Accountants’ Handbook Special Industries and Special Topics 10th Edition_18 pdf

The code is di-vided into eight chapters: Chapter 1 General Provisions Chapter 3 Case Administration Chapter 5 Creditors, the Debtor, and the Estate Chapter 7 Liquidation Chapter 9 Adju

investors give little, if any, weight to book value in appraising the securities of companies with thehigh rates of earnings on capital that are characteristic of this industry.

It should also be noted that we have not used a discounted future benefits approach becauseABC’s prospective growth rates are roughly comparable to those of the guideline companies Theadjusted valuation ratios are, therefore, a reflection of both the growth rate and the capitalization rateappropriate to ABC Snack Foods, Inc., on the valuation date

Dividing the preliminary value of $62,382,000 by the 100,000 shares outstanding results in afreely traded value (the price at which the stock would trade in an active market) of $624 per share.The fact that the ABC stock lacks ready marketability must be reflected by a discount for lack ofmarketability We think that a discount of 30% is appropriate This results in a value for the commonstock of $437 per share

It is our conclusion that a block of 20,000 shares had a fair market value of $437 per share as ofMarch 31, 2009, or $8,740,000 for the entire block

42.6 SOURCES AND SUGGESTED REFERENCES

Blackman, L., The Valuation of Privately-Held Businesses Probus Publishing, Chicago, 1986.

Brown, Ronald L., Valuing Professional Practices and Licenses: A Guide for the Matrimonial Practitioner

Pren-tice-Hall, Englewood Cliffs, NJ, 1987

Burke, Frank M., Jr., Valuation and Valuation Planning for Closely-Held Businesses Prentice-Hall, Englewood

Cliffs, NJ, 1981

Ibbotson, Roger A., Stocks, Bonds, Bills and Inflation Ibbotson Associates, Chicago, 1989.

Internal Revenue Service, IRS Valuation Guide for Income, Estate & Gift Taxes Commerce Clearing House,

Chicago, 1985

, Revenue Ruling No 59-60 U.S Treasury Dept., Washington, DC

Maher, J Michael, “Discounts for Lack of Marketability for Closely-Held Business Interests,” Taxes—The Tax Magazine, September 1976, pp 562–71.

Moroney, Robert E., “Most Courts Overvalue Closely Held Stocks,” Taxes—The Tax Magazine, March 1973,

(a) Out-of-Court Settlements 2

(i) Appointment of Creditors’

(ii) Plan of Settlement 3

(b) Assignment for Benefit of

(c) Bankruptcy Court Proceedings 3

(i) Title 11—Bankruptcy

(ii) Chapter 7—Liquidation 4

(iii) Chapter 12—Adjustment

(i) Relief from the Stay 10

(ii) Accounting Services—

Determining Equity in

(e) Executory Contracts and Leases 11

(i) Limitations on Executory

(ii) Accounting Services—

Search for Preferential

(i) LBO as a Fraudulent

(ii) Accounting Services—

Search for Fraudulent

43.1 OVERVIEW

This chapter contains a brief description of the Bankruptcy Code, a discussion of the services thatcan be rendered by the accountant, and an introduction to the problems faced by accountants work-ing in the bankruptcy area

43.2 ALTERNATIVES AVAILABLE TO TROUBLED COMPANIES

The debtor’s first alternatives are to locate new financing, to merge with another company, or to findsome other basic solution to its situation that avoids the necessity of discussing its problems with rep-resentatives of creditors If none of these alternatives is possible, the debtor may be required to seek aremedy from creditors, either informally (out of court) or with the help of judicial proceedings

(a) OUT-OF-COURT SETTLEMENTS The informal settlement is an out-of-court agreement that

usually consists of an extension of time (stretch-out), a pro rata cash payment for full settlement ofclaims (composition), an issue of stock for debt, or some combination The debtor, through counsel

or credit association, calls an informal meeting of the creditors for the purpose of discussing its

fi-43.5 OPERATING UNDER CHAPTER 11 19

(ii) Accounting Services—

(i) Functions of Examiner 22

(ii) Accountants as Examiners 22

(f) Reporting in Chapter 11 22

(ii) Statement of Operations 24

(iii) Statement of Cash Flows 25

(iii) Reorganization Value 31

(iv) Pro Forma Balance Sheet 31(v) Reorganization Model 31(g) Accounting Services—

(i) Requirements for Fresh

(ii) Allocation ofReorganization Value 34(iii) Disclosure Requirements 35(iv) Reporting by Debtors NotQualifying for Fresh Start 35(i) Accounting for the Impairment

of Long-Lived Assets Under

43.8 SOURCES AND SUGGESTED

nancial problems In many cases, the credit association makes a significant contribution to the of-court settlement by arranging a meeting of creditors, providing advice, and serving as secretaryfor the creditors’ committee.

out-A credit association is composed of credit managers of various businesses in a given region.Its functions are to provide credit and other business information to member companies con-cerning their debtors, to help make commercial credit collections, to support legislation favor-able to business creditors, and to provide courses in credit management for members of thecredit community

At the creditors’ meeting, the debtor describes the causes of failure, discusses the value of assets(especially those unpledged) and unsecured liabilities, and answers any questions the creditors mayask The main objective of this meeting is to convince the creditors that they would receive more ifthe business were allowed to operate than if it were forced to liquidate and that all parties would ben-efit from working out a settlement

(i) Appointment of Creditors’ Committee. To make it easier for the debtor to work withthe creditors, a committee of creditors is normally appointed during the initial meeting of thedebtor and its creditors, providing, of course, the case is judged to warrant some cooperation

by the creditors It should be realized that the creditors are often as interested in working out

a settlement as is the debtor The creditors’ committee serves as the bargaining agent for thecreditors, supervises the operation of the debtor during the development of a plan, and solic-its acceptance of a plan once the committee has approved it Generally, the creditors’ com-mittee meets immediately after appointment for the purpose of selecting a presiding officerand counsel

(ii) Plan of Settlement Provided there is enough time, it is often advisable that the accountant

and the attorney assist the debtor in preparing a suggested plan of settlement for presentation anddiscussion at the first meeting with creditors Typically only the largest creditors and a few repre-sentatives of the smaller creditors are invited so that the group is a manageable size for accom-plishing its goals

There is no set pattern for the form that a plan of settlement proposed by the debtor musttake It may call for 100% payment over an extended period of time, payments on a pro ratabasis in cash for full settlement of creditors’ claims, satisfaction of debt obligations with stock,

or some combination A carefully developed forecast of projected operations, based on tic assumptions developed by the debtor with the aid of its accountant, can help creditors de-termine whether the debtor can perform under the terms of the plan and operate successfully inthe future

realis-(b) ASSIGNMENT FOR BENEFIT OF CREDITORS A remedy available under state law to a

corporation in serious financial difficulties is an assignment for the benefit of creditors In this stance, the debtor voluntarily transfers title to its assets to an assignee, who then liquidates them anddistributes the proceeds among the creditors Assignment for the benefit of creditors is an extremeremedy because it results in the cessation of the business This informal liquidation device (althoughcourt-supervised in many states) is like the out-of-court settlement devised to rehabilitate the debtor,

in-in that it requires the consent of all creditors or at least their agreement to refrain-in from takin-ing action.The appointment of a custodian over the assets of the debtor gives creditors the right to file an invol-untary bankruptcy court petition

Proceedings brought in the federal courts are governed by the Bankruptcy Code Normally it isnecessary to resort to such formality when suits have been filed against the debtor and its property isunder garnishment or attachment or is threatened by foreclosure or eviction

(c) BANKRUPTCY COURT PROCEEDINGS Bankruptcy court proceedings are generally the

last resort for the debtor whose financial condition has deteriorated to the point where it is ble to acquire additional funds When the debtor finally agrees that bankruptcy court proceedings

impossi-are necessary, the liquidation value of the assets often represents only a small fraction of thedebtor’s total liabilities If the business is liquidated, the creditors get only a small percentage oftheir claims The debtor is discharged of its debts and is free to start over; however, the business islost and so are all the assets Normally, liquidation proceedings result in large losses to the debtor,the creditors, and the business community in general Chapter 7 of the Bankruptcy Code covers theproceedings related to liquidation Another alternative under the Bankruptcy Code is to seek sometype of relief so that the debtor, with the help of the bankruptcy court, can work out agreements withcreditors and be able to continue operations Chapters 11, 12, and 13 of the Bankruptcy Code pro-vide for this type of operation.

(i) Title 11—Bankruptcy Code Title 11 U.S Code contains the bankruptcy law The code is

di-vided into eight chapters:

Chapter 1 General Provisions

Chapter 3 Case Administration

Chapter 5 Creditors, the Debtor, and the Estate

Chapter 7 Liquidation

Chapter 9 Adjustment of Debts of a Municipality

Chapter 11 Reorganization

Chapter 12 Adjustment of Debts of a Family Farmer with Regular Income

Chapter 13 Adjustment of Debts of an Individual with Regular Income

Chapters 1, 3, and 5 apply to all proceedings under the code except chapter 9, where only specifiedsections of chapters 1, 3, and 5 apply A case commenced under the Bankruptcy Code—chapter 7,

9, 11, 12, or 13—is referred to as a Title 11 case Chapter 13, which covers the adjustment of debts

of individuals with regular income, is beyond the scope of this presentation because it can be usedonly by individuals with unsecured claims of less than $290,525 and secured claims of less than

$871,550 The dollar amount of the debt limits for a chapter 13 petition are to be increased to flect the change in the Consumer Price Index for All Urban Consumers on April 1 every third year.The amounts are to be rounded to the nearest $25 multiple The next three-year-period adjustmentwill be made on April 1, 2004 Provisions relating to Chapter 11 are discussed in detail in a sepa-rate section

re-(ii) Chapter 7—Liquidation Chapter 7 is used only when the corporation sees no hope of being

able to operate successfully or to obtain the necessary creditor agreement Under this alternative, thecorporation is liquidated and the remaining assets are distributed to creditors after administrative ex-penses have been paid An individual debtor may be discharged from liabilities and entitled to a freshstart A corporation’s debt is not discharged

The decision as to whether rehabilitation or liquidation is best also depends on the amount thatcan be realized from each alternative The method resulting in the greatest return to the creditors andstockholders should be chosen The amount received from liquidation depends on the resale value ofthe firm’s assets minus the costs of dismantling and legal expenses The value of the firm after reha-bilitation must be determined (net of the costs of achieving the remedy) The alternative leading tothe highest value should be followed

Financially troubled debtors often attempt an informal settlement or liquidation out of court;

if it is unsuccessful, they will then initiate proceedings under the Bankruptcy Code Otherdebtors, especially those with a large number of creditors, may file a petition for relief in thebankruptcy court as soon as they recognize that continuation of the business under existing con-ditions is impossible

As soon as the order for relief has been entered, the U.S trustee appoints a disinterested partyfrom a panel of private trustees to serve as the interim trustee The functions and powers of the in-

terim trustee are the same as those of an elected trustee Once an interim trustee has been appointed,the creditors meet to elect a trustee that will be responsible for liquidating the business If a trustee

is not elected by the creditors, the interim trustee may continue to serve in the capacity of the trusteeand carry through with an orderly liquidation of the business

The objective of the trustee is to liquidate the assets of the estate in an orderly manner Oncethe property of the estate has been reduced to money and the security claims have been satis-fied to the extent allowed, then the property of the estate is distributed to the holders of theclaims in the order specified by the Bankruptcy Code The first order, of course, is priorityclaims; when they have been established, the balance goes to unsecured creditors After all thefunds have been distributed, the remaining debts of an individual are discharged As mentionedearlier, if the debtor is a corporation, the debts are not discharged Thus it is necessary for thecorporation to cease existence Any funds subsequently coming into the corporate shell would

be subject to attachment

(iii) Chapter 12—Adjustment of Debt of a Family Farmer with Regular Annual Income.

To help farmers resolve some of their financial problems, Congress passed Chapter 12 of the ruptcy Code It became effective November 26, 1986, and is scheduled to expire December 31,

Bank-2002 However, on previous occasions when the chapter 12 provisions were scheduled to end, gress has extended the date and at times extended it after it expired Because chapter 12 is new andrelates to a specific class of debtors, Congress will evaluate whether the chapter is serving its pur-pose and whether there is a need to continue this special chapter for the family farmer After Con-gress makes this evaluation, it will be able to determine whether to make this chapter permanent IfCongress does not act to either extend the date or make chapter 12 permanent, chapter 12 will ter-minate on October 1, 1998

Con-Under current law, a family farmer in need of financial rehabilitation may file either a Chapter 11

or 13 petition Most family farmers, because they have too much debt to qualify, cannot file underchapter 13 and are limited to Chapter 11 Many farmers have found Chapter 11 needlessly compli-cated, unduly time-consuming, inordinately expensive, and, in too many cases, unworkable Chapter

12 is designed to give family farmers an opportunity to reorganize their debts and keep their land.According to legislative history, chapter 12 gives debtors the protection from creditors that bank-ruptcy provides while, at the same time, it prevents abuse of the system and ensures that farm lendersreceive a fair repayment

In order to file a petition, an individual or an individual and spouse engaged in farming tions must have total debt that does not exceed $1,500,000, and at least 80% of noncontingent, liq-uidated debts (excluding debt from principal residence unless debt arose out of family operations)

opera-on the date the petitiopera-on is filed must have arisen out of farming Additiopera-onally, more than 50% of thepetitioner’s gross income for the taxable year prior to the filing of the petition must be from farm-ing operations

A corporation or partnership may file if more than 50% of the outstanding stock or equity isowned by a family and:

• More than 80% of the value of its assets consist of assets related to farming operations

• The total debts do not exceed $1,500,000 and at least 80% of its noncontingent, liquidateddebts on the date the case is filed arose out of farming operations

• The stock of a corporation is not publicly traded

Only the debtor can file a plan in a chapter 12 case The requirements for a plan in ter 12 are more flexible and lenient than those in Chapter 11 In fact, only three requirements are setforth in Section 1205 of the Bankruptcy Code First, the debtor must submit to the supervision and con-trol of the trustee all or such part of the debtor’s future income as is necessary for the execution of theplan Second, the plan must provide for full payment, in deferred cash payments, of all priority claimsunless the creditors agree to a different treatment Third, where creditors are divided into classes, the

chap-same treatment must apply to all claims in a particular class The plan can alter the rights of securedcreditors with an interest in real or personal property, but there are a few restrictions To alter the right

of the secured claim holder, the debtor must satisfy one of the following three requirements:

1 Obtain acceptance of the plan

2 Provide in the plan that the holder of such claim retain the lien and as of the effective date of

the plan provide that the payment to be made or property to be transferred is not less than theamount of the claim

3 Surrender the property securing such claim

If a holder of an allowed unsecured claim does not accept the plan, then the court may not prove the plan unless the value of the property to be distributed is equal to at least the amount of theclaim and the plan provides that all of the debtor’s projected disposable income to be received withinthree years, or longer if directed by the court, after the first payment is made will be a part of the pay-ments under the plan

ap-To facilitate the operation of the business and the development of a plan, Section 1206 of theBankruptcy Code allows family farmers to sell assets not needed for the reorganization prior to con-firmation without the consent of the secured creditor, provided the court approves such a sale

(iv) Prepackaged Chapter 11 Plans Before filing a Chapter 11 plan, some debtors develop a

plan and obtain approval of the plan by all impaired claims and interests The court may accept thevoting that was done prepetition provided that the solicitation of the acceptance (or rejection) was incompliance with applicable nonbankruptcy laws governing the adequacy of disclosure in connectionwith the solicitation If no nonbankruptcy law is applicable, then the solicitation must have occurredafter or at the time the holder received adequate information as required under Section 1125 of theBankruptcy Code

It is often necessary for a Chapter 11 plan to be filed for several reasons including thefollowing three:

1 Income from debt discharge is taxed in an out-of-court workout to the extent that the debtor is

or becomes solvent While some tax attributes may be reduced in a bankruptcy case, the gainfrom debt discharged is not taxed

2 A larger percent of the net operating loss may be preserved if a Chapter 11 petition is filed For

example, the provisions of Sections 382(l)(5) and 382(l)(6) of the Internal Revenue Code(IRC) dealing with net operating losses only apply to bankruptcy cases

3 A smaller percentage of creditor approval is needed in Chapter 11 Only two-thirds of

the dollar amount of debt represented by those creditors voting and a majority in number

in each class are necessary in Chapter 11 However, for any out-of-court workout to ceed, the percentage accepting the plan must be much greater For example, some bondindenture agreements provide that amendments cannot be made unless all holders ofdebt approve the modifications Since it is difficult, if not impossible, to obtain 100% ap-proval, it is necessary to file a bankruptcy plan to reduce interest or modify the principal

suc-of the bonds

Since the professional fees and other costs, including the cost of disrupting the business, of aprepackaged plan are generally much less than costs of a regular Chapter 11 bankruptcy, a prepack-aged bankruptcy may be the best alternative

The use of a prenegotiated plan is common among public companies today A prenegotiated

plan is a modification of the prepackaged bankruptcy in that the voting is completed after thepetition has been filed rather than before the plan is filed In a prenegotiated plan, the debtorreaches an agreement with the major creditors and then files a plan either at the time or shortlyafter the Chapter 11 petition is filed For public companies, the filing of the petition before vot-

ing allows all documents related to the plan to be filed with the bankruptcy court and eliminatesthe need to follow the SEC requirements in the voting process.

(d) THE ACCOUNTANT’S SERVICES IN PROCEEDINGS One of the first decisions that must

be made at an early meeting of the debtor with bankruptcy counsel and accountants is whether it isbest to liquidate (under provisions of state law or Bankruptcy Code), to attempt an out-of-court set-tlement, to seek an outside buyer, or to file a Chapter 11 petition To decide which course of action totake, it is also important to ascertain what caused the debtor’s current problems, whether the com-pany will be able to overcome its difficulties, and, if so, what measures will be necessary Accoun-tants may be asked to explain how the losses occurred and what can be done to avoid them in thefuture To help with this determination, it may be necessary to project the operations after a 30-dayperiod over at least the next three to six months, and to indicate the areas where steps will be neces-sary in order to earn a profit

For existing clients, the information needed to make a decision about the course of action tomake may be obtained with limited additional work; however, for a new client, it is necessary toperform a review of the client’s operations to determine the condition of the business Once the re-view has been completed, the client must normally decide to liquidate the business, attempt an in-formal settlement with creditors, or file a Chapter 11 petition, unless additional funds can beobtained or a buyer for the business is located For example, where the product is inferior, the de-mand for the product is declining, the distribution channels are inadequate, or other similar prob-lems exist that cannot be corrected, either because of the economic environment or management’slack of ability, it is normally best to liquidate the company immediately

The decision whether a business should immediately file a Chapter 11 petition or attempt an of-court settlement depends on several factors Among them are the following eight:

5 Executory contracts, especially leases

6 The impact of alternatives selected

7 Nature of management

a Mismanagement

b Irregularities

8 Availability of interim financing

43.3 GENERAL PROVISIONS OF BANKRUPTCY CODE

(a) FILING OF PETITION A voluntary case is commanded by the debtor’s filing of a bankruptcy

petition under the appropriate chapter

An involuntary petition can be filed by three or more creditors (if 11 or fewer creditors, only onecreditor is necessary) with unsecured claims of at least $10,000 and can be initiated only under chap-ter 7 or 11 An indenture trustee may be one of the petitioning creditors The Court allows a case toproceed only if (1) the debtor generally fails to pay its debts as they become due, provided such debtsare not the subject of a bona fide dispute; or (2) within 120 days prior to the petition a custodian wasappointed or took possession The latter excludes the taking of possession of less than substantiallyall property to enforce a lien.

(b) TIMING OF PETITION—TAX CONSIDERATIONS The timing for filing the petition is

im-portant For example, if the debtor delays filing the petition until the creditors are about to force thedebtor into bankruptcy, the debtor may not be in a position to effectively control its destiny On theother hand, if the petition is filed when the problems first develop and while the creditors are reason-ably cooperative, the debtor is in a much better position to control the proceeding If possible, it isbest to file the petition near the end of the month or, even better, near the end of the quarter, to avoid

a separate closing of the books

Tax factors should also be considered in deciding when to file the petition For example, if adebtor corporation that has attempted an unsuccessful out-of-court settlement decides to file a peti-tion, the tax impact of the out-of-court action should be considered If, in the out-of-court agreement,the debtor transferred property that resulted in a gain and a substantial tax liability, it would be bestfor the debtor to file the petition after the end of the current taxable year By taking this action, the taxclaim is a prepetition tax claim and not an administrative expense If the tax claim is a prepetitionclaim, interest and penalties stop accruing on the day the petition is filed and the debtor may provide inthe plan for the deferral of the tax liability up to six years If the tax claim is an administrative expense,penalties and interest on any unpaid balance will continue to accrue and the provision for deferred pay-ment of up to six years does not apply

(c) ACCOUNTING SERVICES—ACCOUNTING DATA REQUIRED IN THE PETITION The

accountant must supply the attorney with certain information necessary for filing a Chapter 11 tion This would normally include the following:

peti-• List of Largest Creditors A list containing the names and addresses of the 20 largest unsecured

creditors, excluding insiders, must be filed with the petition in a voluntary case In an tary situation, the list is to be filed with the petition in a voluntary case In an involuntary peti-tion, the list is to be filed within two days after entry of the order for relief See BankruptcyRule 1007 and Bankruptcy Form 4

involun-• List of Creditors The debtor must file with the court a list of the debtor’s creditors of each

class, showing the amounts and character of any claims and securities and, so far as is known,the name and address or place of business of each creditor and a notation whether the claim isdisputed, contingent, or unliquidated as to amount, when each claim was incurred and the con-sideration received, and related data

• List of Equity Security Holders It is necessary to provide a list of the debtor’s security holders

of each class showing the number and kind of interests registered in the name of each holderand the last known address or place of business of each holder

• Schedules of Assets and Liabilities The schedules that must accompany the petition (or filed

within 15 days after the petition is filed—unless the court extends the time period) are swornstatements of the debtor’s assets and liabilities as of the date the petition is filed under Chap-ter 11 These schedules consist primarily of the debtor’s balance sheet broken down into de-tail, and the accountant is required to supply the information generated in the preparation ofthe normal balance sheet and its supporting schedules The required information is supplied

on Schedules A through C, which include a complete statement of assets, and Schedules Dthrough F, which are a complete statement of liabilities Schedule G requires the debtor to listall executory contracts and unexpired leases It is crucial that this information be accurate and

complete because the omission or incorrect listing of a creditor might result in a failure to ceive notice of the proceedings, and consequently the creditor’s claim could be exemptedfrom a discharge when the plan is later confirmed Also omission of material facts may beconstrued as a false statement or concealment.

re-• Statement of Financial Affairs The statement of affairs, not to be confused with an

accoun-tant’s usual use of the term, is a series of detailed questions about the debtor’s property andconduct The general purpose of the statement of affairs is to give both the creditors and thecourt an overall view of the debtor’ operations It offers many avenues to begin investigationsinto the debtor’s conduct The statement (Official Form No 7) consists of 25 questions to beanswered under oath concerning the following areas:

1 Income from employment or operation of business

2 Income other than from employment or operation of business

3 Payments to creditors

4 Suits, executions, garnishments, and attachments

5 Repossessions, foreclosures, and returns

6 Assignments and receiverships

7 Gifts

8 Losses

9 Payments related to debt counseling or bankruptcy

10 Other transfers

11 Closed financial accounts

12 Safe deposit boxes

13 Setoffs

14 Property held for another person

15 Prior address of debtor

16 Spouses and former spouses

17 Environmental issues

18 Nature, location, and name of business

19 Books, records, and financial statements

20 Inventories

21 Current partners, officers, directors, and shareholders

22 Former partners, officers, directors, and shareholders

23 Withdrawals from a partnership or distributions by a corporation

24 Tax consolidation group

25 Pension funds

• Exhibit “A” to the Petition This is a thumbnail sketch of the financial condition of the

busi-ness listing total assets, total liabilities, secured claims, unsecured claims, information relating

to public trading of the debtor’s securities, and the identity of all insiders

The debtor must also file any additional reports or documents that may be required by local rules

or by the U.S trustee

(d) ADEQUATE PROTECTION AND AUTOMATIC STAY A petition filed under the

Bank-ruptcy Code results in an automatic stay of the actions of creditors The automatic stay is one of thefundamental protections provided the debtor by the Bankruptcy Code In a chapter 7 case, it pro-vides for an orderly liquidation that treats all creditors equitably For business reorganizations underChapter 11, 12, or 13, it provides time for the debtor to examine the problems that forced it into

bankruptcy court and to develop a plan for reorganization As a result of the stay, no party, withminor exceptions, having a security or adverse interest in the debtor’s property can take an actionthat will interfere with the debtor or his property, regardless of where the property is located, untilthe stay is modified or removed Section 362(a) provides a list of eight kinds of acts and conductsubject to the automatic stay.

Under Section 362 of the Bankruptcy Code, a tax audit, a demand for a tax return, or the issuance

of a notice and demand for payment for such assessment are not considered a violation of the matic stay

auto-The stay of an act against the property of the estate continues, unless modified, until the property

is no longer the property of the estate The stay of any other act continues until the case is closed ordismissed, or the debtor is either granted or denied a discharge The earliest occurrence of one ofthese events terminates the stay

(i) Relief from the Stay The court may grant relief after notice and hearing, by terminating,

an-nulling, modifying, or conditioning the stay The court may grant relief for cause, including the lack

of adequate protection of the interest of the secured creditor With respect to an act against property,relief may be granted under Chapter 11 if the debtor does not have an equity in the property and theproperty is not necessary for an effective reorganization

Section 361 identifies acceptable ways of providing adequate protection First, the trustee ordebtor may be required to make periodic cash payments to the entity entitled to relief as compensa-tion for the decrease in value of the entity’s interest in the property resulting from the stay Second,the entity may be provided with an additional or replacement lien to the extent that the value of theinterest declined as a result of the stay Finally, the entity may receive the indubitable equivalent ofits interest in the property

The granting of relief when the debtor does not have any equity in the property solves the lem of real property mortgage foreclosures where the bankruptcy court petition is filed just beforethe foreclosure takes place It was not intended to apply if the debtor is managing or leasing realproperty, such as a hotel operation, even though the debtor has no equity, because the property is nec-essary for an effective reorganization of the debtor

prob-The automatic stay prohibits a secured creditor from enforcing its rights in property owned

by the debtor until the stay is removed Without this right, a creditor could foreclose on thedebtor’s property, collect the proceeds, invest them, and earn income from the investment, eventhough a bankruptcy petition has been filed Since the Bankruptcy Code does not allow this ac-tion to be taken, the creditor loses the opportunity to earn income on the proceeds that couldhave been received on the foreclosure The courts refer to this as creditor’s opportunity costs.Four circuit courts have looked at this concept of opportunity cost Two circuits (ninth andfourth) have ruled that the debtor is entitled to opportunity cost, the eighth circuit ruled thatunder certain conditions opportunity costs may be paid, and the fifth circuit ruled that opportu-

nity cost need not be paid In January 1988, the Supreme Court held in In re Timbers of Inwood

Forest Associates [484 U.S 365 (1988)] that creditors having collateral with a value less than

the amount of the debt are not entitled to interest during the period that their property is tied up

in the bankruptcy proceeding Because of the extended time period during which the creditors’interest in the property is tied up in bankruptcy proceedings, this decision will most likely en-courage creditors to properly collateralize their claim and may in limited ways restrict the grant-ing of credit

If relief from the stay is granted, a creditor may foreclose on property on which a lien exists, maycontinue a state court suit, or may enforce any judgment that might have been obtained before thebankruptcy case

(ii) Accounting Services—Determining Equity in Property. The accountant may assisteither the debtor or the creditor in determining the value of the collateral to help determine if

there is any equity in the property As a result of the Timbers decision, the court is more closely

considering the prospects for successful reorganization In cases where there is considerablequestion about the ability of the debtor to reorganize, courts are now allowing the stay to beremoved, providing there is no equity in the property The debtor, creditors’ committee, or se-cured creditor(s) may ask accountants to provide evidences as to the ability of the debtor toreorganize.

(e) EXECUTORY CONTRACTS AND LEASES Section 365(a) provides that the debtor or

trustee, subject to court approval, may assume, assign, or reject any executory contract or unexpiredlease of the debtor Executory contracts are contracts that are “so far unperformed that the failure ofeither [the bankrupt or nonbankrupt] to complete performance would constitute a material breach ex-cusing the performance of the other.”1Countryman’s definition seems to have been adopted by Con-gress in the statement that “executory contracts include contracts under which performance remainsdue to some extent on both sides.”2However, before a contract can be assumed, Section 361 indi-cates that the debtor or trustee must:

• Cure the past defaults or provide assurance they will be promptly cured

• Compensate the other party for actual pecuniary loss to such property or provide assurance thatcompensation will be made promptly

• Provide adequate assurance of future performance under the contract or lease

(i) Limitations on Executory Contracts. To be rejected, the contract must still be an ecutory contract For example, the delivery of goods to a carrier before the petition is filed,under terms that provide that the seller’s performance is completed upon the delivery of thegoods to the carrier, would not be an executory contract in Chapter 11 Furthermore, theseller’s claim would not be an administrative claim On the other hand, if the terms providethat the goods are received on delivery to the buyer, the seller under Uniform CommercialCode (UCC) Section 2-705 would have the right to stop the goods in transit and the automaticstay would not preclude such action If the goods are delivered, payment for such goods would

ex-be an administrative expense

The damages allowable to the landlord of a debtor from termination of a lease of real erty are limited to the greater of onr year or 15% of the remaining portion of the lease’s rent duenot to exceed three years after the date of filing or surrender, whichever is earlier This formulacompensates the landlord while not allowing the claim to be so large as to hurt other creditors ofthe estate The damages resulting from the breach of an employment contract are limited to oneyear following the date of the petition or the termination of employment, whichever is earlier

prop-(ii) Accounting Services—Rejection of Executory Contracts The accountant may render

sev-eral services relating to the rejection of executory contracts, including these three:

1 Estimating the amount of the damages that resulted from the lease rejection for either the

debtor or landlord

2 Evaluating for the landlord the extent to which the debtor has the ability to make the payments

required under the lease

3 Assisting the debtor in determining (or evaluating for the creditor’s committee) the leases that

should be rejected To the extent possible, this assessment should be made at the beginning ofthe case to help reduce the expenses of administration during the Chapter 11 case Amounts paidfor rent for the period after filing petition to the date of rejection are considered administrativeexpenses Each lease needs to be analyzed to determine if there is equity in the lease or if thedebtor needs it to successfully reorganize

1See Countryman, “Executory Contracts in Bankruptcy,” Minnesota Law Review, Vol 57 (1973), pp 439, 460.

2See S Rep No 95-989, 95th Cong., 2nd Sess (1977)

(f) AVOIDING POWER The Bankruptcy Code grants to the trustee or debtor in possession the

right to avoid certain transfers and obligations incurred For example, Section 544 allows the trustee

to avoid unperfected security interest and other interests in the debtor’s property Thus if the creditorfails to perfect a real estate mortgage, the trustee may be able to avoid that security interest and forcethe claim to be classified as unsecured rather than secured

The trustee needs these powers and rights to ensure that actions by the debtor or by creditors inthe prepetition period do not interfere with the objective of the bankruptcy laws, to provide for a fairand equal distribution of the debtor’s assets through liquidation—or rehabilitation, if this would bebetter for other creditors involved

In addition the trustee has the power to avoid preferences, fraudulent transfers, and tion transfers

postpeti-(g) PREFERENCES A preferential payment as defined in Section 547 of the Bankruptcy Code is a

transfer of any of the property of a debtor to or for the benefit of a creditor, for or on account of anantecedent debt made or suffered by the debtor while insolvent and within 90 days before the filing

of a petition initiating bankruptcy proceedings, when such transfer enables the creditor to receive agreater percentage of payment than it would receive if the debtor were liquidated under chapter 7 In-solvency is presumed during the 90-day period A transfer of property to an insider between 90 daysand one year before the filing of the petition is also considered a preferential payment An officer, di-rector, or person in control of the corporation would be considered an insider Action to recover

a preferential payment received by a third party that benefited an officer or other insider mayonly be taken against the officer or other insider and not against the third party For example, if

a president paid off a loan that he personally guaranteed six months before the petition wasfiled, the payment would be recoverable as a preference from the president, but not from thebank Preferences include the payment of money, a transfer of property, assignment of receivables,

or the giving of a mortgage on real or personal property

A preferential payment is not a fraud but rather a legitimate and proper payment of a valid tecedent debt The voidability of preferences is created by law to effect equality of distributionamong all the creditors The 90-day period (one year for transactions with insiders) prior to filingthe bankruptcy petition has been arbitrarily selected by Congress as the time period during whichdistributions to the debtor’s creditors may be redistributed to all the creditors ratably During thisperiod, a creditor who accepts a payment is said to have been preferred and may be required to re-turn the amount received and later participate in the enlarged estate to the pro rata extent of its unre-duced claim

an-(i) Exceptions to Preferential Transfers Section 547(c) contains eight exceptions to the power

the trustee has to avoid preferential transfers Five of the assumptions are discussed below

1 Contemporaneous exchange A transfer intended by the debtor and creditor to have a

contem-poraneous exchange for new value given to the debtor and that is in fact a substantially temporaneous exchange is exempted The purchase of goods or services with a check wouldnot be a preferential payment, provided the check is presented for payment in the normalcourse of business

con-2 Ordinary course of business and ordinary business terms The second exemption protects

payments of debts that were incurred in the ordinary course of business or financial affairs ofboth the debtor and the transferee when the payment is made in the ordinary course of busi-ness according to ordinary business terms

3 Purchase money security interest The third exception exempts security interests granted

in exchange for enabling loans when the proceeds are used to finance the purchase of cific personal property For example, a debtor borrowed $75,000 from a bank to finance acomputer system and subsequently purchased the system The “transfer” of this system ascollateral to the bank would not be a preference provided the proceeds were given after

spe-the signing of spe-the security agreement, spe-the proceeds were used to purchase spe-the system, andthe security interest was perfected within 20 days after the debtor received possession ofthe property.

4 New value This exception provides that the creditor is allowed to insulate from

prefer-ence attack a transfer received to the extent that the creditor replenishes the estate withnew value For example, if a creditor receives $10,000 in preferential payments and subse-quently sells to the debtor, on unsecured credit, goods with a value of $6,000, the prefer-ence would be only $4,000 The new credit extended must be unsecured and can be nettedonly against a previous preferential payment, not a subsequent payment

5 Inventory and receivables This exception allows a creditor to have a continuing security

interest in inventory and receivables (or proceeds) unless the position of the creditor is proved during the 90 days before the petition If the creditor is an insider, the time period

im-is extended to one year An improvement in position occurs when a transfer causes a duction in the amount by which the debt secured by the security interest exceeds the value

re-of all security interest for such debt

A two-point test is to be used to determine if an improvement in position occurred: Theposition 90 days (one year for insiders) prior to the filing of the petition is compared withthe position as of the date of the petition If the security interest is less than 90 days old,then the date on which new value was first given is compared to the position as of the date

of the petition The extent of any improvement caused by transfers to the prejudice of secured creditors is considered a preference

un-To illustrate this rule, assume that on March 1, the bank made a loan of $700,000 to thedebtor secured by a so-called floating lien on inventory The inventory value was $800,000

at that date On June 30, the date the debtor filed a bankruptcy petition, the balance of theloan was $600,000 and the debtor had inventory valued at $500,000 It was determined that

90 days prior to June 30 (date petition was filed), the inventory totaled $450,000 and the loanbalance was $625,000 In this case there has been an improvement in position of $75,000($600,000⫺ $500,000) ⫺ ($625,000 ⫺ $450,000), and any transfer of a security interest ininventory or proceeds could be revoked to that extent

(ii) Accounting Services—Search for Preferential Payments. The trustee or possession will attempt to recover preferential payments Section 547(f) provides that thedebtor is presumed to be insolvent during the 90-day period prior to bankruptcy This pre-sumption does not apply to transfers to insiders between 91 days and one year prior to bank-ruptcy This presumption requires the adverse party to come forth with some evidence toprove the presumption The burden of proof, however, remains with the party in whose favorthe presumption exists Once this presumption is rebutted, insolvency at the time of payment

debtor-is necessary, and only someone with the training of an accountant debtor-is in a position to prove solvency The accountant often assists the debtor or trustee in presenting evidence showingwhether the debtor was solvent or insolvent at the time payment was made In cases wherenew management is in charge of the business or where a trustee has been appointed, the em-phasis is often on trying to show that the debtor was insolvent in order to recover the previouspayments and increase the size of the estate The creditors’ committee likewise wants to showthat the debtor was insolvent at the time of payment to provide a larger basis for payment tounsecured creditors Of course, the specific creditor recovering the payment looks for evi-dence to indicate that the debtor was solvent at the time payment was made

in-Any payments made within the 90 days preceding the bankruptcy court filing and that are not inthe ordinary course of business should be very carefully reviewed to see if the payments were pref-erences Suspicious transactions would include anticipations of debt obligations, repayment of offi-cers’ loans, repayment of loans that have been personally guaranteed by officers, repayment of loansmade to personal friends and relatives, collateral given to lenders, and sales of merchandise made on

a countraaccount basis

In seeking to find voidable preferences, the accountant has two crucial tasks: to determine the liest date on which insolvency can be established within the 90-day period (one year for insiders),and to report to the trustee’s attorney questionable payments, transfers, or encumbrances that havebeen made by the debtor after that date It is then the attorney’s responsibility to determine the void-able payments However, the accountant’s role should not be minimized, for it is the accountant whoinitially determines the suspect payments See Newton (2000) for a discussion of the procedures tofollow in a search for preferences.

ear-(h) FRAUDULENT TRANSFERS Fraudulent transfers and obligations are defined in Section 548

and include transfers that are presumed fraudulent regardless of whether the debtor’s actual intent was

to defraud creditors A transfer may be avoided as fraudulent when made within one year prior to thefiling of the bankruptcy petition, if the debtor made such transfer or incurred such obligation with ac-tual intent to hinder, delay, or defraud existing or real or imagined future creditors Also avoidable areconstructively fraudulent transfers where the debtor received less than a reasonably equivalent value

in exchange for such transfer or obligation and (1) was insolvent on the date that such transfer wasmade or such obligation was incurred, or became insolvent as a result of such transfer or obligation;(2) was engaged in business, or was about to engage in business or a transaction, for which any prop-erty remaining with the debtor was an unreasonably small capital; or (3) intended to incur, or believedthat the debtor would incur, debts that would burden the debtor’s ability to pay as such debts matured.Under Section 544 of the Bankruptcy Code, fraudulent transfers may also be recovered understate law for payments made between one and six years Section 546 provides that any action to re-cover a preference or a fraudulent transfer under Section 548 through the Bankruptcy Code or underSection 544 through state law must commence the action within two years after the order for relief or

if a trustee is appointed during the second year after the petition is filed within one year after thetrustee is appointed

In the determination of fraudulent transfers, insolvency is defined by Section 101(32) as occurringwhen the present fair salable value of the debtor’s property is less than the amount required to pay itsdebts The fair value of the debtor’s property is also reduced by any fraudulently transferred property,and for an individual, by the exempt property under Section 522

(i) LBO as a Fraudulent Transfer A fraudulent transfer may occur in a leveraged buyout (LBO).

For example, in a LBO transaction where the assets of the debtor were used to finance the purchase

of the debtor’s stock and the debtor became insolvent, operated with an unreasonably small capital,

or incurred debt beyond the ability to repay, a fraudulent transfer may have occurred Note that thetransfer may have been made without adequate consideration because the debtor corporation re-ceived no benefit from the proceeds from the loan that were used to retire former stockholder’s stock

(ii) Accounting Services—Search for Fraudulent Transfers It is important for the accountant

to ascertain when a fraudulent transfer has in fact occurred because it represents a possible recoverythat could increase the value of the estate It can, under certain conditions, prevent the debtor fromobtaining a discharge To be barred from a discharge as the result of a fraudulent transfer, the debtormust be an individual and the proceedings must be under chapter 7 liquidation or the trustee must beliquidating the estate under a Chapter 11 proceeding

In ascertaining if the debtor has made any fraudulent transfers or incurred fraudulent obligations,the independent accountant would carefully examine transactions with related parties within the yearprior to the petition or other required period, look for the sale of large amounts of fixed assets, reviewliens granted to creditors, and examine all other transactions that appear to have arisen outside the or-dinary course of the business

(i) POSTPETITION TRANSFERS Section 549 allows the trustee to avoid certain transfers made

after the petition is filed To be avoidable, transfers must not be authorized either by the court or by

an explicit provision of the Bankruptcy Code

(i) Adequate Value Received The trustee can avoid transfers made under Section 303(f) and

542(c) of the Bankruptcy Code even though authorized Section 303(f) authorizes a debtor to tinue operating the business before the order for relief in an involuntary case Section 549 does,however, provide that a transfer made prior to the order for relief is valid to the extent of value re-ceived Thus, the provision of Section 549 cautions all persons dealing with a debtor before anorder for relief has been granted to evaluate the transfers carefully Section 542(c) explicitly au-thorizes certain postpetition transfers of real property of the estate made in good faith by an entitywithout actual knowledge or notice of the commencement of the case

con-(ii) Accounting Services—Preventing Unauthorized Transfers To prevent unauthorized

transfers, the procedures that the accountant should see are operative include the following three:

1 Establishing procedures to ensure that prepetition debt payments are made only with proper

authorization

2 Designating an individual to handle all requests for prepetition debt payments

3 Acquainting accounting personnel with techniques that might be used to obtain unauthorized

prepetition debt payments

(j) SETOFFS. Setoff is that right existing between two parties to net their respective debtswhere each party, as a result of unrelated transactions, owes the other an ascertained amount Theright to setoff is an accepted practice in the business community today When one of the two par-ties is insolvent and files a bankruptcy court petition, the right to setoff has special meaning.Once the petition is filed, the debtor may compel the creditor to pay the debt owed and the credi-tor may in turn receive only a small percentage of the claim—unless the Bankruptcy Code per-mits the setoff

The Bankruptcy Code gives the creditor the right to offset a mutual debt, providing both thedebt and the credit arose before the commencement of the case Major restriction on the use ofsetoff prevents the creditor from unilaterally making the setoff after a petition is filed Theright to setoff is subject to the automatic stay provisions of Section 362 and the use of propertyunder Section 363 Thus, a debtor must obtain relief from the automatic stay before proceedingwith the setoff This automatic stay and the right to use the amount subject to setoff is possibleonly when the trustee or debtor in possession provides the creditor with adequate protection Ifadequate protection—normally in the form of periodic cash payments, additional or replace-ment collateral, or other methods that will provide the creditor with the indubitable equivalent

of its interest—is not provided, then the creditor may proceed with the offset as provided inSection 553

(i) Early Setoff Penalty. Section 553(b) contains a penalty for those creditors who, whenthey see the financial problems of the debtor and threat of the automatic stay, elect to offset theirclaim prior to the petition The Code precludes the setoff of any amount that is a betterment ofthe creditor’s position during the 90 days prior to the filing of the petition Any improvement inposition may be recovered by the debtor in possession or trustee The amount to be recovered isthe amount by which the insufficiency on the date of offset is less than the insufficiency 90 daysbefore the filing of the petition If no insufficiency exists 90 days before the filing of the peti-tion, then the first date within the 90-day period where there is an insufficiency should be used.Insufficiency is defined as the amount by which a claim against the debtor exceeds a mutual debtowing to the debtor by the holder of such claim The amount recovered is considered an unse-cured claim

(ii) Accounting Services—Setoffs. In addition to developing a schedule that helps mine the amount of the penalty, the accountant may assist in determining the amount of debtoutstanding

deter-(k) RECLAMATION. One area where the avoiding power of the trustee is limited is in a quest for reclamation Section 546(c) provides that under certain conditions, the creditor has theright to reclaim goods if the debtor received the goods while insolvent To reclaim these goods,the seller must demand in writing, within 10 days after their receipt by the debtor, that the goods

re-be returned The court can deny reclamation, assuming the right is established, only if the claim

is considered an administrative expense or if the claim is secured by a lien A creditor faces someproblems in attempting to reclaim goods One is that the request must be made within 10 days Ifthe 10-day period expires after the commencement of the case, the seller may reclaim the goodswithin 20 days after the receipt of the goods by the buyer Requests made after this time periodare denied

Another problem is that the right of reclamation under UCC Section 2-702 is basically a right toobtain the physical return of particular goods in the hands of the debtor If the goods have been sold

or used, the ability to obtain the goods may be limited For example, it is doubtful that the sellercould reclaim goods that were sold by the debtor to a purchaser in good faith that had no knowledge

of the debtor’s financial problems Also, the reclamation rights of the seller are subject to any rior right of other creditors, which most likely would include the good faith purchaser or buyer in theordinary course of business

supe-The court may deny reclamation to a seller that has the right to the reclamation only if thecourt either grants an administrative expense for the amount of the claim or secures such claimwith a lien

(l) U.S TRUSTEE Chapter 30 of Title 28, U.S Code, provides for the establishment of the U.S.

trustee program The Attorney General is responsible for appointing one U.S trustee in each of the

21 regions, and one or more assistant U.S trustees perform the supervisory and appointing tions formerly handled by bankruptcy judges They are the principal administrative officers of thebankruptcy system The judicial districts of Alabama and North Carolina were not to be a part of theexpansion of the U.S Trustee program until 1992 The Judicial Improvements Act of 1990 (P.L.101-650) extended the time period in which the six districts must be a part of the system to October

func-1, 2002 In these districts, some of the functions performed by the U.S trustee in other districts areassigned to an administrator in the bankruptcy court

The U.S trustee establishes, maintains, and supervises a panel of private trustees that are eligibleand available to serve as trustee in cases under chapter 7 or 11 Also, the U.S trustee supervises theadministration of the estate and the trustees in cases under chapter 7, 11, 12, or 13 The intent is notfor the U.S trustee system to replace private trustees in chapters 7 and 11 Rather, the system shouldrelieve the bankruptcy judges of certain administrative and supervisory tasks and thus help to elimi-nate any institutional bias or the appearance of any such bias that may have existed in the prior bank-ruptcy system

The U.S trustees are responsible for the administration of cases They appoint the committees ofcreditors with unsecured claims and also appoint any other committees of creditors or stockholdersauthorized by the court If the court deems it necessary to appoint a trustee or examiner, a U.S.trustee makes this appointment (subject to court approval) and also petitions the court to authorizesuch an appointment

U.S trustees monitor applications for compensation and reimbursement for officers and tants and other professionals retained in the case, raising objections when deemed appropriate Otherresponsibilities include monitoring plans and disclosure statements, creditors’ committees, and theprogress of the case

accoun-43.4 HANDLING OF CLAIMS UNDER CHAPTER 11

A claim antedating the filing of the petition that is not a priority claim or that is not secured by thepledge of property is classified as an unsecured claim Claims where the value of the security interest

is less than the amount of the claims are divided into a secured and an unsecured part

(a) PROOF OF CLAIMS. A proof of claim or interest is deemed filed in a Chapter 11 case vided the claim or interest is listed in the schedules filed by the debtor, unless the claim or inter-est is listed as disputed, contingent, or unliquidated A creditor is thus not required to file a proof

pro-of claim if it agrees with the debt listed in the schedules It is, however, advisable for creditors tofile a proof of claim in most situations Creditors who for any reason disagree with the amountadmitted on the debtor’s schedules, such as allowable prepetition interest on their claims, or cred-itors desiring to give a power of attorney to a trade association or lawyer, should always prepareand file a complete proof of claim Special attention must also be devoted to secured claims thatare undersecured

(b) UNDERSECURED CLAIMS. Section 506 provides that if a creditor is undersecured,the claim will be divided into two parts The first part is secured to the extent of the value ofthe collateral or to the extent of the amount of funds subject to setoff The balance of theclaim is considered unsecured The value to be used to determine the amount of the securedclaim is, according to Section 506(a), to “be determined in light of the purpose of the valua-tion and of the proposed disposition or use of such property, and in conjunction with anyhearing on such disposition or use or on a plan affecting such creditors’ interest.” BankruptcyRule 3012 provides that any party in interest may petition the court to determine the value of

a secured claim

Thus, the approach used to value property subject to a lien for a chapter 7 may be different fromthat for a Chapter 11 proceeding Even within a Chapter 11 case, property may be valued differently.For example, fixed assets that are going to be sold because of the discontinuance of operations may

be assigned liquidation values, whereas assets that will continue to be used by the debtor may be signed going concern values Although courts have to determine value on a case-by-case basis, it isclear that the value is to be determined in light of the purpose of the valuation and the proposed dis-position or use of the property

as-Section 1111(b) allows a secured claim to be treated as a claim with recourse against the debtor inChapter 11 proceedings (that is, where the debtor is liable for any deficiency between the value of thecollateral and the balance due on the debt) whether the claim is nonrecourse by agreement or by ap-plicable law This preferred status terminates if the property securing the loan is sold under Section

363 or is to be sold under the terms of the plan, or if the class of which the secured claim is a partelects application of Section 1111(b)(2)

Another available section under Section 1111(b) is that a class of undersecured creditors canelect to have its entire claim considered secured A class of creditors will normally be only onecreditor For example, in Chapter 11 cases where most of the assets are pledged, very little may beavailable for unsecured creditors after paying administrative expenses Thus, the creditor might find

it advisable to make the Section 1111(b)(2) election On the other hand, if there will be a payment

to unsecured creditors of approximately 75 cents per dollar of debt, the creditor may not want tomake this election

The purpose of the election is to provide adequate protection to holders of secured claims wherethe holder is of the opinion that the collateral is undervalued Also, if the treatment of the part of thedebt that is accorded unsecured status is so unattractive, the holder may be willing to waive his unse-cured deficiency claims The class of creditors making this election has the right to receive full pay-ment for its claims over time If the members of the class do not approve the plan, the court mayconfirm the plan as long as the plan provides that each member of the class receives deferred cashpayments totaling at least the allowed amount of the claim However, the present value of these pay-ments as of the effective date of the plan must be at least equal to the value of the creditors’ interest inthe collateral Thus, a creditor who makes the election under Section 1111(b)(2) has the right to re-ceive full payment over time, but the value of that payment is only required to equal the value of thecreditor’s interest in the collateral

(c) ADMINISTRATIVE EXPENSES. The actual, necessary costs of preserving the estate, cluding wages, salaries, and commissions for services rendered after the commencement of the

in-case, are considered administrative expense Any tax including fines or penalties is allowed less it relates to a tax-granted preference under Section 507(a)(8) Compensation awarded aprofessional person, including accountants, for postpetition services is an expense of adminis-tration Expenses incurred in an involuntary case subsequent to the filing of the petition butprior to the appointment of a trustee or the order for relief are not considered administrative ex-penses They are, however, granted second priority under Section 507 Administrative ex-penses of a Chapter 11 case that is converted to chapter 7 are paid only after payment ofchapter 7 administrative expenses.

un-(d) PRIORITIES Section 507 provides for the following nine priorities:

1 Administrative expenses

2 Unsecured claims in an involuntary case arising after commencement of the proceedings but

before an order of relief is granted

3 Wages earned within 90 days prior to filing the petition (or the cessation of the business) to the

extent of $4,000 per individual

4 Unsecured claims to employee benefit plans arising within 180 days prior to filing petition

limited to $4,000 times the number of employees covered by the plan less the amount paid in(3) above and the amount previously paid on behalf of such employees

5 Unsecured claims of grain producers against a grain storage facility or of fishermen against a

fish storage or processing facility to the extent of $4,000

6 Unsecured claims of individuals to the extent of $1,800 from deposits of money for purchase,

lease, or rental of property or purchase of services not delivered or provided

7 Claims for debts to a spouse or former spouse or child for alimony, maintenance, or support

payments

8 Unsecured tax claims of governmental units:

a Income or gross receipts tax, provided tax return was due (including extension) within

three years prior to filing petition, tax is assessable after commencement of the case; or taxwas assessed within 240 days before petition was filed

b Property tax last payable without penalty within one year prior to filing petition

c Withholding taxes

d Employment tax on wages, and so forth, due within three years prior to the filing of

the petition

e Excise tax due within three years prior to the filing of the petition

f Customs duty on merchandise imported within one year prior to the filing of the petition

g Penalties related to a type of claim above in compensation for actual pecuniary loss

9 Allowed unsecured claims based on any commitment by the debtor to the Federal depository

institutions regulatory agency (or predecessors to such agency), to maintain the capital of aninsured depository institution

Priority claims in a Chapter 11 case must be provided for in the plan

(e) PROCESSING OF CLAIMS Several accounting firms and other businesses have developed

models to handle the processing of claims of both small and large debtors Some of their features clude these six:

in-1 Capture of all the various formats of claims needed by the bankruptcy court

2 Information needed for management to review and evaluate each claim

3 Mailing lists and labels

4 Creditor statements

5 Online update and inquiry capability

6 Modeling and decision analysis capability that enables management to evaluate settlement

al-ternatives efficiently

One system uses a multifield data base to help debtors deal with the complexities of a ruptcy Creditors’ files can be sorted in terms of classes of creditors, priorities of claims, and so on,and then alphabetically within these categories Notices sent to creditors include all the necessaryinformation, such as the amount of a claim and its current status Ongoing information that changesover time is constantly updated This could include the extent to which proofs of claim differ fromthe recorded debt, the assessment of market values of collateral pledged as security, other assetsthat are not pledged as security, distributions made during the course of a Chapter 11 case, andchanges to or withdrawals of claims Automatically prepared and mailed notices keep creditors cur-rent on the proceedings of a case The system, through automatic mailings, answers telephone in-quiries as they are entered

bank-43.5 OPERATING UNDER CHAPTER 11

No order is necessary under the Bankruptcy Code for the debtor to operate the business in Chapter

11 Sections 1107(a) and 1108 grant the debtor all the rights, powers, and duties of a trustee, exceptthe right to compensation under Section 330, and provide that the trustee may operate the businessunless the court directs otherwise Thus, the debtor will continue to operate the business unless aparty in interest requests that the court appoint a trustee Until action is taken by management to cor-rect the problems that caused the adverse financial condition, the business will most likely continue

to operate at a loss If the creditors believe new management is necessary to correct the problem, theywill press for a change in management or the appointment of a trustee In most large bankruptcies aswell as in many smaller cases, the management is replaced, often by turnaround specialists, whohave particular expertise in taking over troubled companies They often eliminate the unprofitableaspects of the company’s operations, reduce overhead, and find additional financing as part of theturnaround process Once the plan has been confirmed, turnaround specialists frequently move on toother troubled companies In small cases where management is also the stockholders, creditors areapt to be uncomfortable with existing management, which may have created the problems

(a) USE OF PROPERTY The debtor or trustee must be able to use a secured party’s collateral, or

in most situations there would be no alternative but to liquidate the business Section 363(c) gives thetrustee or debtor the right to use, sell, or lease property of the estate in the ordinary course of businesswithout a notice and a hearing As a result of this provision, the debtor may continue to sell inventoryand receivables and use raw materials in production without notice to secured creditors and withoutcourt approval The use, sale, or lease of the estate’s property other than in the ordinary course ofbusiness is allowed only after notice and an opportunity for a hearing Under Section 363 of theBankruptcy Code, companies, with court approval, may sell all of a large percent of the assets ofthe company As noted below, the sale of all or a large percentage of the debtor’s assets isviewed as a very viable option to the development of a plan

(i) Cash Collateral One restriction on the use of the property of the bankruptcy estate is placed

on the trustee or debtor where cash collateral is involved Cash collateral is cash, negotiable ments, documents of title, securities, deposit accounts, or other cash equivalents where the estateand someone else have an interest in the property Also included would be the proceeds of noncashcollateral, such as inventory and accounts receivable and proceeds, products, offspring, and rents,profits, or property subject to a security interest, if converted to proceeds of the type defined as cashcollateral, provided the proceeds are subject to the prepetition security interest