Case Studies and Best Practices for Your Industry
General Considerations for Written Agreements with Customers
Most businesses that work with consumers will have a written agreement for anything other than an outright cash sale on the spot. Even then, you’ll have a receipt. If you are going to have any sort of relationship with a consumer beyond a point-of-sale transaction, make sure there are documents to memorialize the transaction. A handshake is worthless in bankruptcy court. Get everything in writing.
Make sure that your loan agreements contain language that void the agreement due to insolvency giving the creditor the right to seize the collateral pursuant to state law. Make sure that your documents are signed and witnessed properly as required by your state law. If you’re taking a security interest, make sure your security instrument is recorded properly and has the correct notary and witness seals. There have been many cases where secured status was denied for an improperly recorded or signed document.
Venders and Suppliers
Often in your business, you are shipping products on credit. At the time that you begin a relationship with a client where you’ll be shipping on credit (direct credit, not through a finance company that pays you up front), file a UCC-1 statement on all goods sold and on all inventory. This will give you secured creditor status in the event your customer goes bankrupt. Also make sure your finance agreements declare a default when the buyer becomes insolvent. This will void the contract and make the entire debt due.
Keep extremely accurate books and records. Record all payments and keep copies of all invoices and payment demands. Make sure your accounting system can accurately show a third party how payments are applied to principle, interest, and late fees. The single biggest problem creditors have in bankruptcy court is explaining to a judge how they arrived at their figure for the debt owed. It happens in every industry.
Consumer Lenders
Consumer lenders would do well to read the aforesaid advice, specifically related to contracts and keeping accurate financial records. If you’re a purchase money lender, for example, selling a TV on store credit, you are entitled to file a UCC-1 statement to secure your rights to seize the TV. Now, one has to do the math to see if the goods you’re selling are worth the great effort to become a secured creditor in the event of a consumer bankruptcy. Insurance is available for businesses to protect their accounts receivable.
If your line of business is unsecured consumer lending, not purchase money, be sure to closely follow the rules of the automatic stay. As we said previously, once a bankruptcy case is filed, unsecured creditors have little recourse or hope of recovering money. Monitor a Chapter 13 case closely and, perhaps, do what you can to get it dismissed. This will restore the debt.
Landlords and Tenants
Landlords, whether commercial or residential, are subject to the automatic bankruptcy stay just like all other creditors. How you treat a debtor in bankruptcy depends on your goals. If the debtor intends, and is able to, continue occupying the property and paying rent, a landlord can enter into an agreement with the debtor to continue paying rent during the term of the bankruptcy, and allowing the debtor’s lease to survive the bankruptcy.
However, if the debtor is unable to pay, the landlord must get relief from the automatic stay to proceed with eviction. If the bankruptcy case is pending during the eviction, the landlord is not permitted to sue for unpaid rent or damages. These claims must be made part of the bankruptcy case.
Mortgage Lenders
Mortgage lenders generally require the assistance of an attorney. As a secured creditor, with the collateral being real property, a mortgage lender can ask the bankruptcy court to lift the automatic stay to proceed with state law foreclosure. However, in Chapter 13, if the lender is receiving “adequate protection,” meaning payments sufficient to secure the value of the collateral (equivalent to the correct mortgage payment), the lender cannot seek foreclosure.
Mortgage lenders have to confirm that the subject property is insured and that taxes have been paid. The mortgage lender will want to do their own independent appraisal of the property to confirm the value, relative to the debt owed.
Because of the explosion of foreclosures, courts have begun to scrutinize mortgage lenders more carefully. Make sure that you have all deeds and security instruments signed and witnessed properly as required by your state law. Make sure everything is recorded with the appropriate authority. Improperly signed or recorded documents may void a lender’s security interest.
The single biggest hurdle mortgage lenders face in bankruptcy court is numbers. Mortgage lenders are notoriously bad at keeping track of payments and applying those payments properly to calculate outstanding debt or arrearage. I’ve heard many judges say from the bench, on the record, that they don’t trust any numbers provided by a mortgage lender, because they have been allowed to fudge the math for so many decades.
It is imperative that you keep accurate records of all payments and a running total of the payment application and balance due. You must be able to explain to the court how each number was calculated, and show the method of calculation based on the loan contract. This is an onerous burden on mortgage lenders today. But according to numerous bankruptcy judges I’ve spoken to over the years, it is a consequence of shoddy work that the industry has endured for the last 30 years.
Community Associations
Countless community and homeowners associations exist throughout the United States. They come in every form from subdivisions to condominiums. Homeowner bankruptcy is a huge problem for homeowners associations who cannot collect membership dues from insolvent homeowners.
In most cases, the community association will be considered a secured creditor. Many state statutes provide for automatic (statutory) liens on real property for unpaid membership dues. Even so, it is still best to file a claim or notice of lien in the county real estate records if an arrearage builds up. This will save time and money explaining to an uninitiated bankruptcy judge the process of the statutory lien.
In a Chapter 7 case, most homeowners will be surrendering their real property to the mortgage lender. In this case, the Association is essentially out of luck and will likely never be able to collect the unpaid assessments. This can be especially frustrating since lenders take time to foreclose upon, and take title to, the real property. During that gap period, the association can generally not demand collection, nor attempt to collect after the bankruptcy is over. Some states have proposed statutes under debate to deal with this gap period.
In a Chapter 13 case where the debtor intends to keep their real property, the debtor is liable to pay assessments as they come due during the course of the bankruptcy case, as well as the arrearage. The arrearage will be accounted for in the Chapter 13 Plan. The debtor must show in his Schedules that he can afford to continue to pay assessments. Otherwise the association can ask the bankruptcy court to dismiss the case based on an unfeasible Plan.
If an association is not getting paid, there are precious few options. An association could theoretically ask the court to lift the automatic stay and allow the association to foreclose its lien, if permitted by state law. However, in most cases, the association’s lien is either inferior to the mortgage lender, disallowing the foreclosure, or the foreclosed property would still have the mortgage lender’s lien on title, limiting the sale possibilities.
It is important for community associations to work with attorneys expert in the field of association law. Each state has its own unique legal regime. The best practice for homeowners associations is to keep up with collection and lien filing, and keep meticulous records of billing and payment.
Case Study—“When the Liquor Distributor Went Bankrupt”
The most unique case I ever dealt with involved liquor. I represented a liquor importing company that was a creditor in a bankruptcy case. The debtor was a liquor distributorship. The importer gave the distributor liquor, based on orders, to sell on consignment. Then the distributor sells the liquor to stores and pays the importer back from the profits. One would think this should be a thriving business. But when this distributor went bankrupt, he owed my client in excess of $90,000.00. And all of the liquor that was consigned with the distributor was still in the warehouse.
The first question the trustee asked when we all gathered together was, “How in the world does a liquor distributorship go out of business?!” We were all baffled. The trustee brought in a liquor law expert to assist with licensing and valuation. The distributor was indebted to his landlord for several hundred thousand dollars. The entire balance of the unpaid lease came due. Very quickly, the landlord became the top priority creditor.
My client demanded that we simply seize the liquor. However, my client broke the cardinal rule of doing business: he did not have anything in writing. All we had to go by was a shipping report and my client’s word of the value. There were no consignment agreements, no contracts, no liens, no notes. The trustee accepted our claim, but we did not have enough evidence to get relief from stay to seize the liquor. Nor could we claim priority status as a secured creditor. The trustee proposed to sell the liquor, somehow, to pay off the creditors.
Aside from our inability to get paid or get the inventory returned, my client insisted that under state liquor law, a trustee could not sell liquor without a license. Case law and the judge said otherwise. The trustee, apparently, stepped into the shoes of the distributor, licensed and all, when the bankruptcy case was filed. My client was livid.
In the end, the liquor was sold for 1/10th its value, and my client got nothing. No cash, no returned inventory. The case took over two years to resolve. But the lesson was learned: always get your agreements in writing. My client’s willingness to do big business on a handshake cost him tens of thousands of dollars.