Problem 7.1. Assignment 7: Secured Creditors in Bankruptcy. Interest on Unsecured Claims

Assignment 7: Secured Creditors

in Bankruptcy

Reference: Understanding Secured

Transactions, §§ 16.01, 16.02, 16.03

Problem 7.1

$30,000

– Work done: Feb. 15 – Work billed: March 15 – Petition date: Sept. 15 – Today: Dec. 15

– Contract interest rate: 18% ($450/month)

– Attorney fees incurred prior to bankruptcy: $400

• Amount of CompuSoft’s claim?

• Permissible elements of claim

– Liability for services provided = $30,000

– Pre-petition interest = $450/month @ 18% = $2,700 • Impermissible elements of claim

– Post-petition interest [§ 502(b)(2)] • Unclear elements of claim

– Pre-bankruptcy attorney fees ($400), but only if Argossy

is liable for them under its contract with CompuSoft

• Thus, permissible claim is either:

– $32,700 (if K doesn’t obligate Argossy for atty fees), or – $33,100 (if K does obligate Argossy for atty fees)

Interest on Unsecured Claims

claims? [§ 502(b)(2)]

– In liquidation, distribution is a “zero-sum game” – Allowing unsecured creditors to accrue interest would

just diminish “dividend” rate by increasing total claims

• Note, however: interest would still accrue on the debt under state law! [distinguish a debt and a claim]

– If case is dismissed (or discharge denied), creditor can recover interest that accrued on debt during bankruptcy

Payment of Claims

• As unsecured creditor, CompuSoft will be paid on its claim pro rata along with other unsecured creditors (after all priority creditors are paid) • Problem 7.2: $59,575 available to unsecured

creditors; $1,191,500 unsecured claims = dividend of 5%

– CompuSoft will get paid 5% of its total claim – Balance of claim will be discharged (and written off,

unless CompuSoft has a guarantor)

Problem 7.3

• Speedo Printing files Ch. 11 – Speedo owes Commercial

Investors (CI) $340,000 on petition date, plus 6 months of unpaid interest (prior to bankruptcy) @ 12% – Loan is secured by

equipment (FMV = $400K) • For what amount should CI

file a proof of claim?

• In Problem 7.3, CI is an “oversecured” creditor (i.e., collateral’s value >> amount of claim) • Oversecured creditor can include any unpaid

pre-petition interest as part of its claim, and is also entitled to “pendency” interest (i.e., post-petition interest from petition date until discharge is granted or plan is confirmed) [§ 506(b)]

– Contrast: unsecured creditors are not entitled to “pendency” interest [§ 502(b)(2)]

– Right to accrue post-petition interest from “equity cushion” protects oversecured creditors from impact of delay caused by imposition of automatic stay

Problem 7.3(a): CI’s Claim

• Principal = $340,000

• Accrued but unpaid interest pre-petition = $20,400 • Total claim = $360,400

• Because claim is oversecured, § 506(b) entitles CI to receive pendency interest on its claim

– At 12%, this is $3,604 per month

– Debtor must either pay this amount to CI each month during “pendency” (i.e., until plan is confirmed), or CI

Secured Claims and Chapter 11

• A Chapter 11 debtor begins “repaying” its creditors once its “plan” has been confirmed

– “Plan” creates new payment terms for each creditor, replacing terms that existed pre-bankruptcy

– To confirm the plan over creditor objections, the plan must be fair and equitable [§ 1129(b)(1)]

– For a secured claim, this means the plan must make total payments to the secured creditor = present

value of creditor’s secured claim [§ 1129(b)(2)]

• Suppose Speedo’s plan is confirmed after 3 months in bankruptcy, and Speedo didn’t pay post-petition interest in cash during pendency • At plan confirmation, CI’s claim = $360,400 (secured claim at petition date) + $10,812 (3 months’ pendency interest at 12%) = $371,212 • Under plan, Speedo must pay CI either:

– (1) a lump sum of $371,212 (or other property worth that amount) on the “effective date” of the plan, or – (2) payments in installments, over time, that have a

present value of $371,212 (i.e., $371,212 + interest)

• Problem 7.3(c): What if it takes Speedo 1 year to get its plan and get it confirmed by the court?

– Unpaid post-petition interest will be added to CI’s claim until total claim reaches $400,000 (the value of the collateral)

– At that point, CI is no longer be oversecured – At that point, CI won’t be entitled to “pendency

interest” any longer under § 506(b)

– Speedo’s secured claim thus “maxes out” at $400,000

Problem 7.4

• Speedo Printing files Ch. 11 • On petition date, Speedo

owes CI $360,400

(including 6 mos. accrued but unpaid interest @ 12%)

– Loan secured by equipment (FMV = $325,000)

• For what amount should CI file a proof of claim?

Problem 7.4: Which Is Correct?

$360,400, which will accrue post-petition (PP) interest

B. CI has a secured claim for $325,000 (which accrues PP interest) and an unsecured claim for $35,400 (which doesn’t) C. CI has a secured claim for

$325,000 and an unsecured claim for $35,400; neither will accrue

PP interest CI has a

 secu red  claim  fo... CI ha s a se cure d cla im fo r... CI ha s a sec ured  claim  for.. . 0% 0% 0%

Bifurcation of Claims

• CI is an “undersecured” creditor (amount of the debt >>> value of the collateral)

• § 506(a) “bifurcates” undersecured claims (i.e., it treats 1 claim as 2, for purposes of bankruptcy)

– Claim is secured, up to value of the collateral – Rest of the total claim is unsecured claim

• Unsecured claim is only paid, pro rata, with claims of other unsecured creditors

Problem 7.4

• CI’s total claim = $360,400

• This total claim is deemed to be 2 claims:

• Because CI is not oversecured, no pendency interest accrues on this claim [§ 506(b)]

– Unsecured claim = $35,400

• No interest accrues on this claim [§ 502(b)(2)]

Problem 7.4(b): If Speedo’s Plan Is

Confirmed, What Is CI’s Treatment?

• Secured claim: CI will get either (a) $325,000 lump sum in cash, or (more likely) (b) installment payments totaling $325,000 + interest [§

1129(b)(2)]

• Unsecured claim = percentage dividend (total assets/total unsecured claims) X $35,400 (this will be paid, typically, in a lump sum or in

Problem 7.4(c)

• Does it matter to CI whether Speedo’s plan is confirmed 3 months after petition date, or 1 year after petition date?

• Yes! The sooner, the better

– Because CI is undersecured, CI is not entitled to any pendency interest on its claim

– Thus, the longer Speedo takes to confirm its plan, the greater is CI’s “lost opportunity” cost (we could’ve loaned to someone who COULD pay!)

Bankruptcy Distribution

Undersecured Claims and Interest Payments:

Effective Date of Plan of Reorganization

Debtor must pay interest on secured

claim under plan (if not paid in full on effective date) [BC § 1129(b)(2)(A)] Prior to effective date (during pendency of

bankruptcy), Debtor pays no interest on secured portion of claim

Petition Date

Effective Date of Plan of Reorganization Petition Date

Oversecured Claims and Interest Payments:

Prior to effective date (during pendency of bankruptcy), Debtor must pay interest on

oversecured claim [§ 506(b)]

Debtor must pay interest on secured

claim under plan (if not paid in full on effective date) [BC § 1129(b)(2)(A)]

Assume you are a Chapter 7 trustee for Smith.

On petition date, Smith owed Bank $10,000,

secured by a SI in Smith’s car. FMV of the

car is only $4,000. What should trustee do?

A. Abandon the car and let

Smith and Bank fight it out

B. Sell the car along with the

other property of the

bankruptcy estate

• Trustee may “abandon” property of the estate if it is “burdensome” to the estate or if the equity in the property is of “inconsequential value” to the estate [§ 554(a)]

– Rationale: don’t want to “waste” limited assets; trustee doesn’t want to incur costs of preserving and selling collateral where “there’s nothing in it for the estate”

– Abandonment re-vests title back into the debtor

• If trustee doesn’t abandon voluntarily, court can order trustee to do so [§ 554(b)]

Problem 7.6

• You are Ch. 7 bankruptcy trustee for Perez

– On petition date, Perez owned home, subject to $850,000 mortgage debt

– Interest rate on mortgage = 10%

• Broker has offered to sell home for 6% commission (+ $10,000 in sale expenses)

– Broker: house worth $1MM, but market is slow

• Broker wants a 1-year listing agreement. Should you agree?

What Should Trustee Do?

A. Abandon the house now

B. Don’t abandon the house;

sell it, however long it takes

C. Try to sell the house for

about 6 months, then

abandon it, if it is still

unsold

• If FMV = $1,000,000, First Capital is oversecured • If house can be sold for $1,000,000 six months

from now, that sale would produce total net surplus proceeds of $37,500

– Principal = $850,000

– 6 months’ additional interest = $42,500 – Expected broker fee, expenses of sale = $70,000 – Total debt/costs of sale = $962,500

• If sale takes >> 6 months, additional interest will consume most/all of remaining equity; thus, trustee probably won’t list w/broker for longer than six month period