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C H A P T E R 2 3
DEBTOR-CREDITOR RELATIONS AND BANKRUPTCY
Legal tools designed to stem economic downturns for companies are found in the Bankruptcy
Code. Under the U.S. Constitution, Congress has sole power to regulate bankruptcy. This
chapter summarizes loan agreements, and categorizes commercial loans types. The discussion
I. LOAN AGREEMENTS are usually standard, but may be specifically tailored.
A. Parties to the Agreement.
1. Lenders.
B. Commitment to Make a Loan. A “term sheet” outlines the terms and conditions
of the loan. A commitment need not be in writing.
C. Description of the Loan contains the lender’s promise to lend a specified amount
of money, outlines how the funds will be disbursed, the rate of interest will be,
and repayment terms.
1. Mechanics of Funding.
D. Asset-Based Loans. Generally, asset-based loans are not significant, except in
certain types of financing in which the amount lent is determined according to the
E. Representations and Warranties.
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1. Qualifications.
F. Conditions to Closing.
1. Authority to Approve the Loan.
G. Covenants are borrower’s promises to the lender.
1. Affirmative Covenants.
H. Events of Default will trigger the lender’s right to terminate the loan, accelerate
repayment obligations. Cross-default provides that any breach by the borrower
under any other loan agreement constitutes an event of default.
I. Remedies for Default.
II. COMMERCIAL LOAN CATEGORIES.
A. Loans Categorized by Lender.
B. Loans Categorized by Purpose.
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III. SECURED TRANSACTIONS UNDER THE UCC.
A. Terminology. A “security interest” is any interest in personal property or fixtures
used as collateral to secure payment by the “debtor”(borrower) for the
performance of an obligation to the “secured party” (lender).
D. Security Agreements identify the parties and the property used as collateral. It
can also specify the debtor’s obligations and the lender’s remedies.
1. Parties to the Agreement: Secured party – lender, debtor – borrower.
Third-party guarantor also a debtor.
2. Granting Clause. The security agreement must be signed by debtor and
must expressly grant a security interest in specified property.
E. Perfecting a Security Interest makes it valid against other creditors.
1. Methods of Perfection.
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(i) By Possession. A security interest in letters of credit, goods,
money or negotiable documents is perfected by the secured party’s
taking possession.
F. Security Interests in Uncertificated Securities are governed under Article 8 of the
U.C.C.
G. Filing Procedure.
1. What to File. Financing statement perfects non-possessory security
interest.
IV. EQUIPMENT LEASING. True Lease: The finance lease is treated as a long-term debt of
the lessee, the lessee may therefore enjoy tax benefits such as depreciation deductions.
V. GUARANTIES. The guarantor becomes liable for the obligation of another person, the
primary debtor. A guaranty must be in writing, with terms and amount of liability being
stated in the guaranty agreement.
A. Payment versus Collection. Guaranty of Payment is triggered when the primary
debtor fails to pay. Guaranty of Collection. Guarantor becomes obliged to pay
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only after the lender has attempted to collect from the primary debtor.
B. Limited Versus Unlimited. Guarantor may agree to accept limited or unlimited
liability.
C. Restricted versus Continuing. Restricted Guaranty is enforceable only with
D. Discharging the Guarantor. The guarantor is no longer liable if the lender alters
the agreement or takes actions that discharge liability.
F. Fraudulent Conveyances is a direct or indirect transfer of assets to a third party
with the actual intent or the effect of hindering, delaying, or defrauding creditors
by putting the assets out of the creditors’ reach. A leveraged buyout can be
attacked as a fraudulent conveyance.
G. Voidable Preferences. A transfer from a debtor to an outsider creditor done
within one year of the filing of bankruptcy may be voidable.
VI. SUBORDINATION. As long as the debtor is solvent, both the junior and senior creditors
can expect to be paid.
A. Indebtedness to Insiders. Lenders require that debt to insiders be subordinated to
the lender’s debt.
VII. LENDER LIABILITY. Recent court decisions have expanded recovery for borrowers.
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A. Breach of Contract. The lender’s failure to act or to refrain from acting as
required by the terms of a loan document or other agreement.
B. Breach of Duty of Good Faith. Requires the lender to act reasonably and fairly in
dealing with the borrower, especially when dealing with the borrower’s rights and
remedies under the loan agreement.
CASE 23.1 Tufankujian v. Rockland Trust Co., 57 Mass. App. Ct. 173 (2003).
C. Fraudulent Misrepresentation. The lender can be liable if it represents that it will
make a loan to the borrower though it has decided not to extend credit.
D. Economic Duress. Compensatory and punitive damages can be recovered for
economic duress.
VIII. SPECIAL DEFENSES AVAILABLE TO THE FEDERAL INSURERS OF FAILED BANKS AND
SAVINGS AND LOANS. Lenders are protected under the D’Oench, Duhme doctrine which
IX. MANAGEMENT DUTIES SHIFT WHEN A COMPANY ENTERS INSOLVENCY ZONE.
Generally, corporate directors owe fiduciary duties to company and its shareholders to
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protect assets. However, when a corporation enters the ‘insolvency zone’ directors may
owe fiduciary duties to creditors as well. Directors and officers may be personally liable
in a bankruptcy court for breach of fiduciary duty.
X. OVERVIEW OF BANKRUPTCY LAW. The Bankruptcy Code is divided into chapters, the
most common of which are liquidation under Chapter 7, reorganization under Chapter 11,
and consumer debt reorganization under Chapter 13.
A. Bankruptcy Courts are part of the federal court system. Judges are appointed by
the President and serve 14 year terms. They hear and enter final judgments in
‘core’ and ‘non–core’ proceedings.
CASE 23.2 Stern v. Marshall, 131 S. Ct. 2594 (2011). Vicky Lynn Marshall
(aka Anna Nicole Smith) married billionaire J. Howard Marshall
who passed away 18 months later. Vicky was left with nothing
under JHM’s will. Before JHM passed away Vicky filed a suit in
B. Initiation of Bankruptcy Proceeding. Filing of a voluntary (by debtor) or
involuntary (by creditors) petition constitutes an order for relief.
C. Bankruptcy Estate means “all the legal and equitable interests of the debtor at
the commencement of the case…”
1. Exempt Property is excluded from the bankruptcy estate. Generally it
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goods and personal items, as well as certain income and government
benefits (see page 806).
D. Meeting of Creditors.
E. Appointment of Trustee or Debtor in Possession. In chapter 11 cases, the debtor
F. Administration of Claims. Unsecured creditors must file a proof of claim.
XI. PROVISIONS APPLICABLE TO ALL BANKRUPTCIES. There are two major types of
business bankruptcies: liquidation under Chapter 7 and reorganization under Chapter 11.
A. Good Faith Requirements.
B. Automatic Stay. Bankruptcy filings grant an automatic stay.
CASE 23.3 In re Bryan Road, 389 B.R. 297 (Bankr. S.D. Fla. 2008). Lender
was awarded final judgment against borrower, the owner of a 210
“dray stack” boat storage facility. On the morning of the
foreclosure sale, however, the lender agreed to continue the
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C. Ability to Assume, Assign, or Reject Executory Contracts and Leases. The DIP
has the option of assuming or rejecting pre-bankruptcy executory contracts or
unexpired leases. Intellectual property licenses: copyrights, patents, trademarks,
and know-how licenses.
1. Collective Bargaining Agreements. Section 1113 of the Bankruptcy Code
lays out a process for a company to repudiate a CBA in bankruptcy court.
2. Limitations.
consent.
D. Sale of Property. The DIP can sell interests and disburse the net proceeds.
E. Avoiding Powers. Bankruptcy trustees can invalidate or reverse certain pre-
bankruptcy transactions.
1. Fraudulent Conveyances. Generally occur within one year before filing
bankruptcy that are intended to defraud creditors or provide less than
reasonable exchange to debtors.
XII. CHAPTER 11 REORGANIZATIONS.
A. Obtaining Credit. A DIP’s priority is to stay in business. Assets acquired after the
bankruptcy petition is filed are not subject to pre-petition security agreements.
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1. Customer’s Payments. Bankruptcy allows the DIP to retain otherwise
encumbered revenues from customer payments.
B. The Plan of Reorganization. Debtor has the exclusive right to file a plan of
reorganization with the bankruptcy court within 120 days after the date of the
order for relief. Debtor also has right to have creditors approve the plan 180 days
after the date of the order.
C. Confirmation.
1. General Requirements: (i) Feasibility. The plan must be economically
feasible, (ii) Best Interest of Creditors. Unless accepted unanimously, the
D. Discharge. Nondischargeable debts under Chapter 7 are excluded from the
Chapter 11 discharge.
XIII. WORKOUTS AND PREPACKAGED AND PRENEGOTIATED CHAPTER 11 CASES.
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A. Workouts. The right to file bankruptcy cannot be waived.
XIV. CHAPTER 7 LIQUIDATIONS.
A. Individual Debtors. No discharge for: (1) taxes; (2) educational loans (generally);
(3) spousal or child support; (4) fines or penalties; (5) drunk-driving liabilities;
and intentional torts.
XV. CONSUMER BANKRUPTCY UNDER CHAPTER 13. Chapter 13 deals with adjustments to
the debt of an individual or married couple with regular income.
A. Chapter 13 Requirements include: (1) Individuals with upwards of $360,475 of
unsecured debt and secured debt reaching $1,081,400; (2) repayment plan for
XVI. CHAPTER 15. Deals with cross-border insolvencies, promulgated by UNCITRAL and
approved by the UN General Session in 1997.
THE RESPONSIBLE MANAGER: TEACHING SUGGESTIONS
BAGLEY, MANAGERS AND THE LEGAL ENVIRONMENT 7TH ED—INSTRUCTOR’S MANUAL
1. Discuss the following issues from the perspective of what a legally astute manager should
know and be able to set in place for her company:
• Require any commitment must be in writing and approved by a loan committee or
other appropriate officials of the lender.
2. Why should loan commitments be in writing?
3. Why would a creditor agree to be subordinated to another creditor?
4. Discuss the pros and cons of the “bailout” of Detroit’s automakers and whether they