Articles Posted in Case Update

By Guest Blogger: Paul B. Porvaznik, Esq.

When you file for bankruptcy, you sign sworn schedules that itemize your assets.  If you fail to fully disclose or update your asset summary, you risk a creditor objecting to your discharge on the basis of fraud.  Another peril of nondisclosure concerns claims that arise after the bankruptcy filing; like future lawsuits.   So, what happens if a claim develops after you file your bankruptcy petition but before you are granted a discharge and you don’t inform the bankruptcy court of this claim?  That’s the question examined in Schoup v. Gore, 2014 IL App (4th) 130911 (4 Dist. 2014), a case that will doubtless serve as a cautionary tale for future bankruptcy petitioners.

 In Schoup the debtor filed in 2010 and obtained a discharge in 2012.  Several months into the case the debtor was injured on private property, giving rise to a premises liability claim.  The debtor didn’t tell the bankruptcy court or trustee of the premises suit until after his bankruptcy case was discharged. Indeed, after obtaining his discharge the debtor filed that claim. The property owners moved for summary judgment on the basis of judicial estoppel, arguing that the plaintiff’s failure to disclose the suit as an asset in his bankruptcy barred the post-discharge action entirely.  The trial court agreed and the plaintiff/debtor appealed.

Ruling: Summary judgment affirmed. Why? Because the judicial estoppel doctrine barred the plaintiff’s premises liability suit.  Judicial estoppel prevents a litigant from taking a position in one case and then, in a later case, taking the opposite position (i.e., you can’t claim that you’re an independent contractor in one case and then in a second case, claim that you’re an employee).  Judicial estoppel’s purpose is to protect the integrity of the court system and to prevent a party from making a mockery of court proceedings by conveniently taking whatever position happens to serve that party at a given moment.  (¶ 9).  The five elements of judicial estoppel: (1) two positions are taken by the same party; (2) the positions must be taken in judicial proceedings; (3) the positions must be taken under oath; (4) the party must have successfully maintained the first position and received a benefit from it; and (5) the two positions must be “totally inconsistent.” (¶ 10).  Illinois courts have consistently held that a debtor who fails to disclose an asset – including an unliquidated lawsuit – can’t later realize a benefit from the concealed asset after discharge.  (¶ 14).

The Court agreed with the trial court that all five elements were met.  First, the plaintiff took two positions: he impliedly represented to the bankruptcy court that he had no pending lawsuits and then filed a personal injury suit in state court after discharge.  The two positions were taken in judicial proceedings (Federal bankruptcy court and Illinois state court) and under oath (the plaintiff signed sworn disclosures in the bankruptcy court and filed a sworn complaint in state court).  The plaintiff also obtained a benefit from concealing the premises liability case as he received a discharge without any creditor knowing about the state court claim.  Finally, plaintiff’s positions were “totally inconsistent”: he omitted his personal injury case from his bankruptcy schedules and then filed a state court personal injury suit after he got his discharge. (¶¶ 17-18).

In conclusion, a party that had absolutely nothing to do with the plaintiff’s prior bankruptcy was able to get a case dismissed because the plaintiff didn’t update his asset schedules to account for an inchoate lawsuit.  The case is a great reminder to always check on-line bankruptcy records to see if a plaintiff suing your client has any prior bankruptcies.  More than once I’ve found that a plaintiff recently received a discharge before filing suit and never disclosed the lawsuit as an asset in the bankruptcy case.  In those situations, the plaintiff, not wanting to deal with a judicial estoppel motion (like the one filed by the defendants in this case), is usually motivated to settle for a reduced amount and in one case, even non-suited the case.  Viewed from the debtor’s lens, I counsel clients to fully disclose all assets – even lawsuits that haven’t materialized on the bankruptcy filing date.  Otherwise, they run the risk of having a creditor challenge the discharge or even having a future lawsuit dismissed; like the plaintiff in this case.

My other observation concerns the “sworn statement” judicial estoppel element.  What if the state court complaint wasn’t verified under oath?  Would that still meet the sworn statement criterion?  It’s unclear from the text of the opinion.  If the complaint wasn’t verified, I think I’d argue that the plaintiff didn’t take two sworn contradictory positions.

Paul Porvaznik Photo

About the Author: Paul B. Porvaznik, Esq. is a business litigation attorney practicing in Chicago at the firm of Molzahn, Rocco, Reed & Rouse, LLC, a full-service litigation firm.  He has practiced for 17 years primarily in the areas of general civil litigation, mechanics liens, landlord-tenant law, collections, post-judgment enforcement and general business disputes.

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In June 2013 the US Supreme Court published an opinion arising from a dispute over the estate of Pierce Marshall – better known as the husband of Anna Nichole Smith. That case, Stern vs. Marshall, gave rise to a surprising decision; namely, that Bankruptcy Courts could not rule on the State-law aspects of a dispute even if they were before the Bankruptcy Court as part of the larger dispute. The operative distinction would henceforth come down to whether or not a dispute qualified as a “core proceeding” (i.e. whether it was the kind of question over which the Bankruptcy Court had jurisdiction).

Since the Stern decision was released in 2011, results across the country have often been inconsistent as Bankruptcy Lawyers and Judges attempt to apply this new set of distinctions and decide whether cases should be heard or referred back to the State Courts. In many cases, Bankruptcy Courts defaulted back to State Courts without much discussion.

In an update and clarification to its Stern vs. Marshall Opinion, the Supreme Court recently decided Executive Benefits vs. Ch. 7 Trustee for Bellingham Ins. Agency(Jun. 09). The opinion answered a number of questions that had arisen in the wake of Stern. In particular, the Supreme Court clarified how Bankruptcy Courts should proceed when faced with “core” claims that were now designated as “non-core” under the Stern standard. These claims fall into the so-called “statutory gap” in the Bankruptcy Code.

In its Opinion the Supreme Court observed that 28 U.S.C. §157(c) does in fact permit “Stern” type claims to proceed before the Bankruptcy Court as non-core claims. How? The Supreme Court explained it this way:

With the “core” category no longer available for the Stern claim at issue, we look to section 157(c)(1) to determine whether the claim may be adjudicated as a non-core claim – specifically, whether it is “not a core proceeding” but is “otherwise related to a case under title 11.

In short the Supreme Court determined that, when faced with a Stern claim, the Bankruptcy Court must now decide whether it satisfies the standards of 28 U.S.C. §157(c)(1). If it doesn’t, the Bankruptcy Court could not hear the claim and had to send it back to State Court. If it did however, the the Bankruptcy Court was to “hear the proceeding and submit proposed findings of fact and conclusions of law to the district court for de novo review and entry of judgment.”

Chapter 13 Bankruptcy

[T]here are known knowns… known unknowns … and unknown unknowns… things we do not know we don’t know.—US Secretary of Defense Donald Rumsfeld

When it comes to Bankruptcy, many Debtors don’t know what they don’t know about real estate taxes. Confused? So were the District Courts until the 7th Circuit Court of Appeals addressed the issue in the case of In re LaMont, Opinion 13-1187 (January 7, 2014).

The 7th Circuit began its analysis in LaMont by acknowledging the 2 kinds of real estate taxes with which Debtors must deal:

(a) Sold; and (b) Unsold.

The 2 are treated differently under State law and receive distinct treatment in a Plan of Reorganization as well:

Unsold taxes can be paid through the Plan in the same way that a Debtor would pay arrears to a secured creditor like a mortgage company. The rationale for such treatment is that the taxing body – the County – is presumed to have a secured lien in the subject property for its taxes. Moreover, those axes cannot be sold once a Bankruptcy Petition is filed. Such taxes generally get paid directly to the County Treasurer via the Plan.

Sold taxes are trickier. They can be paid through the Plan like unsolid taxes, but only so long as the “redemption period” has not expired. Even if the redemption period expires during the Plan, sold taxes can still be paid over the rest of the Plan period. And while that is taking place, the Automatic Stay will remain in effect to prevent Tax Buyers from redeeming the sold taxes or forcing a sale of the underlying property (the typical State law remedy).

In LaMont the issue was sold taxes. The LaMont Debtors owed real property in Minooka, Illinois on which the Village had levied a special assessment that they hadn’t paid. The Court noted that in this context a special assessment was deemed a property tax. Thus, the unpaid assessments were disposed of at a tax sale. Shortly afterwards the Debtors filed Chapter 13 and their Plan provided for payment of the assessment directly to the Village. However, the Plan did not identify. nor did notice go out to, the tax buyer. Nonetheless, the Plan was confirmed and the Debtors made payments to the Trustee who distributed them to the creditors including the Village.

But was the tax buyer bound by the terms of the confirmed Plan even though he had not been notified? In answering the questions the Court conducted a thorough analysis of the Illinois property tax system including tax sales and redemption periods – treating the sold special assessments the way they would sold property taxes.

The upshot of the analysis was that for the entirety of the redemption period – usually 2 to 2 ½ years, – a property owner could redeem his or her sold taxes by paying the County Clerk the past due amount, plus penalties and interest. Between 3 and 6 months before the expiration of the redemption period, a tax buyer had to file a Petition for Tax Deed with the Circuit Court, then take the resulting Order to the County Clerk to secure a Tax Deed, which then had to be recorded within a year. If those steps were not followed the tax buyer would lose his interest in the subject property. That is time enough for the property owners to act, but here the time period was tolled because of the Bankruptcy. Still, the Debtors neither identified the proper party to pay nor made adjustments to their Plan of Reorganization.

The LaMont the tax buyer filed his Petition for Tax Deed with the Circuit Court 3 years after the Debtors filed Bankruptcy and the Circuit Court denied it. The tax buyer then filed a Lift Stay Motion in the Bankruptcy Court, which denied the Motion because he was ostensibly being taken care of in the Plan. The tax buyer appealed, arguing that the Stay should not apply since he was not given notice of the case. But the District Court affirmed the Bankruptcy Court.

The tax buyer had also argued that his interest was in the real property, so it was not an interest against the Debtors. In other words he argued that his interest automatically divested the Debtors of their interest in the property after the redemption period expired. In response the 7th Circuit first examined whether or not the tax buyer had a claim, concluding that he did even though there wasn’t a traditional creditor-debtor relationship present. Nonetheless, the Court found that the tax buyer did not have an executory interest in the property itself: he merely had a tax lien on the property.

In reaching its decision the LaMont Court reviewed Illinois case law in concluding that, while there were differences, precedent favored the treatment of sold taxes as a lien. Since the tax buyer’s claim was deemed to be a lien, it could be modified under Section 1322(b)(2) of the Bankruptcy Code and the Debtors could force him to take payments even past the redemption date as long as the Plan was in effect.

In short, sold taxes can be addressed in a Plan of Reorganization but notice should be given to the payee or the Debtors risk paying into their Plan for 5 years only to end up with no credit towards their sold property taxes – and in the end stand to lose their home. Sad but true.

Battle Royale

A Little Light Reading

Are you excited to read about a dispute between competing secured creditors for the priority of their liens in property of the Bankruptcy Estate? Of course not.

Lucky for you issues such as these are generally heard in State court rather than in Federal Bankruptcy courts. Why? Because real property is considered a unique feature of the state and county in which it is located. Local features get local treatment.

But priority disputes can, and do, get played out in Bankruptcy court. For example take the case of In re Jones, 2011 WL 6140686 (Bankr. SD IL 2011) in which Debtors in a Chapter 11 case owned several pieces of property encumbered with mortgages cross-collateralized with other property of the Estate.

1st mortgage on Property #1 was taken by Bank #1, cross-collateralized, and provided that the maximum secured liability under its terms was approximately $214,000.

2nd mortgage on Property #1 was taken by Bank #2.

Both mortgages were timely recorded and Bank #2 did not contest its priority status. But then something happened.

1st mortgage on Property #2 was taken by Bank #1 and cross-collateralized with its mortgage on Property #1.

Since the interest of Bank #2 was not yet recorded when the additional loan from Bank #1 was taken, Bank #2 found itself in a tentative position.

Got all that? Because here is where it gets interesting…

As part of their reorganization, the Debtors sought lave to sell, and the Court agreed to permit the sale of, Property #1.  But by that time the Great Recession was in effect. Property #1 was not worth nearly what it had been when the loan was taken. In fact, it looked as if a sale of the property would not even generate enough to pay off all the lenders.

That’s when the fighting started.

Eventually Property #1 sold for $388,000. At that time Bank #1 was owed $115,000 under the terms of its 1st mortgage, plus more than $300,000 under the loan against Property #2. Bank #2 looked to be owed more than $300,000. But it was Bank #1 that sought all sale proceeds; so when Bank #2 objected, the battle was on!

Come Out Swinging

At the core of In re Jones was the distinction between 2 equally accepted concepts found in Illinois law:

  • Actual Notice; and
  • Record (“Inquiry”) Notice

There was no denying that Bank #1 and Bank #2 had actual notice of  claims on Property #1. Nor could it be denied that Bank #2 did not know of Bank #1′s claim on the 2nd Property until it was too late.

Rather, the question was whether Bank #2 should have known of the cross-collateralization clause and investigated further. In its opinion the Court noted that the cross-collateralization clause was on the first page of the mortgage document so even a cursory review of the title records would have revealed it. The Court also went through an analysis of Illinois case law and the recording statute in reaching its decision.

The opinion in Jones explains record notice: if a mortgage is properly recorded, then actual knowledge is no longer important. The burden of due diligence shifts to subsequent lenders who can, and should, search public records. The Court explains inquiry notice in a similar way. Where a lender has been made aware of facts or circumstances that lead it to believe there could be other liens on a property, that lender has a duty to perform a diligent inquiry.

The Decision and Appeal

Here, the Court found Bank #2 knew about the senior mortgage and cross-collateralization – the language was on the front page of the mortgage document, which was sufficient to put Bank #2 on inquiry notice that its borrower might have additional loans that could trigger the cross-collateralization. Finally, since Property #2 was in the same county as Property #1, the loan could easily have been discovered.

On appeal, the 7th Circuit affirmed the Bankruptcy Court and found for Bank #1.

There are many instances where priority fights occur in bankruptcies. Cross-collateralization is a frequent case, but refinancing can also trigger such clauses. Generally, the lender who refinances will get a formal subrogation agreement to eliminate a potential priority fight, but even if it doesn’t, equitable subordination will allow it to keep its priority intact.  

Questions about your own situation? Contact us for a no-cost consultation.

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In Illinois, as in most jurisdictions, retirement funds like 

  • Pension proceeds
  • 401(k) accounts
  • 403(b) accounts
  • IRA’s and Roth IRA’s 

constitute exempt assets that cannot be taken away in Bankruptcy. 

But what if a Debtor were to inherit an IRA? Would the inheritance still be “exempt?”

This was the issue before the Bankruptcy Court for the Western District of Wisconsin in the case of In re Clark. The Clark Court found that the retirement funds did not retain their exempt character. 

The 7th Circuit Court of Appeals agreed; noting that  11 USC 522(b)(3)(C) and (d)(12) only makes an IRA exempt if it is part of a tax exempt fund  Thus a spouse that inherits or rolls over a retirement fund can take advantage of the exemption because they are bound by the same IRS rules that bound the deceased – that money could not be withdrawn (without penalty) until the inheritor reached age 59 1/2. But if the inheriting spouse wanted to take a distribution before then, the transfer or rollover would be retroactively treated as a taxable event.

Rules applicable to a non-spouse inheritor are even more strict, and those differences played a large role in the decision of the 7th Circuit. As noted by the Court for instance, the Debtor in Clark inherited an IRA from her mother since she was the beneficiary. But an inherited IRA cannot be rolled over into another IRA, and additional funds could be be added to the inheritor’s IRA per 26 USC 408(d)(3)(C)); and since all distributions from the inherited IRA would have to commence within a year according to 26 USC 402(c)(11)(A), the Court refused to treat those funds as exempt because doing so would be the equivalent of form over substance.

Unfortunately, resolving this issue isn’t that easy. The 7th Circuit isn’t the only Federal Appeals Court that has considered this issue: and wouldn’t you know it, there’s a circuit split. 

The 5th and 8th Federal Circuits treat inherited retirement funds as exempt. See In re Nessa, 426 BR 312 (BAP 8th Cir. 2010), In re Chilton, 674 F.3d 486 (5th Cir. 2012). The rationale is that 522(b)(3)(C) of the Bankruptcy Code specifies that retirement funds in the Debtor’s possession are exempt.

The 7th Circuit on the other hand examined the nature of the inherited funds following their distribution. Since such funds could not be held until Debtor’s retirement, to simply treat them as retirement funds would exalt form over substance. Put another way, the 7th Circuit believed inherited IRA funds were an “opportunity for current consumption, not a fund for retirement savings.”

Since there is a Circuit split on this issue, it is important to determine which way the wind blows where you are; and if the Debtor has a choice as to where to file, it would be a wise to keep these factors in mind. An interesting issue not addressed by the Clark opinion is this: 

What if the Debtor in that case had actually within a year of retirement (i.e. 59 1/2 years old)? 

In that instance, an inherited IRA could be held until the Debtor’s retirement. Ultimately that is a case for another day. 

But if Clark is the law of the land then another question comes to mind: 

Is there a way around the harsh results of the 7th Circuit’s Clark decision? 

Well, other than filing in the 5th or 8th Circuits, the answer seems to be that in order to avoid such a problem, estates would have to roll their IRA’s into Trusts having a valid discretionary or spendthrift provision. Under those circumstances the money in the Trust would still be exempt from Bankruptcy execution (albeit not because it was in an IRA but because it was in a spendthrift trust).

As usual, no perfect solution, but it pays to plan. Thinking of your estate or planning for the future? Contact us for a free consultation to find out how to deliver more to your heirs and less to Uncle Sam.

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Yes Virginia, it is possible to both discharge unsecured debts forever (Chapter 7) and strip down secondary mortgages (Chapter 13). The result is a so-called “Chapter 20.” But should Debtors file two cases when it’s hard enough to put themselves through one? Read on and find out.

When Is Chapter 20 a Good Idea?

There are situations that fairly cry out for Chapter 20 treatment:

Situation #1: Debtor is burdened with priority unsecured obligations like IRS debt, that must be completely retired in Chapter 13. But that would yield unsustainably high monthly payments. By contrast, once the Debtor’s unsecured obligations are discharged, the resulting Chapter 13 plan payments become downright manageable. Chapter 20 is the solution.

Situation #2: Debtor’s mortgage exceeds the value of the Debtor’s home (i.e. the property is “underwater”). Chapter 7 cannot help the Debtor ameliorate their high payments or deal with their delinquent second mortgage. All Chapter 7 can do is give the Debtor an opportunity to reaffirm the mortgage(s) on the same outrageous terms. Chapter 20 is the solution because it permits the Debtor to treat its second mortgage like an unsecured debt and pay only pennies on the dollar to retire it.

How Does Chapter 20 Help, Exactly?
Chapter 20 works by reducing the overall amount of debt to be paid, then stretches that smaller sum over as many as 60 months. Practically speaking, Chapter 13 plan payments are determined by 2 factors:

  • The Means Test imposed by the 2005 BAPCPA Amendment to the Code; and
  • The amount of secured claims, arrears, and priority debts the Debtor must pay

This is where Chapter 13 Debtors may take advantage of the lien strip – an option not available in Chapter 7 – that allows them to treat secured loans on owner-occupied property as unsecured, and pay down those loans at far less than face value.

What is Lien Stripping, Again?

Lien stripping is the process of treating some “secured” loans as unsecured: it applies only when the property in question is “underwater” – i.e. its market value is exceeded by the face value of the primary mortgage. In that case the 2nd mortgage or home equity line of credit (HELoC) is really unsecured and may be paid under the plan of reorganization at the same rate as other unsecured debt – $.10 on the dollar, $.50 on the dollar, etc. And Boom! goes the dynamite.

Are People Using Chapter 20 Successfully?

In re Davis, 4th Cir., slip opinion 12-1184 (2013), the latest case to discuss the legitimacy of Chapter 20 lien strips, points out that Chapter 7 eliminates personal liability but leaves in rem interests like mortgage liens undisturbed. It goes on to point out that an interest is “secured” only to the extent of the creditor’s interest in the
underlying real estate. See Code §506. Thus, if a house is worth
less than its primary mortgage then 2nd and 3rd liens are
unsecured by definition. And since §1322
of the Code permits the modification of the rights of unsecured creditors, a lien strip is both warranted by the facts and supported by the law. Finally, the Davis Court points out that while not every circuit has explicitly ruled
on lien stripping, the 2nd, 3rd, 4th, 5th, 6th, 9th, and 11th Circuits have, and all have permitted it.(Id.

at 7). 

Last But Not Least…

The
only remaining question is whether a Debtor must receive a discharge at the end of its
Chapter 13 case in order to complete a lien strip; or if the mere
completion of its plan of reorganization is sufficient. The issue
arises here because the BAPCPA mandates that once  a discharge is received in a Chapter 7 case the Debtor must wait 4 years to file Chapter 13 and obtain another discharge. Realistically however, a Debtor that has received a Chapter 7 discharge does not need a Chapter 13 discharge on top of it. Unfortunately, there is no consensus in this area.  Even in the Northern District of Illinois the answer
may depend on your Judge (cf In re Fenn, 428 B.R. 494 (Bankr. ND Ill. 2010) with
In re Anderson,
10-B-45294 (unreported)).

Conclusion

Bankruptcy discharges affect only personal (in personam“) liability: a discharge does not simply cause liens on property to disappear. As set forth in Sec.1322(b)(2) of the Bankruptcy Code, a plan of reorganization may only modify the rights of unsecured creditors. A lien strip exposes the wholly-unsecured lien on real property and, under the auspices of Code Section 506, allows the Debtor to pay off that “secured” interest for pennies on the dollar, as if it were merely an unsecured interest (which it really is).

Sure, a Chapter 20 lien strip is just the thing for homeowners with too much unsecured debt and a lousy second mortgage or HELoC hanging over their heads. But is it right for you. Call us in confidence to find out. Happy stripping!

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Q: Can a Citation to Discover Assets filed prior to  a Bankruptcy

case have an affect on the resulting Bankruptcy estate?

A: You Bet It Can …

The Facts


In the 7th Circuit Case of In re Porayko, appealed from the Bankruptcy Court for the Northern District of Illinois, a Citation to Discover Assets was served on a year before the Debtor filed bankruptcy, while a 3rd Party Citation was served on his bank the month he filed. The creditor moved for relief from the Automatic Stay to seize the $10,000 in the Debtor’s bank account and the Trustee objected on the basis that the initial citation had not created a lien, while the 3rd Party Citation was avoidable pursuant to 11 USC 547.

The Law
Citations to Discover Assets are addressed in Illinois Statutes, Section 5/2-1402. According to Sec. 1402(m) a Citation to Discover Assets creates a lien on all

“nonexempt personal property including money, choses in action and effects of judgment debtor” as well as “personal property belonging to the judgment debtor in the possession or control of the judgment debtor or which may thereafter be acquired or come due…”

Illinois cases support the concept that a checking account is personal property to which a lien may attach. See Chicago v. Air Auto Leasing Co., 297 Ill. App. 3d 873, 878 (1st Dist. 1998), a problem for the Trustee.

The Argument
The Trustee in Porayko tried to distinguish Air Auto Leasing by pointing out that other Illinois Courts treated bank accounts as mere promises to pay rather than items of personal property that could be subject to a lien. The leading case of its kind, Citizens Bank of Maryland v. Strumpf, 515 US 16 (1995), dealt with whether a bank could offset a payment while the Debtor was in Bankruptcy. But the Porayko Court found the situation before it to be quite different, and concluded that the creditor’s citation had created a secured interest in the checking account, so the relief from the Automatic Stay granted by the Bankruptcy Court was proper. 

Surprisingly, this meant that under the proper circumstances the lien of a pre-filing creditor could trump the interest of a Bankruptcy Trustee: a notion that would appear to stand the law of insolvency on its head.

The Takeaway
The takeaway from the Porayko case is that Debtors are wise to address debts before their creditors secure judgments that turn into liens. At a minimum, a Debtors ought to file soon enough so that creditors cannot perfect their judgment liens and trump the case Trustee.

Continue reading →

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Everything Was Going Fine Until…

Your customer or borrower has been paying like clockwork and you, the creditor or vendor, have been dispensing goods and services as promised. Then your customer starts to pay a little later, then later still. Why not? Times are tough. So you do the decent thing and take their payments without complaining. Next thing you know, your customer seeks bankruptcy protection, leaving you holding the bag for thousands, tens of thousands, even hundreds of thousands of dollars worth of goods and services. Money you’ll never see again. 

The Worst Part Is (Not) Over

You’re out a lot of material, and now you’ll never get paid. Sure that’s tough to take, but at least the worst part is over, right? Wrong.

All sums paid by customers or clients in the 90 days before a bankruptcy is filed are de facto preferences. In other words, sums paid in the 3 months before a bankruptcy case is filed can be recouped by the Bankruptcy Estate without a guaranty of ever getting that money, or any portion of it, back.

Most creditors think that once a payment is received, all is good and they can move on. This is not the case if a customer filed bankruptcy. Sections 547 and 550 of the Bankruptcy Code allow a Trustee (in Chapter 7 cases) or Debtor in Possession (DIP) in Chapter 13 or 11 cases to recover preferential transfers

Will you have this problem? Was your customer’s payment a preferential transfer? Short answer: “Yes it was” if

  • payment was for the creditor’s benefit    See 547(b)(1)
  • on account of antecedent debt   (i.e. bought on credit)
  • for goods or services that were received  See 547(b)(2)
  • while a Debtor was insolvent as defined  See 547(b)(3)
  • within 90 days before a bankruptcy filing See 547(b)(4)

Note: It is immaterial whether the vendor or creditor knew, had reason to know, or suspected a borrower or customer was about to file for bankruptcy or was insolvent. Once the case is filed the 90-day look-back is automatic. See 547(f)

Taken literally these rules mean creditors ought to stop lending, and vendors stop selling, if there is any concern about the financial health of the borrower or customer. Of course if that happened creditors and vendors could fail themselves. So what should creditors really do? While there is no one-size-fits-all answer, here is a list of 3 Don’ts and 1 Do If a Customer or Borrower Files Bankruptcy:

Don’t 

  • Volunteer to return sums paid by your Customer or Borrower. The case Trustee or DIP must first calculate what is due, decide whether to attempt to recoup it, and file a motion with the Court. 
  • Contact your customer and raise hell – that will only make things worse.
  • Represent your own interests in Bankruptcy Court. You wouldn’t perform brain surgery on yourself, would you?

Do 

  • HIRE A LAWYER 

Why only a single “Do?” And why put it in all caps? Because Bankruptcy Courts already favor the Trustee or DIP. Failing to hire a good lawyer to argue on your behalf if like bringing a knife to a gunfight, partner.

Defenses to a Preference Action

All doom and gloom aside, there are defenses that creditors can use when confronted with a motion to recover preferential transfers.The 2 most common defenses are 

  • Contemporaneous Exchange for Value; and 
  • Payment in the Ordinary Course of Business

A so-called Contemporaneous Exchange is essentially a COD arrangement. The creditor will supply goods and is paid on delivery or within a few days thereafter – functionally at the same time. These payments can be defended as non-preferential transfers.

The Ordinary Course of Business defense is more subjective: it relies on the way the parties treat each other. For instance if a vendor supplies goods to the buyer on a standard basis like Net-30, and the buyer pays as envisioned, then the payments made according to those terms can be defended as non-preferential transfers.

The Limits of the Ordinary Course Defense

Several recent cases have weighed in on the Ordinary Course of Business defense and shed light on the limits of this theory. 

In In re Universal Marketing, 481 B.R. 318 (Penn. E.D. 2012) the Chapter 7 Trustee sought to recover two $25,000 payments made to the Debtor’s financial advisor. An Engagement Letter had been executed before the bankruptcy providing for 7 months worth of service at the rate of $25,000. The Debtor had made its monthly payments, but some had been late: opening the door for for the claim that no ordinary course defense existed. The Court disagreed, and found that the subject payments were made in the ordinary course of business. In its Opinion, the Universal Marketing Court considered the following facts:

  • the existence of an agreement (the engagement letter)
  • the services offered were of the type the debtor needed
  • the creditor was in the business of providing such services
  • length of time during which the arrangement was in place
  • that the payments were typical for such an arrangement
  • that the creditor did not exert undue influence to get paid.

The Court found the payments under consideration to be consistent and proportional to fees charged by the creditor for like services to other customers. This only left the occasional late payment. But the Court noted that this amounted to just a few days: too small of a divergence to transform them into preferential transfers. 

In re Mainline Contracting, 2012 WL 5247173 (N.C. BK 2012) was a Chapter 7 case involving not only late payments by the Debtor but lax collection tactics by the vendor. To begin with, Invoices clearly labeled “Net 30″ had seldom been paid within 30 days by the Debtor. What’s more, in the year leading up to the bankruptcy filing the Debtor took an average of 79 days to pay, with the number creeping up as the Debtor neared its bankruptcy filing date. Then there was testimony that the Debtor actually never paid before 90 days, unless the creditor called or emailed to inquire. There had also been a number of instances in which the Creditor put the Debtor on a COD basis due to its poor payment history, the Debtor would catch up, and the whole process started over. Eventually the Debtor filed for bankruptcy and the Trustee sought to recover certain payments.

The Marine Contracting Court found that the payments in question were not preferences, and thus not avoidable. In reaching its decision the Court noted that

  • although the invoices read “Net 30,” that was not the practice of the parties
  • the creditor would continue to supply materials on credit even when not paid
  • it was only after invoices were 60+ days overdue the creditor demanded payment
  • it was only after invoices were 90+ days overdue that the creditor switched to COD
  • such behavior was consistent over both the baseline period and the preference period 

The weightiest factor in the Court’s analysis was the behavior of the parties during and before the the 90-day preference period.The consistency of that treatment indicated that these were truly payments made in the ordinary course of business.

Take-Away:What Does It All Mean?

The takeaway from this discussion is that creditors should strive to be consistent in the way they treat customers. Talk to cistp,ers about past-due payments. Follow up consistently and in a timely fashion. If payment terms are “Net 30″ for instance, send reminders at 45 and 60 days. And if a customer is a bad payer consider COD or a prepayment arrangement. After all, if credit is not extended there can be no preference action.

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Okay nobody dies, but the case does address the long-overdue question:

What happens when the property taxes of a Chapter 13 Debtor, protected by the Automatic Stay, are sold at auction? 

Here the Bankruptcy Court for the Northern District of Illinois, Eastern Division, had to decide whether a Chapter 13 Plan of Reorganization affects the deadline for the Debtor to redeem sold taxes. 

The answer is, Yes. Who says tax sales + bankruptcy doesn’t = fun?

The main issue was as follows: 11 USC 108(b)(2) provides that if a time frame established under applicable non-bankruptcy law determines when and where the debtor can cure a default, then that date is extended by 60 days from the entry of an order for bankruptcy relief. At the same time however, 11 USC 1322(b)(2) provides that a Chapter 13 debtor may take up to 60 months to pay liabilities such as past due real estate taxes. The question was, which section ought to prevail under the circumstances of the case?

As of the initiation of the case, there was a split within the Northern District of Illinois as to which section of the Code ought to win the day. Older opinions tended to take a rigid view of Section 108 and held that 60 days was it: no Plan of Reorganization could change that. See In re Murray, 276 BR 869 (Bankr. N.D.Ill 2002), and Smith v. Pheonix Bond, 288 BR 793 (N.D.Ill 2002). But newer cases had taken a more holistic view and concluded that since a primary driver of the decision to file Chapter 13 case is the debtor’s determination to keep their primary residence and cure mortgage deficiencies over the life of the Plan of Reorganization, it was only natural to extend that logic to real estate taxes and other debts that affect how ownership. This line of reasoning is well demonstrated by Judge Wedoff’s opinion in the matter of In re Bates, 270 BR 455 (Bankr. N.D.Ill 2007), as well as Judge Hollis’ opinion in In re Kasco, 378 BR 207 (Bankr. N.D.Ill 2007).

A “tax buyer,” i.e. one who purchases unpaid property taxes from the County, has no legal claim against a debtor but, rather, an in rem interest against the debtor’s real property. So, as with any other party holding an in rem interest, the tax buyer can – and according to the opinion, should – file a claim in the debtor’s Chapter 13 case. In bankruptcy, creditor’s claims are often modified by the debtor’s plan. Payment terms can be extended, interest rates can be modified, and in the case of a plan of reorganization in Chapter 13 or 11, claims can be paid off at a fraction of their face value. In other words, debtors who face this problem and file Chapter 13 as a means to deal with it are not counting on the ability to extend a non-bankruptcy deadline (by 60 days for instance), but rather the ability to pay off the underling debt within 60 months. 

If the above reasoning is correct, then as long as the tax buyer/creditor’s claim is honored in the debtor’s plan of reorganization, the creditor’s interest is preserved throughout the case; and if the debtor fails to successfully complete the plan, the creditor can snap back into action. This is no different than the situation of a mortgagee that must refrain from taking action to foreclose so long as the debtor is making the payments the Trustee and Court consider reasonable. Those “reasonable” payments, combined with the underlying secured claim, constitute adequate protection Adequate for what, you ask? Adequate to assure the tax buyer/creditor that they are getting their money’s worth, or at least that they are receiving no less than others of the same stature (secured creditors).

Put these pieces together and here is what they mean: so long as any creditor is adequately protected, they have no grounds to lift, modify, or annul the Automatic Stay and are effectively forced to wait out the debtor’s plan like everyone else. As always, the lynchpin of this system is for debtors to complete their plan payments and earn the removal of the tax buyer’s in rem interest in their property.

As an aside, the poor innocent tax buyer might think – Hey what about me, I only have a year to obtain a tax deed once the redemption period has expired. If the Debtor’s plan goes for 5 years, I could blow the statute and never be able to collect. Illinois law provides for this. Under 35 ILCS 200/22-85, if the tax buyer is prohibited by court injunction from obtaining the deed, the one year period is tolled during this time. Since the automatic stay is an injunction, tax buyers are protected.

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Guest Post By Jonathan Trent
Edited by M. Hedayat, Esq.

It’s that time of year again! As January winds down business owners are contemplating new projects, new ideas, and New Year’s resolutions. Putting together resolutions can be an eye opening experience… or a chore. Sure, you want to continue improving what works, weed out what doesn’t, and learn from the past to avoid making the same mistakes in the future. But when the rubber meets the road, how do you make that call?

Here’s a simple method that has been used by small businesses for year.

(1) Review the significant business events of the past year – marketing, financial, etc.

(2) Ask yourself “What worked? What didn’t? Could we have avoided that problem?”

(3) This is critical: repeat the process until you have turned over all events in detail

(4) Prepare these 3 distinct lists (be prepared to write and rewrite them as needed)

Things I Should Do Again: these worked and should be part of your workflow

Things Never To Do Again: these didn’t work, or they hurt more than helped

Tweak and Try Again: With changes, these practices could work

Sounds easy, right? Too bad it’s one of the hardest things you have to do as a business person. Not only is the self-reflection challenging, but the act of turning objective facts into recommendations and then seeing those recommendations through is… well, it’s what distinguishes good businesses from great ones.

Until you really complete your own business evaluation and give yourself a business-practices audit (a more formal term for this process), here are 5 New Year’s resolutions being put into effect by businesses right now!

Be More Earth-Friendly

There are several ways a business can go green. Using less power and less paper is a good start. Buy recycled materials. Install energy efficient lighting, heating, and cooling. This not only helps the environment but your business costs as well. You may be surprised how much a company can save after one year of saving energy and cutting costs.

Improve Communications

Install a new office communications network. Office phone systems can be built to suit your needs. Connect all your employees like never before. Get high-tech with voice activated phones, 3-way calling, and messaging services. Information is relayed quicker and clearer when all departments are better connected. Messaging and conference calls can help to bring in new clients and seal important deals.

Reevaluate Company Policies

Send out a new list of rules and standards and make sure all personnel know what is expected of them in any situation. What is the company’s policy of on social media? What are the consequences if it is misused during work hours? What should employees do if there is an emergency, power outage, or natural disaster? Making everyone aware of what is expected of them leaves no gray areas or confusion.

Offer Achievement Incentives

Gather and showcase the best employees based on sales figures, leadership, or morale. You could also send top employees to leadership or group training seminars. It’s amazing what this can do for your company. You may see a great change in your staff. Plan and implement team meetings, pep talks, or even parties. A lively, encouraged team will want to excel and work in a fun environment.

Financially Prepare for Next Year

Create a nest egg and be financially secure. You never know if certain laws may be passed and it means drastic company changes. You need to prepare long term. Be ready for possible problems that could result in company losses. Owning a business can be tough and you many need to take extra care to avoid paying more taxes, fees, or business owner penalties. Get business taxes done by a professional and keep perfect records.

And Finally…

Don’t forget to secure a Legal Audit to ensure compliance with applicable laws, regulations, and industry best-practices. How? That’s easy: contact M. Hedayat & Associates, P.C. for your Free Legal Audit. With over 18 years of legal experience under his belt, a string of start up companies to his credit, and an MBA in addition to his law degree Mazy Hedayat is ready to roll up his sleeves and tell you where your business stands from a legal perspective.

About the Author: Jonathan Trent is a web marketing specialist with NextUC, a provider of audio, video and web conferencing solutions. He is a sports fanatic that enjoys writing about the internet and modern technology. He has written several articles about the advancements and future of communication and technology.