Sum up the legal problems a company may run into during financial distress or while being restructured.
The idea
Once a firm is distressed or restructuring, several legal issues arise. In a US bankruptcy filing, the automatic stay halts collection actions and lawsuits. Claims are paid under the absolute priority rule: secured creditors first, then unsecured by seniority, with equity last. A trustee or debtor can reverse preferences, which are payments that let a creditor receive more than it would in liquidation, made within 90 days before filing (one year for insiders). A trustee can also reverse fraudulent transfers, which are transfers for less than reasonably equivalent value while insolvent (two years under the federal code, often longer under state law). Courts may subordinate claims of creditors who acted inequitably. A plan needs class approval by two-thirds in amount and more than half in number of voting claims, or a cram-down that is fair and equitable. Do not confuse the 90-day preference window with the fraudulent transfer look-back.
A practice question
What is the effect of the automatic stay when a company files for bankruptcy protection in the United States?
- It discharges all of the debtor's debts immediately upon filing.Why not: Confuses the stay with discharge, which occurs only at the end of the process under a confirmed plan.
- It prevents the debtor from selling any assets until the plan is confirmed.Why not: The debtor may sell assets in the ordinary course and, with court approval, outside it.
- It applies only to unsecured creditors and leaves secured lenders free to foreclose.Why not: Secured creditors are also stayed, although they may ask for relief from the stay.
- It halts most creditor collection actions on pre-filing claims, including lawsuits and foreclosures. - correct
The automatic stay arises on filing and stops most collection efforts, protecting the estate so value can be preserved. It is not a discharge and is not limited to unsecured creditors.
A harder one
A company files for bankruptcy. The trustee reviews prior transfers. Assume the debtor was insolvent throughout and none of the transfers was in the ordinary course. Which transfer is most clearly subject to avoidance as a preference?
- Repayment of an old unsecured loan to an unrelated bank, made 120 days before filing, when the firm was insolvent.Why not: Applies the 90-day window to a non-insider payment made outside it, so it is not a preference.
- A payment to a fully secured lender 30 days before filing.Why not: A fully secured creditor receives no more than it would in liquidation, so the payment is not preferential.
- Repayment of an unsecured loan to a director 8 months before filing. - correct
- Payment for goods delivered the same week, under normal trade terms, 40 days before filing.Why not: A contemporaneous exchange in the ordinary course is not a preference; value was given at the time.
The preference period is 90 days before filing, or one year for insiders. A director is an insider, 8 months is within one year, and an unsecured creditor gets more than it would in liquidation. The other transfers are outside the window or lack a preference.
The hardest tier
In a Chapter 11 case a class of unsecured creditors with voted claims of 100 million is considered for plan approval. Of the 20 creditors who voted, 9 holding 70 million voted to accept. Which statement is correct?
- The class has accepted, because 70% in amount exceeds the two-thirds threshold, which is the only test that applies to a class.Why not: Applies the amount test only and ignores the numerosity test (9 of 20 is 45%, not more than half).
- Not accepted: acceptance needs a majority in number as well as two-thirds in amount, so only cram-down can confirm the plan. - correct
- The class has not accepted, because 70% is below the 75% required in amount.Why not: Misremembers the amount threshold; it is two-thirds (66.7%), which 70% exceeds.
- The class has accepted, because 9 of 20 creditors exceeds one third of the voting creditors.Why not: Uses a one-third blocking figure as the acceptance test; acceptance needs a majority in number.
Class acceptance needs both two-thirds in amount of voting claims (70% passes) and more than half in number of voting creditors (9/20 = 45% fails). The class therefore rejects, and the plan needs cram-down under the fair and equitable test.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
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