This post is part of a series of posts entitled First Considerations for the Financially Distressed Business. For a comprehensive list of articles contained in this series, click here.
Filing for bankruptcy involves disclosing debt, or “creditor claims,” on official bankruptcy paperwork. Generally, once a company or individual files for bankruptcy, it may not make any payments on claims that arose or existed prior to the date of filing. Instead, prepetition creditors will have a claim against the bankruptcy estate. To be paid, each creditor is required to file a proof of claim with the bankruptcy court indicating how much they are owed and the type of debt. There are three main categories of debts in a bankruptcy case: priority unsecured debt, secured debt, and general unsecured debt.
All secured debt is composed of a debt that is owed and a lien (also called a secured interest) on a piece of the debtor’s property. This simple definition allows for many different types of secured lenders within the context of a chapter 11 bankruptcy. Some examples include: an equipment lender, the holder of a tax lien, the holder of a car loan or real estate mortgage, and a bank with a blanket lien on all assets. Some of the secured lenders may be oversecured or fully secured, while others are likely undersecured. A debtor may have only minimal contacts with the secured lender or they may be parties to a long-standing business relationship. As demonstrated, there is simply no “typical” secured lender/debtor relationship.
Generally, a debtor is permitted to continue to use a secured lender’s collateral during the course of a bankruptcy case. For example, if a debtor has a loan on certain equipment, they will be permitted to use the equipment even if the secured loan is in default. Under certain circumstances, however, the Bankruptcy Code permits a secured lender to be compensated for any loss of value caused by the continued use of their collateral. Additionally, a secured creditor may seek relief from the automatic stay to proceed against collateral that is in default. If approved by the bankruptcy court, this relief allows a secured creditor to recovery the property, sell it, and apply any proceeds to the account balance.
A bankruptcy discharge (thecourt order that wipes out debt) does not eliminate a secured creditor’s lien on a debtor’s property; instead, it only eliminates a debtor’s liability to any of the debts. Thus, a secured creditor may still foreclose or repossess the property, even after discharge, if the loan has not been paid. Therefore, any distressed business who files for bankruptcy wishing to keep property securing a loan, needs to continue making payments to the secured creditor until the debt is paid in full. In some circumstances, a bankruptcy court can remove a lien; however, this is not guaranteed.
In contrast, a creditor with an unsecured claim does not have a lien and is not secured by collateral. There are two types of unsecured claims in bankruptcy: priority unsecured claim and general unsecured claims. Priority unsecured claims consist of debts that are not dischargeable in bankruptcy. If money is available, these types of claims will be paid before general unsecured claims. Examples of priority unsecured claims include child support, certain tax obligations and debts for personal injury or death caused by drunk driving. A debtor will need to pay these debts if there is a balance even after the bankruptcy is completed.
General unsecured claims, on the other hand, are those claims that are dischargeable in bankruptcy and will receive the lowest priority of repayment by proceeds of the bankruptcy estate. Examples of general unsecured claims include credit card debt, personal loans, and medical debt. It is not uncommon for creditors holding general unsecured claims to receive pennies on the dollar toward what is owed regardless of the bankruptcy type. Additionally, a debtor does not need to pay the balance of these debts (with the exception of student loan debts) once the bankruptcy is completed.