Attorneys dealing with distressed businesses, whether on the debtor or the creditor’s side, should carefully explore alternatives to the bankruptcy code. In 2005, Congress enacted the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 ("BAPCPA") to curtail the perceived "abuse" of the bankruptcy process. The Act made sweeping changes to the Bankruptcy Code, such as requiring means-testing for all Chapter 7 consumers, limiting what types of debts are actually dischargeable in bankruptcy, and requiring credit counseling for those considering bankruptcy. These changes are viewed by many to be creditor-friendly and add to the cost of "going bankrupt." However, the Act is not completely slanted in favor of the creditors. In one such revision, the Act expands the defenses available in preference actions filed by a trustee. Creditors, debtors and their attorneys, must therefore keep in mind non-bankruptcy alternatives available. This article addresses several of these alternatives and identifies the pros and cons of each.
Choosing the Right Chapter. By design, bankruptcy "gives to the honest but unfortunate debtor who surrenders for distribution of the property which he owns at the time of bankruptcy, a new opportunity in life and a clear field for future effort, unhampered by the pressure and discouragement of pre-existing debt."1 Individuals have two main options when declaring bankruptcy-Chapter 7 and Chapter 13. In Chapter 7 cases, a trustee is appointed to collect and sell the debtor’s non-exempt assets and distribute the proceeds to creditors. In the collection process, the Chapter 7 trustees can seek to void fraudulent transfers and preferential transfers. Following liquidation, a consumer is discharged from liability for all debts remaining unpaid. BAPCPA adds a few hurdles that a Chapter 7 consumer must clear. BAPCPA requires all consumers to engage in credit counseling before seeking bankruptcy protections.2 Chapter 7 cases are now subject to a means-test. If a consumer debtor does not meet the means test, Chapter 7 is not available and the discharge of debts that follows a Chapter 7 case is equally unavailable. In Chapter 13 cases, the debtor has a source of income and proposes a plan specifying the amounts to be paid to each creditor from that source of income. Creditors do not need to be fully paid, but they must get at least as much as they would receive in a Chapter 7 case. Unlike Chapter 7 cases, the debtor, filing under Chapter 13, keeps his or her non-exempt property. Like a Chapter 7 debtor, a Chapter 13 debtor receives a discharge; however, the extent of the discharge has also been narrowed by BAPCPA.
Businesses can also file for Chapter 7 bankruptcy protection; however, the business does not need to complete the credit counseling requirement of BAPCPA nor must it satisfy the means test. Like consumer cases, a trustee is appointed to collect and sell the debtors assets and distribute the proceeds. Alternatively, businesses can enter into Chapter 11 bankruptcy, which is similar to a Chapter 13 proceeding. In a Chapter 11 proceeding, the debtor keeps its property and proposes a "plan of reorganization" that outlines how creditors will be repaid in the future. The proposal is then submitted to the creditors. If the creditors accept the plan, the plan is confirmed and the debtor discharged. If the creditors do not accept the plan, the plan would be presented to a bankruptcy judge who determines whether to confirm the plan.
Assignments for the Benefit of Creditors. Given the added administrative costs of BAPCPA and the narrowing of the benefits of bankruptcy, many practitioners believe that Illinois will see a resurgence in the use of non-bankruptcy alternatives to satisfying the obligations of the financially distressed.
The most common alternative, in the business setting, is the common law assignment for the benefit of creditors.3 An assignment for the benefit of creditors is defined as "a voluntary transfer by a debtor of its property to an assignee in trust for the purpose of applying the property or proceeds thereof to the payment of its debts and returning any surplus to the debtor."4 Assignments are, therefore, nothing more than a special type of trust which the assignee (or trustee) holds property for the benefit of another (the creditors of the assignor). The assignee owes fiduciary duties to the creditors in the same way a trustee owes fiduciary duties to the trust beneficiaries.5
A careful assignee will examine the debtor’s books and records to determine whether the debtor has made transfers of its property that are voidable under the Fraudulent Transfer Act.6 Assignments place the debtor’s property into the hands of the assignee and out of the reach of the debtor’s individual creditors who subsequently file post-judgment enforcement proceedings. Significantly, a debtor does not need to obtain a creditor’s permission to make the assignment, although often times a creditor is in favor of the assignment and will cooperate with the assignee.
Assignments must satisfy all the common law requirements or will be of no effect. In Illinois Bell Tel. Co. v. Wolf Furniture Co., the appellate court rejected "middle ground approaches" advocated in other states7 and held that if an assignment is invalid, then all of the debtor’s property in the possession of the assignee can be reached by creditors.8 Therefore, when drafting an assignment for the benefit of creditors, one must be extremely careful to comply with all the common law requirements.
Illinois common law imposes some formal requirements on debtors wishing to make an assignment for the benefit of creditors. All valid assignments must be in writing and have express language that establishes a trust over specific property for the benefit of all creditors, and not just a selected group of creditors.9 No particular form is necessary to create a valid assignment so long as the intention of the parties may be inferred from the instrument and so long as the assignor and the assignee are the parties.10 The transfer of the property must be absolute and unqualified and the assignee must accept the assignment in order for it to be valid.
For a debtor, assignments are similar to Chapter 7 liquidations; however, an assignment carries benefits for both debtor and creditor. Compared to bankruptcy, assignments generally have lower costs and the proceeds are distributed more quickly. With an assignment, the debtor has the ability to select an assignee who understands its business and can competently liquidate its assets in a manner that yields the highest value. In bankruptcy, the debtor loses all control and a random trustee is assigned to essentially perform the same tasks as an assignee. Creditors likewise reap the benefit of the assignee’s experience and speed. From the creditor’s perspective, the major drawback to an assignment is the inability of the assignee to void a preferential transfer. However, BAPCPA makes it harder for trustees to recover preferential transfers in bankruptcy proceedings. Therefore, this difference has become significantly diminished.
Composition and Extension Agreements. Other common alternatives to filing for bankruptcy protection include entering into an extension agreement or a composition agreement with a creditor. These agreements take on a variety of shapes and sizes depending on the particular circumstances of the debtor and the creditor; however, they have two main themes. In "extension agreements", a creditor agrees to extend the time for payment, without altering the amount owed.11 Usually, the creditor agrees to accept multiple payments over time in satisfaction of its debt. In other cases, the agreement is a "composition" that reduces the amount of debts owed.12 Like an assignment, these agreements are executed outside of the bankruptcy system. Unlike an assignment where the debtor relinquishes control of his property, the debtor remains in control with composition and extension agreements. It simply makes the negotiated payments and continues to go about its business. Problems arise when the debtor cannot meet the requirements of the extension or composition agreement. In cases of multiple creditors, the debtor must ensure that the remaining creditors do not believe the agreement is being made for the benefit of one creditor at the expense of the other creditors. If multiple creditors believe they can get a better deal in the bankruptcy court, they could force the debtor into involuntary bankruptcy and request that the bankruptcy trustee void the agreement.
Receivers. Creditors can request that the court appoint a receiver over the debtor’s property. While receivers are typically appointed in post-judgment cases, it is possible for a receiver to be appointed prior to judgment being entered. The appointment of a receiver pendente lite is a branch of equity court jurisdiction and not dependent on any statutory authority. While rare and considered a drastic measure, a pendente lite receiver can be appointed in cases involving corporate waste, self-dealing, inactivity or dissension among the corporation’s directors, fraud, mismanagement or in other cases in which it is impossible for a corporation to carry on its business or preserve its assets until a settlement of the creditor’s claim is reached.13 A party requesting a receiver also must show it has some clear right or some lien on the property for which the receiver is sought, that there is as an "imminent danger of dissipation if a receiver is not appointed" and that there is no other adequate remedy or means of accomplishing the desired result.14
Receivers serve as an alternative to forcing involuntary bankruptcy under Chapter 7. A receiver is particularly helpful in cases in which a debtor has a viable business but has been simply mismanaged. A court appointed receiver may be able to operate the debtor’s business in a manner that produces enough income to meet its obligations to its creditors in full. A receiver cannot undo the damage caused by the mismanagement of the debtor’s business; however, the bankruptcy trustee can undo some of the damage by bringing preference actions to void a debtor’s transactions. Therefore, in cases in which the creditor believes the debtor’s assets have been previously dissipated and in which the debtor’s business is no longer viable, forcing bankruptcy may be the preferred option for the creditor.
Conclusion. Illinois law provides a number of alternatives to bankruptcy such as the assignment for the benefit of creditors, composition and extension agreements and the appointment of receivers. For debtors, these alternatives can be used to help debtors meet their obligations, retain some degree of control over their affairs and avoid bankruptcy. For creditors, these alternatives often provide returns that exceed what the creditor would receive from the bankruptcy code. Attorneys representing either debtors or creditors should carefully consider whether these alternatives would better suit their clients than going to bankruptcy court.
1 Local Loan Co. v. Hunt, 292 U.S. 234, 244, 54 S.Ct. 695, 78 L.Ed. 1230 (1934).
2 See Jeanne Sahadi, The New Bankruptcy Law and You, CNNMoney.com, (Oct. 17, 2005) available at http://money.cnn.com/2005/10/17/pf /debt/bankruptcy_law/index.htm (summarizing BAPCPA).
3 Zazove, Daniel, Alan Solow and Bruce Wald, "Illinois Common Law Assignment for the Benefit of Creditors", Business Bankruptcy Practice, §7.1 (2006 ed.).
4 Paul H. Schwendener, Inc. v. Jupiter Elec. Co., 358 Ill. App. 3d 65, 74, 829 N.E.2d 818 (1st Dist. 2005)
6 Zazove, supra note 2, §7.5.
7 For example, in states like Missouri, an invalid assignment simply means that a bailment is created between the assignor and the assignee. Calumet Paper Co. v. Haskell, 144 Mo. 331, 340, 45 S.W. 1115, 1117 (1898). In Colorado and other states, an invalid assignment still results in the creation of a trust; however, the assignor is the beneficiary of the trust, not the creditors. McDermith v. Voorhees, 16 Colo. 402, 408, 27 P. 250, 252 (1891).
8 Illinois Bell, 157 Ill.App.3d at 198, 509 N.E.2d at 1293.
9 Illinois Bell Tel. Co. v. Wolf Furniture House, 157 Ill.App.3d 190, 194, 509 N.E.2d 1289 (1st Dist. 1987).
11 Howard, Margaret. "Creditors’ Rights and Remedies", BANKRUPTCY, p. 15 (3d. ed. 2004).
13 Firebaugh v. McGovern, 404 Ill. 143, 149, 88 N.E.2d 473 (1949).
14 Steinwart v. Susman, 94 Ill.App.3d 471, 476, 238 N.E.2d 200 (2nd Dist. 1968)
James L. Ryan is an associate attorney at the Wheaton law firm of Roberts & Caruso. He concentrates his practice in the areas of civil and commercial litigation, business law and probate. He received his undergraduate degree from the University of Notre Dame in political science and economics and his law degree from Loyola University of Chicago School of Law. While in law school, Mr. Ryan completed Loyola’s Trial Advocacy Program earning a certificate in trial advocacy and served as a lead articles editor for the Loyola University Chicago Law Journal. Mr. Ryan would like to thank attorney Patrick Mazza for his support and guidance in formulating this article.