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Craig M. Rankin David B. Golubchik

Historically, business disputes were resolved informally and, if a resolution was not achieved, litigation ensued. Recently, a trend has emerged of pursuing business disputes and collection actions through the bankruptcy system by forcing companies into involuntary bankruptcy. Such a strategy may backfire by causing the complete meltdown of the business-guaranteeing little or no recovery for all unsecured creditors, including those unsecured creditors who filed the involuntary petition. When an involuntary proceeding may be brought A bankruptcy case is commenced by the filing of a bankruptcy petition by the debtor voluntarily or by several creditors forcing an involuntary proceeding. When the entity against whom an involuntary proceeding is being filed has 12 or more creditors, each of the following requirements must be met: There must be three or more petitioning creditors. Each of the entities must hold a noncontingent claim as to liability which also is not subject to a bona fide dispute. The petitioning creditors’ claims must be separate and distinct from one another. The petitioning creditors must hold unsecured claims that aggregate at least $11,625. If the involuntary petition is controverted, the petitioning creditors must establish that the alleged debtor is generally not paying its debts as they become due, unless such debts are the subject of a bona fide dispute. See 11 U.S.C. 303(b)(1)(h). Pending the resolution of the last element and either dismissal of the case-which is required if any of the foregoing requirements are not satisfied-or entry of an “order for relief,” the involuntary bankruptcy is in the “gap period.” In most involuntary bankruptcies, the case is either dismissed or an order for relief is entered relatively quickly. This allows the company to operate outside of bankruptcy (in case of dismissal) or to enjoy the benefits of the law by converting its status to that of a debtor in possession. However, the alleged debtor can also controvert the involuntary filing. The ensuing evidentiary process can last from weeks to months. This time period of legal limbo may seriously affect the value of the alleged debtor. Upon commencement of an involuntary bankruptcy case, the alleged debtor must still continue operating in order to preserve its business. This often requires continued financing from creditors, including trade creditors and lending institutions. Before agreeing to extend additional financing, the creditor should think carefully about lending money to an alleged debtor during the gap period. Initially, a prepetition lender must assess the involuntary case and the status of its security interest in the debtor’s property. Sec. 552(a) of the Bankruptcy Code provides that, upon the filing of an involuntary petition, a security interest in the alleged debtor’s property does not attach to property acquired by the alleged debtor postpetition. In re Trans-Texas Petroleum Corp., 33 B.R. 67, 69 (Bankr. N.D. Texas 1983). However, � 552(b) provides an exception: Property acquired by the debtor after the commencement of a case is subject to a pre-petition lien, provided that before the case, the debtor and the creditor entered into a security agreement that covered proceeds, product, offspring, profits or rents of such property, and applicable non-bankruptcy law authorizes the extension of the security interest to such property. 11 U.S.C. 552(b). Nonetheless, a debtor, trustee or creditors’ committee may argue that assets generated after the filing of the involuntary petition are not proceeds, product, offspring or profits from the secured creditor’s prepetition collateral, but rather are newly created assets not subject to the security interest. J. Catton Farms Inc. v. First National Bank of Chicago, 779 F.2d 1242 (7th Cir. 1985). For example, a magazine publisher may argue that postpetition issues are the product of its employees’ creative work, in which the prepetition creditor does not have a security interest, thus making the postpetition issues of the magazine unencumbered assets for the benefit of unsecured creditors. While that claim could be challenged by the secured creditors (arguing, for example, that the magazines are made from secured assets such as paper and ink), the secured creditor bears the burden of proof as to the extent of its collateral. This may be a difficult and expensive fight. Documenting a prepetition loan agreement is crucial to avoid the possibility that an otherwise secured creditor will lose its security interest in postpetition assets. In drafting loan documents, practitioners should carefully consider the Bankruptcy Code or seek the assistance of an expert. Good loan documentation may still not protect a lender for advances made during the gap period. In a voluntary bankruptcy filing, � 363(b) of the code forbids the debtor to use assets in which another entity has an interest, defined as “cash collateral,” unless all creditors with an interest in the collateral consent to such use or the court enters an order authorizing it. This gives the creditor some protections; it can either negotiate a cash collateral agreement with the debtor or present its concerns to the bankruptcy court in response to the debtor’s motion to use cash collateral and seek adequate protection for the use of its collateral. But in an involuntary case, the creditor does not enjoy these benefits because, during the gap period, the debtor is authorized to operate without bankruptcy court intervention (see 11 U.S.C. 303(f)), while all prepetition creditors are subject to the automatic stay. See 11 U.S.C. 362(a). The prepetition creditor has the burden to seek affirmative relief from the court. Unless the creditor obtains an appropriate court order, the plain language of � 552 appears to eliminate the lenders’ security interest in all assets created during the gap period that are not direct and traceable proceeds of preinvoluntary collateral. While the debtor may be able to survive using its current collection, often its existing collections are insufficient, and it needs more money to maintain a going-concern value for the business and avoid a forced liquidation. During the gap period, the debtor has two possible sources of financing. It may obtain it in the ordinary course of business, which is usually limited to trade credit. As we know, postpetition administrative claims in a voluntary bankruptcy are entitled to the highest priority. See 11 U.S.C. 503(b). However, �� 502(f) and 507(a)(2) provide priority directly behind such administrative expenses for ordinary-course financing obtained by the involuntary debtor during a gap period, in the absence of a court order. For other financing, which is often imperative for the debtor’s survival, the debtor (and the prepetition lender) must resort to seeking financing pursuant to � 364. Allowing the debtor to obtain secured financing Secs. 364 (c) and (d) allow a debtor to obtain unsecured credit outside of the ordinary course of business after notice and a hearing. Sec. 364 is invoked by the debtor in voluntary cases to obtain debtors-in-possession financing. This financing is critical to all companies that cannot survive on collections alone. Yet the plain language of � 364 suggests that it does not apply to “alleged debtors” contesting an involuntary petition, but only to those operating under �� 721, 1108 or 1304. These sections concern actual debtors, not alleged debtors. Since during the gap period, the debtor is operating under � 303(f), the court cannot give an alleged debtor’s secured creditor any protections. In re Roxy Roller Rink Joint Venture, 67 B.R. 479 (Bankr. S.D.N.Y. 1987). Such financing is crucial to avoid irreparable harm both to the alleged debtor and to creditors who would be hurt by a forced closure and “fire sale” of the business’s assets. Sometimes one can get the court’s help in solving this problem (stemming from an apparent legislative error). Alleged debtors may request approval for protections for the secured creditor similar to those grantable under � 364 by asserting � 105(a) as the basis for the court’s authority. Under � 105(a), “the court may issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of” the code. The aim is “to enable the court to do whatever is necessary to aid in its jurisdiction, in anything arising in or relating to a bankruptcy case.” 2 Collier on Bankruptcy � 105.02 at 105-4 (15th ed. 1988). Essentially, � 105(a) codifies the court’s inherent equitable powers. In re Feit & Drexler Inc., 760 F.2d 406 (2d Cir. 1985). Sec. 105(a)’s broad grant of power may provide the court with the ability to protect the lender, while preserving the company’s survival. To the extent that a party in interest opposes such financing and appeals the court’s � 364 order, � 364(e) protects the lender by providing that a modification or reversal of a � 364 order on appeal does not affect the rights given to the creditor thereunder. Without financing, the cash needs of a company in bankruptcy often causes the business to cease operating or liquidate, foreclosing any possibility of reorganizing or generating a distribution to creditors. The involuntary status increases the risks for all parties involved. However, proper loan documentation and an appropriate bankruptcy court order may preserve the value of the business for the benefit of all parties. Craig M. Rankin is a partner at the Los Angeles-based bankruptcy boutique Levene, Neale, Bender, Rankin & Brill. He can be reached at [email protected] David B. Golubchik is an associate at the firm.

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