by Scott Schuster, Esq.

A recent article in the Pittsburgh Post-Gazette indicates that bankruptcies are once again on the rise. With the economy in a deep recession and unemployment hovering at over 10% with no end in sight, this comes as no surprise. As an attorney that practices almost exclusively in bankruptcy, here are some of my observations about bankruptcies in the past year.

1) Increasingly, secured creditors find themselves “under water,” leaving little to nothing for unsecured creditors through traditional bankruptcy reorganization. In these trying times, 503(b)(9) “20-day” claims are extremely valuable and should always be analyzed before closing a collection file after a customers’ bankruptcy. Don’t assume that you’ll get paid through a plan of reorganization.

2) Many chapter 11 debtors are failing to reorganize due to the lack of “exit” financing in the financial market. This means that creditors doing business with chapter 11 debtors should keep credit terms tight and may want to consider having legal counsel keep an eye on the bankruptcy proceedings. Often times, legal counsel can spot a failure months in advance, allowing creditors to get paid before the debtor is forced to liquidate.

3) More and more, debtors and trustees are looking to preference actions as a means to fund distributions to unsecured creditors. This means creditors should be aware of the defenses to those actions and should review their “danger” clients to make sure that payment times are not getting too high.

4) Fraud seems to have become more prevalent than ever before. In the past, debtors relied on easy credit to fund cash flow shortages and business operations. As debtors face tight credit markets, the pressure to “cut corners” increases. As a result, we’re seeing an increase in falsified financial reports, falsified credit applications, and fraudulent billings. Creditors should be on the look-out for this behavior. Since debts obtained by fraud are not dischargeable through bankruptcy, if a creditor discovers that a debtor has committed fraud in obtaining a debt, the creditor should consider a “nondischargeability action” as a way of maintaining their ability to pursue those debts after bankruptcy.

5) More “good” companies are in bankruptcy than ever before. Previously, with some exceptions, a corporate debtor was in bankruptcy due to one of three things: poor management, a poor business model, or a failing industry. Now, we’re increasingly seeing well run companies in struggling industries (construction, steel, auto) falling victim to difficult economic times. It’s important to keep an eye on the credit terms you extend to even your best customers, as no one seems to be immune from this economy.

by Scott Schuster

Typically, the central purpose of filing a bankruptcy is to “discharge” all or most of the debtors’ debts. A bankruptcy “discharge” releases the debtor from personal liability for certain specified types of debts. In other words, the debtor is no longer legally required to pay any debts that are discharged. The discharge is a permanent order forever prohibiting the debtor’s creditors from taking any form of collection action on discharged debts, including legal action and communications with the debtor, such as telephone calls, letters, and personal contacts. Generally, excluding cases that are dismissed or converted, individual debtors receive a discharge in more than 99 percent of chapter 7 cases.

However, the Bankruptcy Code sets forth an extensive list of debts that are nondischargeable. Unfortunately, nondischargeability is not automatic – a creditor that holds such a debt must file a complaint with the Bankruptcy Court seeking to have the debt declared nondischargeable. A nondischargeability complaint must usually be filed within about sixty (60) to ninety (90) days after the debtor files his or her bankruptcy petition. 

The largest category of nondischargable debts are those incurred through: 1) false pretenses, a false representation, or actual fraud; or 2) obtained through the use of a statement in writing, which is materially false regarding the debtor’s financial condition, and on which the creditor reasonably relied.

As one would imagine, the terms “false pretenses, false representations, or actual fraud” can encompass many types of dishonest behavior. An important consideration the court will make is whether the debtor intentionally and knowingly made the false/fraudulent representations. To except a debt from discharge under this section, the false representations giving rise to the debt must have been knowingly and fraudulently made. In other words, the failure to pay a debt is not sufficient, even if there is no excuse for the failure. The debtor has to incur the debt knowing that he will not be able to pay the debt, and knowing that the statements he is making to the creditor about his ability and intention to pay are untrue.

A creditor alleging fraud has the burden of proving that the debtor knew that any stated intention to repay was false and that the debtor nevertheless deliberately incurred the debt. The fact that the debtor was insolvent does not by itself provide a sufficient basis for inferring the debtor’s intent. A debtor’s honest belief that a debt would be repaid in the future, even if in hindsight found to have been very unrealistic, negates any fraudulent intent.

Use of a materially false writing concerning the debtor’s financial position comes up often in transactions that required the debtor to complete a credit application. On most credit applications, lenders will ask a debtor to list their monthly income and their current outstanding debts. Lenders then use this information to determine the debtor’s “debt-to-income” ratio. If the debtor falsely inflates their income, or omits certain debts, then the debt-to-income is inaccurate. If the court determines that the creditor reasonably relied upon the credit application in making the loan, then the debt is nondischargeable.

by Scott Schuster

Small cases, that often do not seem to be worth pursuing at all, can have a big impact on your company’s bottom line. I have often heard clients say “I want to pursue this as a matter of principle, but I’m not sure it’s worth the cost.” Some attorneys agree. However, pursuing and winning such a case tells the world that you are serious about collecting your debts and that message is often far more valuable than expected.

I recently defended a case wherein the debtor attempted to discharge certain student loans through bankruptcy. The amount of the debt was small ($20,000) and the monthly payment ($122 per month for 25 years) was insufficient to make any noticeable impact on the client’s monthly financials.

However, the debtor’s case was absolutely frivolous because the Bankruptcy Code makes discharge of student loans subject to very stringent conditions. The Code states that student loans are not discharged unless the debtor can show that it would be an “undue hardship” to force the debtor repay the debt. Typically, to prove an undue hardship, a debtor must provide evidence that the debtor has minimized his or her expenses and maximized his or her income.

The aforementioned case was frivolous because the debtor, who was disabled and only earned $1,300 per month from social security disability, lived in a $285,000, five bedroom, three bathroom home that was paid for by her husband. Debtor’s SSI income was used to support the $1,800 in mortgage payments the family made each month. More egregiously, the Debtor was disabled when she accepted the student loan and agreed to repay the money.

Despite the fact that paying $122 per month would not cause an “undue hardship,” Debtor filed a complaint seeking to discharge the student loan. The client immediately asked whether the case was “worth pursuing.” Clearly, the client would win the case if we fought hard enough, but the debt was small.

My advice to the client was to take a step back and look at the case in the grander scheme of its business operations. The Debtor’s attorney in the case has practiced for many years and files dozens of bankruptcies each year. If the client were to “roll over” and show that it would not fight the smaller cases, the attorney would know what he could get away with in future cases. One thing I pointed out to the client is that debtors’ attorneys tend to be very friendly with one another and tend to share their experiences. As a result, showing weakness in this case could give rise to dozens of frivolous student loan dischargeability actions in the future.

In the end, we litigated the matter. The parties exchanged discovery, conducted depositions, and eventually filed motions with the court seeking summary judgment. Debtor’s counsel was flabbergasted; he repeatedly said ”I cannot believe your client is fighting this case.” In the end, he probably spent ten times more time and effort on the case than he expected. I flew to Philadelphia to argue the case and put our argument - that Debtor’s lavish lifestyle is not an “undue hardship” - on the record. The Judge agreed and entered an order in our favor, excepting the debt from discharge and guaranteeing that the debtor could not take the easy way out.

Yes, the client spent some money to litigate the case and the immediate result ($122 per month for the next 25 years or so) will make no difference to the client’s year-end profit. However, the client took a stand and made it known that, as a matter of principle, frivolous cases will be defended. Debtor’s attorneys will think twice about filing such a claim the next time around.

Many bankruptcy attorneys are concerned about the efficiency of their process. By definition, at least the debtor has limited funds to pay for an engagement. This impacts the creditors who may not see a full recovery on their claim. As a result, many bankruptcy practitioners are leery of spending any resources on electronic discovery. This podcast was created to share the experiences of Bob Bernstein, a bankrupcty practitioner in Pittsburgh, PA with Bernstein Law Firm and Jeffrey Ritter, an electronic discovery consultant from the Waters Edge who has just written a book on electronic discovery and the bankruptcy process called Discovering the Digital Record-The Questions for Examination. 

Click link to listen to Podcast: http://www.esibytes.com/?p=718

Click on this link to see Bob Bernstein talk with Kevin Miller on WPXI’s NightTalk about Bankruptcy and Get P.A.I.D.: A Guide to Getting Paid Faster (and What to do if You Don’t!)

http://www.youtube.com/watch?v=vsgGf2RIig4

Please feel free to share this link with people.

I recently was on Pittsburgh Business Radion for a discussion about credit and bankruptcy.  Listen in…

http://www.prrradio.com/index.php?option=com_content&view=article&id=215:podcastsfridayfebruary132009&catid=35:pastshow-podcasts-programming&Itemid=54

(Submitted to the Post-Gazette in response to a recent article)

First the disclaimer:  I am a bankruptcy and creditors’ rights lawyer.  I generally represent vendors, lenders and creditors.  I have also helped a few companies reorganize in Chapter 11 bankruptcy.

People (media and otherwise) are wailing about how bankruptcy equates to shutting down.  Recently, the P-G had some consultants concluding that bankruptcy won’t do for automakers what it did for the steel industry.  Notably, there were no bankruptcy lawyers quoted in the article.  There is fear-mongering that bankruptcy will mean millions of jobs lost and thousands of businesses closed.  With respect to the Big Three, this couldn’t be farther from the truth.  It is extremely rare for a bankruptcy of a business this size to result in a total shutdown and liquidation.  Typically, if a company enters into a Chapter 11, it will be able to reorganize its business or become acquired by someone else who will run the business.  In both scenarios many employees keep their jobs and suppliers continue to sell product to the company.  Under a Chapter 11, there are some powerful tools which allow a Judge to terminate or change contractual relationships.  In particular, the bankruptcy judge can order the restructuring of labor contracts.  I suspect that this, in conjunction with the potential loss of shareholder value, is the driving force behind Congress’s desire to “bail out” the Big Three.  There are very powerful lobbyists on the side of the unions and major shareholders that are joining forces.  The problem as I see it, however, is that the American public is being misled about the effects of Chapter 11 bankruptcy.

Chapter 11 reorganization will not create investment and borrowing ability for the Big Three, but it can create an atmosphere to allow that investment or credit on terms that might interest investors and lenders.  Lenders are more willing to lend to a bankrupt company when they know the company’s “old” debt will be discharged and they see the company bringing costs under control.  This gives the lender confidence that its “new” loans will be repaid.  At the very least, it can allow public (government) money to be loaned, directly or through bank guarantees, on a priority basis and only after a change in the business model has been proposed and vetted.  Congress has recently asked the Big Three to provide it with a plan as to how they will restructure their business model in order to be profitable in the future.  The irony of this demand is that proposing a workable business plan is exactly what Chapter 11 requires.  The difference, however, is that in Chapter 11, the creditors, employees and shareholders get to vote on whether the plan is viable.  In Congress, it is only the politicians who get to vote. 

With or without reorganization in Chapter 11 bankruptcy, fixing the Big Three will not be easy.  Jobs will be lost and some supplier businesses will fail.  Those businesses will fail because they became dependent on an industrial model that was ill-conceived and is past its prime.  All else being equal, would we expect the government to bail out the buggy-whip maker when the horse-drawn carriage maker went out of business?  Would we have kept the carriage maker alive just to save the whip maker?  No, we would not.  Bankruptcy reorganization will allow the Big Three automotive companies to have a breathing spell to restructure their business models and create more competitive products.  For a better analogy than the article’s comparison to the steel industry bankruptcies, take a look at the airline bankruptcies of the past two decades.  The airlines operated on an outdated and unprofitable hub and spoke business model.  Bankruptcy afforded many of the larger airlines the opportunity to restructure labor agreements and reorganize more along the lines of low cost carriers such as Southwest.  Just as would happen in Detroit, the airlines kept operating in Chapter 11, suppliers kept selling goods and services, and most people kept their jobs.  Yes, there was pain, but the airlines are still operation, many of them profitable, and the American economy did not collapse.  Despite fear mongering that consumers won’t by cars produced by a company in bankruptcy, people kept flying on planes and racking up miles on airlines in bankruptcy.  NONE of the Big Three will file for Chapter 7 liquidation.  If you hear any politician, lobbyist or Detroit executive say that’s a likely result, tune them out because they are either ill-informed or not telling the truth.  Even if one of the Big Three did file for Chapter 7, some creditor would surely ask the Court to force it into a Chapter 11 and for the appointment of a Trustee to preserve the business operations as a going concern.  Actually, I am surprised securities litigation has not already been initiated against GM executives for making such reckless comments over the past days.

Bankruptcy is much more complex than Congress, the media and Big Three executives are telling the public, but on some level, it comes down to whether or not we can and should save a sick business (or 3 sick businesses).  Regardless of who is to blame for Detroit’s problems, not one person has said how giving them taxpayer money will solve any of their problems.  Bankruptcy is an option to facilitate a responsible and workable business plan.  It may not be the most ideal situation, but it is the best option we have.

Bankruptcy is not the ideal solution.  While the discharge of debt and the termination of contracts are powerful tools, they aren’t the “cure” for the sick business model.  That cure will have to occur through thoughtful change.  Closing the business is a change.  Figuring out  how to build a product that people want, at a price people will pay, would also be a change.  Bankruptcy can facilitate that kind of change, but bankruptcy is a means, not an end.

The New York CLLA meeting is always busy.  This year, there was a buzz of excitement relating to a few areas.

First, everyone was taking about how the economy affects them.  For a group of collection and bankruptcy professionals, it was interesting to hear the dichotomy.  Pure collection folks (especially consumer collection folks) were bemoaning the reduction in collections.  Although they have more accounts, people are less able (willing?) to pay.  The commercial folks said the same things, but seemed a little more pessimistic.  Why?  In most places (with wage garnishment), the debtor will eventually get back to work.  A failed business is generally “failed” forever.  Those with creditor bankruptcy or workout practices were much more upbeat. They are busy (and making money).

Another area of “buzz” was the League’s Stategic Plan.  There was focused discussion and energy behind the movement of the Key Strategy Teams toward their first year objectives.  Click here to view the Plan.

Finally, there was an excitement around CLLA’s new Executive Vice President, Oliver Yandle.  Oliver is proving himself to be an asset in his very early weeks.  Now having been through one Fall meeting, I am sure he is even better position to help the CLLA reach its strategic goals and more.

If you are reading this, you most certainly have at one time received an email from the sister-in-law to the Finance Minister of Nigeria (or someone like her), telling you they have $xx million in a bank they need to get out and you can help and get 10% (or some incredible number).  The whole idea is to get you to accept a check from them, to show good faith.  Once you are CERTAIN enough time has passed for the check to clear, you send them back some amount.  Months later, you find their check was phony and your account has been debited, leaving you out the amount you sent them.

Being in the collection and bankruptcy biz, we have been receiving the new Asian Email Scam messages.  These entreat us to represent XYZ Shanghai Company (or someone) who is owed $xxx,xxx from a US company and they offer us a piece of the action to collect it.  The US company is, we are told, afraid to send a check overseas (or some similar excuse).  That is what we do, right?  Collect money.  So we are interested.  They will even pay a retainer and pay us hourly if we want.  We are already sensitized to possible scams, so we look closely.  We ask questions.  They have invoices.  The email address for the sender looks like the XYZ domain (although when we look closely, perhaps the email domain for the alleged Accountant from XYZ Shanghai Company Ltd is www.yyzcoshanghai.com, rather than the real www.xyzshanghaicoltd.com.  Pretty subtle, huh?

In any event, there is almost no way to be sure!  The idea is that the US “debtor’s” contact information could be a confederate of the scammer.  They could argue a bit or willingly agree to pay the huge sum, sending us a check.  We could deposit the check and wait several days, even checking with the US company’s bank to make sure it went through their account.  We would feel confident it has cleared and we could send a check (most likely a wire) to XYZ Company in Shanghai.  Weeks later, we would get that fateful notice that the US debtr’s check was fraudulent and our account has been charged back.  Gulp.

I wonder whether insisting the US company pays by wire would be enough protection.  Can someone send a fraudulent wire that can be reversed?

Every collection we make and every check I sign, I look to see if it is a regular client/forwarder or whether the collection was too easy for a large amount.  Or if there is anything unusual about it.  It adds a whole new dimension to this business.