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12
T H E P R I M E R U S P A R A D I G M
next, unsecured creditors then follow and
finally equity is at the bottom. All credi-
tors in the same class of creditors must
be treated the same way:
·
Generally, secured creditors are
entitled to get paid in full (up to the
value of their collateral) or to get their
collateral back;
·
Unsecured creditors often get partial
payments, but they all have to be
dealt with the same way. For example,
if the plan calls for the unsecured
creditors to get 50 cents on the dollar
in monthly payments over a two-
year period, they must all be given
the same terms. The calculation of
how much will be paid to unsecured
creditors will often be the result
of negotiation with the creditors'
committee taking into account how
much the company can reasonably be
expected to set aside in the future to
pay creditors after paying expenses
for operations;
·
Under the "absolute priority rule"
unless the unsecured creditors are
paid in full, the equity holders cannot
participate and retain their ownership
of the company. As a practical matter,
the creditors of a smaller company
are usually not interested in operating
that company and if they stand any
hope of seeing a recovery after the
Chapter 11, it typically is because
the current ownership continues
ownership and operation of the
company after bankruptcy. Creditors
do, however, often use this "absolute
priority rule" as leverage to make
sure that the company pays them the
most that can reasonably be expected
as part of the reorganization plan
that is negotiated by the parties and
approved by the court.
Often it is evident that a company
cannot survive the Chapter 11 process
either because it cannot obtain financ-
ing or for other strategic reasons. The
company's assets may however have
value to a third-party buyer. Buyers are
often very cautious about buying the
assets of a troubled business because of
the concern that the company's creditors
could pursue the acquired business on
various legal theories including "succes-
sor liability." The sale through a Chapter
11 bankruptcy offers the buyer a means
to acquire the assets without concern that
a creditor of the seller will pursue the
buyer. It also offers the creditors of the
seller a way to maximize the value of the
assets by selling them to a buyer rather
than simply liquidating the company.
Such a sale is called a "section 363"
sale, as the process takes place under
section 363 of the Bankruptcy Code.
In a section 363 sale the assets
which may be subject to bank and other
judgment liens can be sold free and clear
of liens so that the buyer receives the
assets lien free. The cash proceeds paid
by the buyer for the assets then attach to
the liens in the same order and priority
as the liens previously attached to the
assets. This process allows the assets to
be sold for the maximum price, leaving
the disputing parties to litigate over the
cash paid.
recovery rights in Bankruptcy
Preferences
A trustee in a Chapter 7 bankruptcy and
the debtor in possession in a Chapter
11 bankruptcy have what are called
"avoidance powers" to recover moneys
paid out prior to the bankruptcy. One of
the purposes of bankruptcy is to treat
creditors of the same class equally.
Sometimes when a business is in trouble
and is about to file bankruptcy, it pays
to creditors who scream the loudest,
or those creditors whom the owner has
personally guaranteed. These payments
may be considered a "preference." While
a preference is not illegal, the payment
may be recoverable in the bankruptcy.
Since the bankruptcy system is designed
to treat creditors fairly and equally, if one
creditor has been preferred, the funds
may be recovered and divided among all
like creditors.
A payment is considered a preference if:
·
There is a transfer by the company,
whether voluntary such as a payment
to a creditor, or involuntary such as a
judgment obtained by a creditor;
·
It is made within 90 days prior to
the bankruptcy, or in the case of a
payment to an insider (such as a
relative or a director), it is paid within
one year prior to the bankruptcy;
·
It is paid on account of antecedent
debt (i.e. a debt that is not current).
So for example, payment of a current
bill even if paid within 90 days is
not a preference. The result may be
different if the bill is past due;
·
Paid while the company is insolvent
(liabilities exceed the assets);
·
As a result of the payment the
recipient creditor receives more
money than it would have as a result
of a liquidation of the company in a
Chapter 7.

There are several defenses to a
preference, including that the payment
was made in the ordinary course of
business of the company, or that the
payment is for a contemporaneous
exchange for new value, for example a
COD payment and delivery of goods.
Fraudulent transfer
One of the other frequently used
avoidance powers is a fraudulent transfer
recovery. It sometimes occurs in the life
of a business that is in financial distress
that there are transactions by which
the owner either intentionally caused
the business to transfer assets in order
to remove the assets from the grip of
creditors (called an intentional fraudulent
transfer), or where assets are transferred
but without "reasonably equivalent"
value (called a constructive fraudulent
transfer). In both of these cases the
trustee in bankruptcy or the creditors'
committee can seek to recover such assets
which are transferred within four years
prior to the bankruptcy.