(d)(1) and 549(c), a purchaser against whom the transfer could have been perfected. Section 545 deals only with statutory liens and not judicial liens or security agreements. A judicial lien, while not subject to avoidance under § 545, may be assailed as a preference. In re McNeely, 51 B.R. 816, 819 (Bankr. D. Utah 1985).
D. Avoidance of Preferential Transfers - § 547
A trustee can avoid a prepetition transfer of property of the debtor if the elements of a voidable preference as set forth in § 547 of the Code are provided. See, In re Independent Clearing House Co., 41 B.R. 985 (Bankr. D. Utah 1984).
Under § 547, the trustee can void a transfer that was (i) made to or for the benefit of a creditor, (ii) for or on account of an antecedent debt, (iii) while the debtor was insolvent, (iv) within a requisite period of time, and (v) the effect of which is to provide a creditor a greater percentage of its claim than it would have received had the transfer not occurred and the creditor simply received a distribution in a liquidation of the debtor’s estate under Chapter 7.
a. Transfer. Under the Code the term “transfer” is broadly defined. It includes “every mode, direct or indirect, absolute or conditional, voluntary or involuntary, of disposing of or parting with property or with an interest in property, including retention of title as a security interest and foreclosure of the debtor’s equity of redemption.” 11 U.S.C. § 101(50).
b. Date of Transfer. The transfer is deemed to have occurred “when the transfer is so perfected that a bona fide purchaser from the debtor against whom applicable law permits such transfer to be perfected cannot acquire an interest in the property transferred that is superior to the interest in such property of the transferee.” See 11 U.S.C. § 547(e)(1), (2) and (3).
c. Creditor. A creditor includes an entity that has a claim against the debtor that arose at or before the time of petition, and holders of claims against certain community property of the debtor. 11 U.S.C. § 101(9). A claim is broadly defined and generally includes every right to payment and every right to an equitable remedy. It is immaterial whether the claim is liquidated, unliquidated, fixed, contingent, matured, unmatured, disputed, undisputed, legal, equitable, secured or unsecured. 11 U.S.C. § 101(4).
d. Antecedent Debt. The Code does not define the term “antecedent debt.” Generally, however, courts have held that if goods, services or extension of credit were supplied before the filing of the bankruptcy petition, the debt is an antecedent debt for preference avoidance purposes.
e. Insolvency. The test of insolvency is a balance sheet test using “fair valuation.” If the total value of the debtor’s debts is greater than the total value of its property at the time of the transfer, then the debtor is insolvent. Under § 547(f), there is a statutory presumption that the debtor was insolvent during the 90 days preceding the bankruptcy filing. The balance sheet test excludes from the asset side property concealed or removed with intent to hinder, delay or defraud and property that may be exempted under the Code. 11 U.S.C. § 101(31)(A). As to partnerships, the test includes and excludes the same property as for nonpartnership debtors, and also includes the excess value of the general partners’ nonpartnership property over the general partners’ nonpartnership debts. 11 U.S.C. § 101(31)(B).
f. Preference Period. The ordinary preference period begins ninety days before the filing of the bankruptcy petition and ends on the date of the filing of the petition. However, as to insiders, the trustee can reach back one year to recover preferences.
g. Greater Percentage. The liquidation distribution test requires a determination of the amount that the creditor in question would have received had liquidation occurred and the transfer not been made. The court must therefore determine the disposition that would be made of the various items of property that are collateral for claims, the amount required to pay administrative and other priority creditors, and the amount that would have been distributed to the creditor in question. Compare In re Tenna Corp., 801 F.2d 819, 823 (6th Cir. 1986) (date bankruptcy petition is filed is date as of which hypothetical Chapter 7 distribution should be made), with In re Independent Clearing House Co., 41 B.R. at 1013 (administrative expenses likely to be incurred in bankruptcy case should be included in “greater percentage” test). If the transferee was a fully secured creditor before the transfer, there would be no preference, since the creditor would receive no greater distribution as a result of the prepetition transfer than it would have received if the transfer had not occurred.
h. Exceptions. There are several exceptions to the foregoing preference rules, some of which are more relevant than others regarding real estate transactions. (i) Substantially Contemporaneous Transaction. If the transfer was intended by the debtor and the creditor to be a contemporaneous exchange for new value and was, in fact, substantially contemporaneous, the trustee cannot avoid the transfer.
One of the most frequent questions with regard to the contemporaneous exchange transaction involves payment by check. The Tenth Circuit Court of Appeals ruled that for purposes of § 547(c)(1) and (2), payment is considered to have been made when the check is delivered. See, In re White River Corp., 799 F.2d 631, 633 (10th Cir. 1986). (ii) Ordinary Course of Business. If the transfer was made in the ordinary course of business, the trustee cannot avoid the transfer. Under the 1978 version of the Code, the ordinary course of business exception was limited to payments made within forty-five days after the debt was incurred. Courts then had to deal with the question of exactly when the debt was incurred and exactly when the payment was made and then determine whether it fell within the precise 45-day time period. When the 1984 amendments were enacted, the 45-day period was eliminated from the exception, and now all payments made in the ordinary course of business and according to ordinary business terms will escape preference avoidance. BAPCPA further amended the Code, allowing preference defendants to invoke the “ordinary course of business defense” by demonstrating that the transfer was made either in the ordinary course of business between the debtor and transferee or according to ordinary business terms. (Bohn at 13).
This change will eliminate a significant amount of litigation involving the ordinary course of business defense and should make it easier for preference defendants to establish the defense. (Id.)
The ordinary course of business exception contemplates normal credit transactions. The exception may be interpreted broadly. The exception was enacted to leave undisturbed normal financial relations of the debtor, which do not detract from the general policy of discouraging unusual actions by the debtor and its creditors during the debtor’s slide into bankruptcy. See, In re Magic Circle Energy Corp., 64 B.R. 269 (Bankr. W.D. Okla. 1986). The exception embodies both a subjective test and an objective test. The subjective test asks: was the transfer “ordinary” as between the debtor and the creditor? To be subjectively “ordinary” as between the parties implies some consistency with prior transactions. The objective test asks: was the transfer made according to the “ordinary” business terms? This test looks to standards existing in the business in which the parties are engaged. In re Gleed Investment Corp., slip op. at 22-23.
(iii) Enabling Loan. If a creditor receives a security interest for an enabling loan, that security interest is excepted from the preference avoidance provisions.
In order to be free from attack,
(a) the security interest must be for new value that was given by the secured party at or after the signing of a security agreement;
(b) the security agreement must contain a description of the property as collateral;
(c) the security interest must have been given to enable the debtor to acquire the property and the value must have, in fact, been used to acquire the property; and
(d) the security interest must be perfected on or before ten days after the debtor receives possession of the property.
(iv) New Unsecured Value. If the creditor gave new value and either did not receive a security interest or received an avoidable security interest, the new value given after the preference will reduce, and possibly extinguish, the preference. The test is not a netting out of all transactions during the preference period. The exception under 11 U.S.C. § 547(c)(4) pertains only to a preference followed by new value. If the new value occurs before the preference, no reduction in the voidable preference will occur.
(v) Statutory Liens. If a lien is not avoidable under § 545 of the Code, then the lien is excepted from Section 547 avoidance provisions. A statutory lien is also avoidable if it (i) is not perfected or enforceable against a bona fide purchaser at the time of the commencement of the case, (ii) is for rent, or (iii) is a lien for distress of rent. Generally mechanics’ and materialmen’s liens that have been properly perfected, or can be properly perfected pursuant to § 546(b), are not voidable as preferences, since they are, in most states, enforceable against a bona fide purchaser even before recordation and certainly after recordation.
i. Burden of Proof. The trustee or debtor-in-possession has the burden of proving by a preponderance of the evidence that each element of a preference under § 547(b) is met. The creditor against whom recovery or avoidance is sought then has the burden of proving that a defense or exception to the preference applies under § 547(c). See 11 U.S.C. § 547(g); In re Independent Clearing House, 41 B.R. at 985.
E. Avoidance of Fraudulent Conveyances - § 548
Under § 548 of the Code, a trustee has the power to avoid a transfer of an interest in property of the debtor or an obligation incurred by the debtor within one year before the date of the filing of the petition initiating the case, if certain tests are met. BAPCPA amended § 548(a) by adding a new subsection which empowers trustees to avoid, as a fraudulent transfer, a prebankruptcy transfer to an insider under an employee contract and not in the ordinary course of business absent reasonably equivalent value. (Bohn at 14).
a. Elements. The Code fraudulent conveyances test is a two-pronged test, so that in appropriate circumstances both intentional and innocent transfers can be set aside. If the debtor had the actual intent to hinder, delay or defraud an existing or future creditor, the transfer can be set aside. 11 U.S.C. § 548(a)(1)(A). Under § 548(a)(1)(B)(i), a transfer may also be set aside if the debtor received “less than a reasonably equivalent” value and:
(I) was insolvent at the time of the transfer or became insolvent as a result of the transfer;
(II) was engaged in business or a transaction for which any remaining property was an unreasonable capital; or
(III) intended to incur or believed that it would incur debts beyond its ability to pay maturity, then the transfer can likewise be set aside.
b. Date of Transfer. A transfer is deemed to have occurred when it becomes so perfected that a bona fide purchaser from the debtor would take subject to the interest of the transferee. If the transfer is not so perfected prior to the commencement of the case, the transfer is deemed to have occurred immediately before the commencement of the case. 11 U.S.C. § 548(d)(1).
c. Insolvency. There is no presumption of insolvency under § 548 of the Code. The determination of insolvency is a factual determination and courts apply a balance sheet test. Consove v. Cohen, 701 F.2d 978 (5th Cir. 1982). Under the test, the inability to pay debts when they become due does not constitute insolvency; rather, insolvency occurs when the value of the debtor’s property, at a fair valuation, is less than the value of its assets. In re Schick Oil and Gas, 35 B.R. 282 (Bankr. W.D. Okla. 1983).
The following transfers and obligations have been set aside when made or incurred within one year before the date of filing the bankruptcy petition:
(i) Transfers with Intent. A transfer to the debtor’s children’s trust was voided when the transfer was made with intent to hinder, delay or defraud creditors. In re Harris, 7 B.R. 456 (Bankr. S.D. Fla. 1980).
(ii) Transfers for Less than Reasonably Equivalent Value. The issue of reasonably equivalent value presents two questions. The first looks at what the debtor received. Did the transferee give value? Or, stated differently, did the debtor receive any value in exchange for its transfer? The second question is, if the transferee gave value, was the value given reasonably equivalent to the value of the transferred property? See, In re Universal Clearing House Col, 60 B.R. 985, 998 (D. Utah).
F. Avoidance of Unauthorized Post-Petition Transfers - § 549
Section 549(a) of the Code permits a trustee, generally speaking, to avoid unauthorized transfers of property of a debtor that occur after the commencement of the case. See generally, Rochelle & Feder, “Unauthorized Sales of a Debtor’s Property: The Rights of a Purchaser Under Section 549 of the Bankruptcy Code,” 57 Am. Bankr. L.J. (Winter, 1983).
Sections 549(b) and 549(c) provide protection for certain transferees from a debtor after the filing of a bankruptcy. Section 549(b) protects a transferee in an involuntary case if the transfer occurred before the order for relief and notwithstanding the transferee’s notice or knowledge of the petition, to the extent that the transferee gave value, including services but excluding satisfaction or security of an antecedent debt.
Section 549(c) protects a good faith purchaser who is without knowledge of the commencement of the case and who buys for present fair equivalent value real property located in a county other than the one in which the case was filed, unless a copy of the petition is filed there before the transfer becomes so far perfected that a bona fide purchaser could not acquire a superior interest. A buyer at a judicial sale in another county is similarly protected. The post-petition execution and recording of a deed following a pre-petition sheriff’s sale is not avoidable if no copy of the petition has been filed in the office of the recorder of deeds. If the good faith purchaser gives less than present fair equivalent value, he has a lien on the property to the extent of any value given. See 11 U.S.C. § 550(d). BAPCPA clarified that a trustee may not avoid a postpetition transfer of real property for present fair value to a good faith purchaser, when notice of the bankruptcy cases has not been properly recorded. (11 U.S.C. § 549(c), Bohn at 14). Section 549(d) limits actions under § 549 to the earlier of two years after the date of the transfer, or the time the case is closed or dismissed.
VI. CHALLENGING THE DEBTOR’S EXEMPTION
Rule 4003, Fed. R. Bankr. P. provides:
(a) Claim of exemptions
A debtor shall list the property claimed as exempt under § 522 of the Code on the schedule of assets required to be filed by Rule 1007. If the debtor fails to claim exemptions or file the schedule within the time specified in Rule 1007, a dependent of the debtor may file the list within 30 days thereafter.
(b) Objecting to a claim of exemptions
. . . [a] party in interest may file an objection to the list of property claimed as exempt only within 30 days after the meeting of creditors held under § 341(a) is concluded or within 30 days after any amendment to the list or supplemental schedules is filed, whichever is later. The court may, for cause, extend the time for filing objections if, before the time to object expires, a party in interest files a request for an extension. Copies of the objections shall be delivered or mailed to the trustee, the person filing the list, and the attorney for that person.
(c) Burden of proof
In any hearing under this rule, the objecting party has the burden of proving that the exemptions are not properly claimed. After hearing on notice, the court shall determine the issues presented by the objections.
(d) Avoidance by debtor of transfers of exempt property
A proceeding by the debtor to avoid a lien or other transfer of property exempt under § 522(f) of the Code shall be by motion in accordance with Rule 9014. . . .
Section 522 of the Bankruptcy Code governs exemptions granted in the context of bankruptcy. Under the scheme Congress adopted, each state could elect to utilize the uniform exemptions set forth in § 522(d) or could elect to \"opt out\" of the Bankruptcy Code's uniform exemptions and adopt its own, under § 522(b)(1). See In re Neiheisel, 32 B.R. 146 (Bankr. D. Utah 1983) (providing an excellent review of the development of § 522). Utah elected to \"opt out\" and adopt its own exemptions. See Utah Code Ann. § 78B-5-513 (\"No individual may exempt from the property of the estate in any bankruptcy proceeding the property specified in Subsection (d) of Section 522 . . ., except as may otherwise be expressly permitted under this part.\"). Because the Utah Legislature established the basic exemptions permitted under § 522(b)(1), it is only logical that a determination of the propriety of those exemptions is governed by Utah law. Thus, unless otherwise specified, the exemptions available to debtors in Utah are generally set forth in § 78B-5-501 et seq.
Section 522, however, also provides a debtor with several federally-created rights that assist the debtor in obtaining his or her exemptions. For example, § 522(f) enables a debtor to avoid certain liens. In addition, § 522(g) enables a debtor to obtain exemptions in certain property recovered by the trustee.
While a state can \"opt out\" of § 522 with respect to the exemptions provided in § 522(d), a state cannot \"opt out\" of the remaining provisions of § 522. See In re Neiheisel, 32 B.R. 146, 168 n.109 (Bankr. D. Utah 1983) (Judge Clark noting, \"[a]lthough states may preempt section 522(d), section 522(b)(1) does not permit states to preempt other subsections of Section 522.\").
Moreover, because provisions such as § 522(f) and § 522(g) provide a debtor with unique rights under bankruptcy law, such rights are governed by federal law. In other words, although state law determines the extent of the exemption--the amount of the exemption--federal law determines a debtor's entitlement to an exemption under such federally-created rights. In re Herman, 120 B.R. 127, 129 (Bankr. 9th Cir. 1990). Section 522 provides in pertinent part:
(g) Notwithstanding sections 550 and 551 of this title, the debtor may exempt under subsection (b) of this section property that the trustee recovers under section 510(c)(2), 542, 543, 550, 551, or 553 of this title, to the extent that the debtor could have exempted such property under subsection (b) of this section if such property had not been transferred, if - (1)(A) such transfer was not a voluntary transfer of such property by the debtor; and
(B) the debtor did not conceal such property . . . The Tenth Circuit Court of Appeals has denied claims for exemptions based on the standard prescribed in § 522(g). In Redmond v. Tuttle, 698 F.2d 414 (10th Cir. 1983), certain debtors attempted to obtain an exemption in funds that were recovered by the trustee of their bankruptcy estate, pursuant to § 522(g). In denying the exemption, the court stated:
Property fraudulently transferred out of an estate and later recovered by the trustee cannot then be exempted by the debtor. Indeed, the transfer need only be voluntary, not just fraudulent, to preclude exemption. Section 522(g)(1), under which debtors seek to exempt the money, provides that a recovered asset can be exempted to the extent that it could have been exempted had it not been transferred out of the estate if (a) the transfer was not voluntary and (b) the debtor did not conceal the property.
Id. at 417 (citations and footnote omitted.). Under Bankruptcy Rule 4003(c), a party objecting to property claimed as exempt has the burden of proving the exemption is not proper. The preponderance-of-the-evidence standard has been adopted by the courts as the standard proof regarding objections to exemptions. See, e.g., In re Shurley, 163 B.R. 286, 291 (Bankr. W.D. Tex. 1993) (“As previously indicated, Bankruptcy Rule 4003(c) assigns to the objectors the burden of proving that the Debtors’ exemptions are not properly claimed. Such burden is by a preponderance of the evidence.”)
VII. OTHER RIGHTS AND REMEDIES OF CREDITORS
a. Relevant Statutory Provision.
11 U.S.C. § 553 provides as follows:
(a) Except as otherwise provided in this section and in sections 362 and 363 of this title, this title does not affect any right of a creditor to offset a mutual debt owing by such creditor to the debtor that arose before the commencement of the case under this title against a claim of such creditor against the debtor that arose before the commencement of the case, except to the extent
(1) the claim of such creditor against the debtor is disallowed;
(2) such claim was transferred, by an entity other than the debtor, to such creditor—
(A) after the commencement of the case; or
(B)(i) after 90 days before the date of the filing of the petition; and
(ii) while the debtor was insolvent; or
(3) the debt owed to the debtor by such creditor was incurred by such creditor—
(A) after 90 days before the date of the filing of the petition;
(B) while the debtor was insolvent; and
(C) for the purpose of obtaining a right of setoff against the debtor.
b. Relief From Automatic Stay Required. 11 U.S.C. § 362(a)(7) expressly enjoins “the setoff of any debt owing to the debtor that arose before the commencement of the case under this title against any claim against the debtor.” The automatic stay does not cut off the setoff rights of the creditor; it merely prevents the enforcement of such rights until an orderly examination and administration of the debtor’s estate can be made.
Therefore, as long as the stay is in effect, a creditor must obtain relief from the stay in order to enforce its setoff rights. Collier observes, “As a general rule, unless the creditor’s alleged setoff right is patently invalid, relief from the stay to permit the creditor to interpose its right in an action brought by the trustee against the creditor should be granted.” 5 COLLIER ON BANKRUPTCY ¶ 553.06[b] (15th ed. Revised 2002).
c. Mutuality Required. In the typical setoff situation, a creditor seeks to offset, or reduce, its claim by an amount equal to a debt that the creditor owes to the debtor. Mutuality requires that the claim and the debt that is to setoff the claim be between the same parties. If creditor A has a claim against debtor B, and A’s subsidiary C is indebted to B, the parties may not offset the claim against B with the debt owed by C, even though A and C are related. See Elcona Home Corp. v. Green Tree Acceptance, Inc. (In re Elcona Homes Corp.), 863 F.2d 483, 486 (7th Cir. 1988). Collier explains an exception to this rule:
If the parties all agree in a prepetition contract that a setoff may be taken between A, B, and C, then the agreement may be enforced in bankruptcy to the extent that it is enforceable under applicable nonbankruptcy law. However, a formal, prepetition contract is required, and industry practice is not a sufficient substitute for a binding contractual arrangement.
5 COLLIER ON BANKRUPTCY ¶ 553.03[b][ii] (15th ed. Revised 2002). In addition, for setoff purposes, majority of courts hold that agencies of the federal government are considered to be one “unitary creditor.” See, United States v. Maxwell, 157 F.3d 1099 (7th Cir. 1998), Doe v. United States, 58 F.3d 494, 498 (9th Cir. 1995) (“for purposes of setoff under 11 U.S.C. § 106, all agencies of the United States, except those acting in some distinctive private capacity, are a single governmental unit.”). Generally, mutuality also requires that the parties owe each other in the same capacity. In other words, if A owes B, and B owes A but only because A is a trustee or a fiduciary of some third party, setoff will not be allowed. See Dakin v. Bayly, 290 U.S. 143, 146 (1933) (obligation owed by entity in its own right could not be employed to offset obligation owed to entity as agent for third party).
d. Creditor’s Claim and Debt Must Arise Before Commencement of the Case. Generally, both the creditor’s claim against the debtor and the creditor’s debt to the debtor must have arisen before the commencement of the debtor’s bankruptcy case. See 11 U.S.C. § 553(a). One reason for the rule against allowing a prepetition claim to be offset by a postpetition debt is to prevent the debtor from preferring one creditor over another by simply making a loan to the creditor that will be used to setoff that creditor’s claim. That type of transaction would effectively serve as a payment to the creditor. Collier notes an exception to this rule:
Although section 553 expressly preserves certain prepetition rights of setoff, it says nothing about setoff rights that are wholly postpetition in nature. Although this silence has created some confusion, the general rule is that, subject to the restrictions imposed by section 362, a postpetition claim may be offset against a postpetition debt so long as the claim and debt constitute valid, mutual obligations. 5 COLLIER ON BANKRUPTCY ¶ 553.03 (15th ed. Revised 2002) (emphasis added).
In a Chapter 7 case, property may leave the estate by several avenues, e.g., exemption under § 522(b), sale under § 363, dismissal of the case under § 349, by order of the court permitting a distribution to creditors or the payment of an administrative claim, by disposition by the trustee under § 725, and by abandonment under § 554.
a. Under Notice and Hearing. Section 554(a) permits the trustee, after notice and hearing, to “abandon any property of the estate that is burdensome to the estate or that is of inconsequential value and benefit to the estate.” It makes good sense for the trustee at the earliest possible moment in the course of administration to abandon property to facilitate, especially where the property is subject to liens and encumbrances, the ability of the creditor to protect his security interest and realize the greatest value from his collateral.
b. Effect of Order Terminating Stay. As Judge Clark pointed out in an unpublished memorandum opinion in Commercial Security Bank v. Gillman, (In re Contractors Realty and Development, Inc.), Adversary Proceeding No. 83PC-0405 (May 13, 1983), there is “nothing in the Bankruptcy Code [which] provides that an order terminating the stay automatically removes property from the estate.” Reasoning further, the Court observed that even after lifting the stay, the estate may retain important interests, including the right of redemption, and until abandonment by the trustee that interest in the estate remains. The Court suggests that where the trustee intends to stipulate to relief from the stay, and also desires to abandon, that the notice of hearing expressly refer to both remedies.
c. Effect of Abandonment Upon the Automatic Stay. Although property of the estate may be abandoned to any party with an interest in such property, see H.R. Rep. No. 95-595, (95th Cong., 1st Sess. 377 (1977), unless the motion and order specifies that it shall be abandoned to the creditor, property is abandoned to the debtor, not the secured lender. Accordingly, while abandonment causes the interest of the estate in property to pass to the debtor, the bankruptcy court retains jurisdiction over such property pursuant to 28 U.S.C. § 1334(d), and thus actions against such property remain stayed under § 362(a)(5). See In re Cruseturner, 8 B.R. 581 (Bankr. D. Utah 1981).
a. Reaffirmation. Section 524(c) and (d) permit a debtor, with express court approval, to enter into a reaffirmation agreement with a creditor, the consideration for which, in whole or in part, is based upon a dischargeable debt. The typical reaffirmation agreement involves secured obligations such as the debtor’s residence or his automobile.
Certain conditions are mandated:
(i) the reaffirmation agreement must be in writing and must be entered into before the granting of the discharge;
(ii) the agreement must contain a clear and conspicuous statement advising the debtor that the agreement may be rescinded at any time prior to discharge or within sixty (60) days after the agreement is filed with the court, whichever occurs later;
(iii) the agreement must be filed with the court and must be accompanied by a declaration or an affidavit of the attorney that represented the debtor during the course of negotiating the agreement, stating that the agreement represents a fully informed and voluntary agreement by the debtor and does not impose an undue hardship on the debtor; and
(iv) where an individual was not represented by an attorney during the course of negotiation the court must approve the agreement as being in the best interest of the debtor and not imposing an undue hardship on the debtor.
b. Redemption. Redemption is a procedure formalized by § 722 of the Code which permits an individual Chapter 7 debtor to retain collateral (“tangible personal property intended primarily for person, family or household use”) securing a dischargeable consumer debt, provided the property is exempt under § 522 or has been abandoned under § 554. The debtor is required to pay the holder of the lien the amount of the allowed secured claim, i.e., the value of the collateral and not the entire balance which may be due the claimant. An order authorizing redemption must be entered prior to the debtor’s discharge. In re Balance, 33 B.R. 89 (Bankr. E.D. Vas. 1983).
If the parties cannot agree on the value, the debtor may file a motion to redeem pursuant to Rule 6008, Rules of Bankruptcy Procedure, and the court will fix the value for purposes of redemption. A lump sum payment is usually required. In re Carroll, 11 B.R. 725 (Bankr. App. Pan. 9th Cir. B.A.P. 1981).
VIII. STERN V. MARSHALL – A CONTINUING ISSUE REGARDING BANKRUPTCY COURT JURISDICTION
In Stern v. Marshall, 564 U.S. __ (2011), the United States Supreme Court held that a bankruptcy court, as a non-Article III court (i.e. courts without full judicial independence) lacked constitutional authority under Article III of the United States Constitution to enter a final judgment on a state law counterclaim that is not resolved in the process of ruling on a creditor’s proof of claim, even though Congress purported to grant such statutory authority under 28 U.S.C. § 157(b)2(C). The case drew much interest because the petitioner was former Playboy Playmate and celebrity Anna Nicole Smith.