A company typically files for chapter 11 protection because the claims against it exceed the value of the company’s assets (“balance sheet insolvency”) or because the company cannot pay claims against it when they are due (“cash flow insolvency”). 1
The concept of a “claim”—both inside and outside of bankruptcy 2 —is pretty simple but critically important. You hold a claim against a debtor 3 if the debtor owes you money or if the debtor owes you an obligation to do something, which if not done, would give rise to the debtor owing you money. You may hold a claim against a debtor even if your claim is:
A claim may be secured by the debtor’s property or it may be unsecured (or partially secured and partially unsecured). Not all unsecured claims are created equal, though. This means that some claims enjoy a higher priority under the law than other claims. More on this below. First, we discuss how the Bankruptcy Code defines a “claim,” and discuss how some common claims are treated in bankruptcy.
Bankruptcy Code § 101(5) defines a “claim” as any:
(A) right to payment, whether or not such right is reduced to judgment, liquidated, unliquidated, fixed, contingent, matured, unmatured, disputed, undisputed, legal, equitable, secured, or unsecured; or
(B) right to an equitable remedy for breach of performance if such breach gives rise to a right to payment, whether or not such right to an equitable remedy is reduced to judgment, fixed, contingent, matured, unmatured, disputed, undisputed, secured, or unsecured.
This definition is broad and covers a wide array of rights a party may hold with respect to a debtor. Importantly, the Bankruptcy Code does not require a party have a present right to receive money from a debtor before it has a claim against that debtor. To illustrate, claims that fall outside the common “this-debtor-owes-me-money-that-I-have-the-right-be-paid-today” context and which can presently exist (albeit in a contingent, unliquidated, and/or disputed state) and include claims related to:
One of the most basic distinctions between types of claims is whether a claim is secured or unsecured.
A secured claim is a right to payment, or an equitable remedy, that is held by a creditor for which payment or performance is supported by the debtor by granting the creditor a security interest in specific property. The property serves as collateral for the secured claim and, as a result, if the debtor does not pay the creditor or perform its obligations to the creditor, the creditor can foreclose on the collateral to recover some (or all) of the value of its claim. 4
For our purposes (and for the purposes of most commercial law, including debtor-creditor law), think of all property as falling within one of two broad categories: real and personal.
Real property refers to real estate, and everything else is considered personal property.
Real property rights (including the right of owners of real property to pledge it as collateral to a lender (or other secured party) as security for a debt, and the rights of such secured parties to foreclose on such security) , are governed by state law. Real estate law varies a fair amount from state to state.
Personal property, again, is an umbrella term that encompasses all other property. In other words, if the property at issue is not real property, then it is personal property. The 50 states each have their own laws governing personal property (sort of). Why “sort of,” you ask? Read on!
The Uniform Commercial Code (“UCC”) is not the law in any state. Rather, it is a comprehensive suggestion to the legislators of the 50 states by an organization established in 1961 called the Permanent Editorial Board for the Uniform Commercial Code (“PEB”). The PEB, in turn, is comprised by members appointed by the Uniform Law Commission (established in 1892) and the American Law Institute (established in 1923).
The UCC was created to make the economy work better, which it does. That’s in large part why it has been adopted in virtually every state nearly lock, stock, and barrel. 5
Nevertheless, Article 9 of the UCC governs security interests in personal property, and Article 9 is one of the most widely accepted article of the UCC. So, our point is that even though each state has its own “version” of UCC Article 9, all of them are virtually identical to one another. For example, while security interests governed by New York law are governed by New York’s specific adoption of UCC Article 9 (as the New York legislature may have tweaked it), in practice most attorneys do not usually look first at the New York version. Rather, they look at the UCC as drafted and amended by the PEB.
At the end of the day, a lawyer must confirm that the specific sections at issue in the UCC are indeed identical to those in New York’s version, but they almost always are. To reiterate, reference to New York is just an example; what you just read remains constant within the other 49 states.
So, again, secured claims in personal property are governed by Article 9 of the Uniform Commercial Code. [EDITORS’ NOTE: before selling personal property collateral in connection with a foreclosure or acceptance in satisfaction under Article 9, you (or our attorney) should be sure to read The Myth of the Newspaper Being a Commercially Reasonable Notice.
A common example of a secured claim is a claim by a bank for the money it loaned you to buy your house. When you borrowed the money, you signed a promissory note and a mortgage or deed of trust. The promissory note serves as evidence of your debt (making you a debtor) owed to your bank (your “secured creditor”).
The mortgage or deed of trust serves as the security instrument granting the secured creditor a security interest (commonly called a “lien”) in the real property context) in your home. 6
In stark contrast to a secured claim, an unsecured claim is a right to payment or equitable remedy held by a creditor, for which no collateral exists as security for the claim. Don’t confuse this with the question of whether a claim is guaranteed by a third party; that’s an entirely different issue, which we discuss below.
Unsecured claims are all around you. From a consumer’s perspective, every time you pay your monthly credit card, 7 cable, phone, electric, and gas bills, you are probably paying an unsecured debt. In the business context, most trade vendors (i.e., suppliers of goods and services) sell to their customers on an unsecured basis. 8
Remember how we told you that all unsecured claims are not created equal? (Well, we did. In the third paragraph of this article. You have to pay more attention!)
Let’s look away from the secured creditor and focus on the unsecured creditor.
George Orwell wrote “[a]ll unsecured claims are equal, but some unsecured claims are more equal than others,” or something like that.
There are different types of unsecured claims, and the likelihood that the holder of an unsecured claim against a chapter 11 debtor (or any debtor for that matter) will be paid depends on the type of unsecured claim it is.
You know those unsecured claims that are all around you, which we mentioned a few paragraphs above? Well, these are generally examples of “general unsecured creditors,” or “GUCs” (pronounced “Gee-You-Sees” by some, and “Gucks” by others). In the bankruptcy context, this means that GUCs sit toward the bottom of the tower that we describe below and are paid after all other claims of higher priority have been paid. This frequently means they will be paid nothing because all they are legally entitled to is their pro rata share of whatever assets remain after the creditors above them have been paid.
Bankruptcy Code § 507 codifies the priority scheme that dictates the order in which certain unsecured claims are paid in bankruptcy (the bankruptcy priority scheme is similar but not identical to the order of priority that unsecured claims are paid in outside of bankruptcy, and the fact that there is a difference can sometimes drive a company in one direction or another (that is, to file a bankruptcy or to go down an alternative path)).
And Bankruptcy Code § 507 is nasty. Not nasty in the sense of being cruel or mean spirited, rather, we mean that it’s one of the longer and denser sections of the Bankruptcy Code. It consists of lots of cross-references to other sections of the Code, which makes it one of the more difficult sections to get one’s arms around if one doesn’t have a tour guide. Luckily, you have us. Here is a more holistic way to think of Bankruptcy Code § 507:
One thing we left out above, intentionally for simplicity: the champagne tower doesn’t consist only of claims against the debtor. It also includes, at the very bottom, equity interests in the debtor. Absent the new value exception, the equity holders’ glasses will not receive a drop of champagne in a traditional chapter 11 unless all the creditors’ glasses are completely filled. 9
Most unsecured claims are grouped together on the tier just above equity, and below the 10 types of claims entitled to priority under § 507 (generally, not all of these 10 types are present in a given chapter 11 case).
The first priority tier which is delineated under § 507(a)(1), is for “domestic support obligations,” which includes claims for alimony and child support. While this can certainly be relevant in the chapter 11 case of an individual, it cannot be in the context of the chapter 11 of a company (or other entity) since only individuals (i.e., people) get divorces. 10
The other tiers have the priority afforded to them in subsections (a)(2) through (a)(10). Some are applicable in most or all business bankruptcy cases, and some are not. Here is a summary of the former:
Bankruptcy Code § 507(a)(2) gives top priority in a business bankruptcy case to “administrative expenses allowed under § 503(b).” Section 503(b), in turn, defines an “administrative expense” as “the actual necessary costs and expenses of preserving the [debtor’s bankruptcy] estate.” 11 U.S.C. § 503(b)(1)(A).
Administrative expenses include, among other things, the fees incurred by estate professionals (attorneys, accountants, and financial advisory firms, among others), postpetition rent payments, postpetition employee wages, as well as the value of any goods delivered to the debtor within 20 days before the chapter 11 case is filed.
Notably, administrative expenses can often be the subject of litigation within a chapter 11 case. The pesky inclusion of the word “necessary” in § 503(b)(1)(A) gives rise to disputes over whether certain expenses were truly necessary to preserving a debtor’s estate.
Bankruptcy Code §§ 507(a)(4) and (a)(5) address the priority of certain employee claims incurred pre-bankruptcy. Section 507(a)(4) grants a limited priority to claims for employee wages. This priority is limited because the Bankruptcy Code imposes a cap on the total amount any single employee may claim as entitled to priority. At present (in 2021), this cap is $13,650 per claimant, which is periodically adjusted by Congress to account for inflation. Section 507(a)(5) grants a limited priority to claims arising from a company’s employee benefits plan, also capped at $13,650 per claimant.
Further down the tower, but nevertheless important, are priority tax claims. Section 507(a)(8) grants eighth priority to prepetition unpaid tax claims.
We left out, until now, two types of claims that, while not secured, are superior to all other unsecured claims, including the priority claims of § 507(a): so-called “superpriority” claims.
The most common example of a superpriority claim occurs when, if permitted by the bankruptcy court, a debtor grants adequate protection to a secured creditor under Bankruptcy Code §§ 362, 363, or 364. If that happens, then the secured creditor’s claim for adequate protection “skips the line” and puts it ahead of all other priority unsecured claims (including administrative expenses) and must be paid in full before other claims can be paid anything.
Other Important Bankruptcy Claims Concepts to Be Aware of Before We Go Further
Understanding the basics of what a claim is and its relative priority in chapter 11 is just the beginning of understanding the world of claims (both in and out of bankruptcy). We discuss these concepts in other installments, but preview them for you here so you can begin familiarizing yourself:
It is often the case that a creditor (most often a secured creditor) will require that a third party (typically the debtor’s parent entity, an affiliated entity, or the owner of the debtor) guarantee repayment of a debt in the event the debtor fails to pay the creditor on account of its secured claim. Thus, in the event of a bankruptcy filing by a debtor but not by a guarantor, a creditor holding a guaranty has an additional means of collecting on its claim if it determines a guarantor to be collectible.
The marshaling of claims is an equitable doctrine sometimes known as the “two funds,” doctrine. Where successful, marshaling claims require that a senior creditor satisfy its claim first from a debtor’s property in which a junior creditor has no interest before looking to other sources of repayment (i.e., funds in which junior creditors have an interest).
As defined by the U.S. Supreme Court, marshaling “rests upon the principle that a creditor having two funds to satisfy his debt, may not by his application of them to his demand, defeat another creditor, who may resort to only one of the funds.” Meyer v. United States, 375 U.S. 233, 236 (1963).
Certain general unsecured creditors may be viewed by a debtor as being so integral to its ongoing business and reorganization efforts, that any failure to pay these vendors for their significant prepetition claims, would result in postpetition service interruptions from these vendors that would then kill the debtor’s ability to operate its business.
When this is the case, the debtor may seek to designate its most necessary trade vendors “critical,” and file a motion (usually in the first days of the case) with the bankruptcy court asking that the court enter an order allowing the prepetition claims of each critical vendor. Doing so authorizes the debtor to immediately pay those prepetition claims ahead of the claims of other creditors.
Being a critical vendor in chapter 11, therefore, is very good from the perspective of the general unsecured creditor being afforded that status, since a general unsecured creditor in most bankruptcy cases has a low chance of being paid in full absent such treatment. This treatment, of course, usually carries with it the reciprocal burden of requiring the vendor to continue shipping to the debtor post-petition.
In larger chapter 11 cases, claims against a debtor can be exceedingly high: both in number and amount. Since there is no express prohibition in the Bankruptcy Code against a creditor transferring its claim to a third party in exchange for compensation, an industry exists for selling, buying, and trading claims in chapter 11 cases. Bankruptcy claim traders offer creditors an opportunity to be paid something for their claims (i.e., some reduced percentage of their claim). In exchange, the creditor transfers its claim to the claims trader. Many creditors are willing to sell their claims, because doing so results in immediate payment for its claim (albeit at a reduced amount), which may be preferable to sitting and waiting to see when, and how much, the debtor will pay on account of the creditor’s claim under a chapter 11 plan. We suggest you read this for more information about claims trading.
[Editors’ Note: To learn more about Claims Trading, check out this Bankruptcy Claims Trading webinar.
This article, while written to be read and understood on a standalone basis, is part of a series. To read Installment 1, which includes a table of contents and links to every article in the series, click here.
The authors are corporate restructuring and insolvency attorneys. Read more about three of them at the end of Installment 1.
Understanding all this stuff in the context of bankruptcy is important, but not every distressed company winds up in bankruptcy. So, you also need to understand how it works outside of bankruptcy. Read Installment 10 to get the rest of the story. Chris Horvay is our guest co-author for this Installment.
To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can listen to at your leisure and each includes a comprehensive customer PowerPoint about the topic):
©2022. DailyDACTM, LLC d/b/a/ Financial PoiseTM. This article is subject to the disclaimers found here.
Jonathan Friedland is a principal at Much Shelist. He is ranked AV® Preeminent™ by Martindale.com, has been repeatedly recognized as a “SuperLawyer” by Leading Lawyers Magazine, is rated 10/10 by AVVO, and has received numerous other accolades. He has been profiled, interviewed, and/or quoted in publications such as Buyouts Magazine; Smart Business Magazine; The M&A…
Jack is a corporate and restructuring partner in the Chicago office of Sugar Felsenthal Grais & Helsinger LLP. Jack’s practice covers a range of healthy and distressed business engagements. He is widely recognized for his excellent work as a restructuring attorney including recognition by various organizations for his strategic thinking and tactical expertise, including SuperLawyers…
Hajar is an associate with Much Shelist in both its Business Transactions Group and its Restructuring & Insolvency Group.
Dealing with Corporate Distress 17: Focus on Assuming & Rejecting Executory Contracts & Unexpired Leases in Bankruptcy
Dealing with Corporate Distress 16: Overview of Bankruptcy Code § 365
When a Seller of Real Property Files for Bankruptcy Before Closing
Strategic Filing: Chapter 11 Bankruptcy for Litigation Advantage?
Dealing with Corporate Distress 14: The Secured Creditor’s Perspective About its Debtors
Dealing with Corporate Distress 11: How to Protect Your Claim In & Out of Bankruptcy
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