Involuntary Bankruptcy Filings Create Traps for the Unwary Creditor – Is “Business as Usual” Wise During the “Gap Period?”

The large majority of bankruptcy cases commenced in the United States start with the filing by the debtor of a voluntary petition for relief pursuant to 11 U.S.C. §301.^[1] Such a filing automatically results in the entry of an order for relief and, in a chapter 11 reorganization case, the debtor in possession is entitled to operate on a going-forward basis with the same powers that would be granted to a bankruptcy trustee.^[2] The bankruptcy filing provides the debtor with protection from its creditors, a significant component of which is the section 362 automatic stay (Stay) which, in general, prevents creditors from taking any action against the debtor or its property absent prior relief from the bankruptcy court. While operating under protection of the Stay, the debtor in possession is authorized to operate its business.^[3] However, the debtor in possession cannot enter into a number of significant transactions without notice to all creditors in the bankruptcy case and prior approval by the bankruptcy court.^[4] Operating together, these statutory controls allow the debtor in possession to operate its business in the ordinary course without interference from creditors, yet prevent the debtor in possession from taking actions out of the ordinary course of business without bankruptcy court approval.

 

In contrast, a smaller number of bankruptcy cases are commenced by the filing of an involuntary bankruptcy petition under section 303.^[5] As in a voluntary filing, the Stay is instantly triggered to protect the alleged debtor. However, unlike a voluntary filing, the order for relief will not enter until the bankruptcy court determines that an order for relief should be entered against the alleged debtor, or the debtor consents to the entry of the order for relief.^[6] Moreover, while the alleged debtor does not have the powers of a bankruptcy trustee prior to entry of the order for relief, the alleged debtor may operate its business and may continue to use, acquire, or dispose of property “as if the involuntary case against the debtor had not been commenced.”^[7] Further, while a petitioning debtor is charged with providing notice to all of its creditors upon the filing of a voluntary bankruptcy petition under section 301, the very nature of an involuntary petition means that some creditors may not have notice of the filing of the involuntary bankruptcy for some time.

The time between the filing of an involuntary petition under section 303 and the entry of an order for relief is often referred to as the “gap period.” As numerous courts and commentators have noted, great uncertainty exists as to how creditors can safely transact business with an alleged debtor during this gap period.^[8] On one hand, section 303(f) permits the alleged debtor to operate its business as if the bankruptcy petition had not been filed. On the other hand, the Stay prohibits creditors from taking any action against the alleged debtor and its assets, and certain transfers of the alleged debtor’s property made after the filing of the involuntary petition but before the order for relief can be avoided and the property recovered by a bankruptcy trustee or a debtor in possession.^[9] Further, while a creditor who provides goods or services to a debtor after the order for relief is generally entitled to an administrative priority claim, the creditor who provides similar goods or services during the gap period is only entitled to priority after all other administrative claims are satisfied.^[10] Thus, although the alleged debtor recognizes the significant protections offered by the Stay during the gap period, creditors are not afforded the same certainties and protections during the gap period that they enjoy after entry of the order for relief.

Recently, the apparent conflict between section 303(f) and section 362, as it pertains to actions a creditor can take during the gap period, was at the center of a dispute involving a fully secured lender after entry of the order for relief. The United States Court of Appeals for the First Circuit addressed an appeal “from diverging decisions of the bankruptcy and district courts [involving] a cautionary tale about the dangers of ignoring the ‘automatic stay’ that takes effect upon the filing of a bankruptcy petition.” In re Bankvest Capital Corp (hereinafter, Bankvest).^[11] As described by the Appellate Court in Bankvest, both of the lower courts determined that by accepting payments from the debtor and by applying those payments to pre-petition debt during the gap period, the secured creditor violated the Stay notwithstanding the fact that at least some of the gap period payments were made in the ordinary course of debtor’s business affairs. As a result, the lender was subject to sanctions for violating the Stay under section 362.

Bankvest Capital Corporation (Debtor) was a lessor of commercial equipment and a buyer and seller of portfolios of leases. Debtor financed its operations with a series of loans from the lender, all of which were entered into pre-petition and were secured by liens on Debtor’s assets. On December 17, 1999, an involuntary chapter 11 petition was filed against Debtor. An order for relief was entered against Debtor approximately two months after the filing of the involuntary petition. During the gap period prior to entry of the order for relief, the lender received payments from Debtor in the approximate amount of $2.2 million, and applied these amounts against the outstanding balance due under one of the loans.^[12]

After the order for relief was entered, the gap period payments to the lender were disclosed to the Official Committee of Unsecured Creditors (Committee) shortly after the lender sold its interest in the loans to a third party.^[13] Subsequently, the Committee and the liquidating agent under the Debtor’s confirmed plan (Liquidating Supervisor) brought an action against the lender seeking avoidance of the transfers under section 549 and sanctions against the lender for violation of the Stay. The matter was tried to the bankruptcy court, which determined that the lender had violated the Stay by accepting and applying the gap period payments to the loans. The bankruptcy court also concluded that the gap period payments had to be returned to the Debtor’s estate under both section 362 and section 549.^[14] In addition, the bankruptcy court determined that the lender was not entitled to assert a claim under section 502(h)^[15] for the gap period payments which the lender was required to return to Debtor’s estate.

The lender appealed the bankruptcy court’s ruling. The district court disagreed with the bankruptcy court’s analysis with respect to the avoidance claim and reversed the bankruptcy court’s determination that the transfers should be avoided under section 549. The district court, however, upheld the finding that the lender had violated the Stay.

The Committee and the Liquidating Supervisor appealed the district court’s reversal of the avoidance claim to the First Circuit Court of Appeals. The Appellate Court upheld the district court’s determination that the gap period payments would not be avoided because the lender’s section 502(h) claim would have the status of a pre-petition secured claim, entitling the lender to a full recovery of the gap period payments if the Appellate Court were to avoid the payments under section 549. With respect to the lower courts’ determination that the lender had violated the Stay, the Court of Appeals noted in its decision that while the appeal was pending the parties had reached a settlement on the amount of the sanction, which settlement had been approved by the bankruptcy court. As a result of the settlement, the only issue before the Appellate Court was the appeal of the district court’s determination on the avoidance claim.

The Bankvest decision stands as a stark reminder that the Stay goes into effect immediately upon the filing of a petition for relief, whether voluntary or involuntary. While section 549(b) does provide some protection to the creditor who engages in transactions with an alleged debtor in an involuntary bankruptcy on a post-petition, pre-entry of order for relief basis, that protection is limited to the extent that “value” is provided to the debtor in the post-petition period. This protection does not extend to a creditor who receives postpetition payments on pre-petition obligations. Even assuming that payments made to a creditor during the gap period are in the ordinary course of business, that protection – at least in the First Circuit – only extends to the debtor.

If there is a lesson to be learned from Bankvest, it is one of creditor diligence. If a creditor suspects that one of its customers/borrowers is experiencing financial difficulties that may lead to the filing of an involuntary bankruptcy petition, that creditor would be prudent to attempt to determine whether an involuntary petition has been filed against its customer/borrower before engaging in any material transactions that may be subject to later challenge under either section 549 or section 362 of the Bankruptcy Code. This can be accomplished by monitoring PACER or other electronic databases, by inquiring of its customer/borrower, or by any other means.

1. Hereinafter all cites to the Bankruptcy Code (11 U.S.C. §101, et seq.) will be “section ___.”

2. See sections 1106 (powers of the trustee) and 1107 (debtor in possession cloaked with all powers of the trustee).

3. Section 1108.

4. For example, the debtor cannot, without prior notice and court approval, employ professionals (section 327), use, sell or lease property (section 363), obtain credit (section 364), or assume or reject executory contracts and unexpired leases (section 365).

5. While a voluntary petition is filed by the debtor, an involuntary petition is filed by either one or more creditors (if there are fewer than 12 creditors) or by three or more creditors (if there are 12 or more creditors) in accordance with the statutory requirements found in section 303.

6. Section 303(h).

7. Section 303(f).

8. For a thorough examination of the uncertainties present under the Bankruptcy Code during the gap period, see Mullin, Joseph, Bridging the Gap: Defining the Debtor’s Status During the Involuntary Gap Period, 61 U.Chi.L.Rev. 1091 (1994).

9. Under section 549, the bankruptcy trustee can generally avoid any post-petition transfer of debtor’s property that was made without court approval. However, in the case of an involuntary petition, section 549(b) prevents the avoidance of any post-petition, pre-order for relief transfer made to a creditor to the extent of post-petition “value” provided to the debtor in exchange for the transfer.

10. See sections 507(a)(2) and 502(f).

11. 375 F.3d 51, 55 (1^st Cir. 2004).

12. There were two sources of funds for the gap period payments. One source was the proceeds realized from a sale of a large portfolio of leases that funded during the gap period, whereas the other source of funds was the Debtor’s regular payments made on leases financed by the lender.

13. While the facts surrounding the third-party loan sale are not directly relevant to this article, the discussion contained in Bankvest regarding whether the lender had conveyed its right to assert a claim to any avoided interest under section 502(h) in the sale to the third party is instructive to any secured creditor contemplating a sale of a claim against a debtor’s estate and with respect to the care which should be exercised in defining which rights are being conveyed in the sale.

14. Since the loans were made to Debtor pre-petition, and the payments at issue were made post-petition, the exemption against avoidance under section 549(b) was not available as a defense.

15. Typically, when a bankruptcy trustee is successful in avoiding a transfer of property or the payment of funds to a creditor, the creditor is entitled to assert the resulting claim in the bankruptcy case. See Section 502(h).