State Insolvency Proceedings: Compositions and Extensions (Workouts), Assignment for the Benefit of Creditors (ABC)
Although bankruptcy is the most common method to accomplish reorganization or dissolution of the debtor, states also have laws that allow a business debtor to reorganize or liquidate. Although individuals could use these remedies, they would not have any advantages over bankruptcy, and the result would be decidedly inferior to bankruptcy.
Bankruptcy is a more powerful remedy because the federal bankruptcy law can compel both creditors and debtors in its required actions, but some debtors are ineligible for bankruptcy or they do not want the stigma of being a bankrupt.
State insolvency actions are simpler, and therefore potentially cheaper and faster than bankruptcy, but it requires the cooperation of the creditors and the debtor.
Most financially stressed businesses will have several concurrent creditor actions against them, since creditors must compete for the debtor's assets.
State laws have several collective proceedings that allow the debtor to deal fairly with its creditors: compositions and extensions, otherwise known as workouts, and an assignment for the benefit of creditors.
Insolvency proceedings allow the financially distressed debtor, though not necessarily insolvent, to deal with its creditors collectively, so that the debtor's assets are not sold at liquidation prices by creditors who are further along in their collection efforts.
There are 2 tests for insolvency:
- balance sheet or bankruptcy test where insolvency is determined by whether the debtor's liabilities are greater than its assets
- equity test, which determines whether the debtor can pay its bills as they become due.
Only the debtor can initiate insolvency proceedings. Since insolvency proceedings are simply an agreement between creditors and the debtor for the resolution of its debts, there is usually no court involvement unless there is a dispute between the parties, which makes insolvency proceedings faster and cheaper than bankruptcy.
Compositions and Extensions (Workouts)
A composition is a contract between the debtor and its creditors where the debtor offers partial payment to the creditors from its future income as a full settlement of their debts.
An extension is a contract between the debtor and its creditors that extends the time for payment of the debt. An extension is often included in a composition which both reduces the total amount to be repaid and extends the time for repayment. Compositions and extensions are often called workouts.
Because workouts are contracts, their formation, performance, and breech are all determined by contract law, and only creditors that agree to the contract are bound by it. If the debtor breeches the contract, then the creditors are free to pursue their own actions.
The consideration required of every contract is the willingness of the debtor to pay its bills as well as possible in exchange for creditors getting more than they would otherwise get by other methods. Few creditors would likely agree to a workout unless the debtor is financially distressed and is making a good faith effort to pay.
The agreements of the assenting creditors will be superseded by the workout. If the debtor successfully completes the workout, then the debts of the assenting creditors will be satisfied, as stipulated in the contract.
Unlike in bankruptcy, which is largely determined by state and federal laws, workouts can be tailored specifically for the debtor and those creditors that assent to it. Although some creditors may reject the workout and try to get more by pursuing their own actions, the debtor always has the option to file bankruptcy and stay all the creditors' actions, whether they agree to it or not. However, if most of the creditors don't agree to the workout, especially those with large debts, the workout will probably not work since the non-assenting creditors will continue to pursue their own actions. In this case, bankruptcy would be the only option.
One thing that can undermine a workout is if the debtor has secretly promised to pay 1 or more creditors more than what was stipulated in the workout agreement. Although the workout agreement itself can allow for the unequal treatment of creditors, in which case the other creditors know about the unequal treatment, any secret preference that is later found out will nullify the discharge of the others' debts.
One common requirement specified in the workout agreement is that at least a certain percentage of the creditors must agree to the workout, since non-assenting creditors are free to pursue their own individual remedies and leave less for the workout creditors.
Although non-assenting creditors are free to pursue full payment, they take 2 substantial risks.
- The debtor can always file Chapter 11 bankruptcy, which would force all the creditors to accept the terms of the majority of the creditors.
- The debtor could give the workout creditors a lien on all its property, leaving nothing for the non-assenting creditors.
Another common provision of the workout agreement is what will happen if the debtor fails to make the full payments as promised in the agreement. Are the creditors entitled to the full amount of their original debt or only to the reduced amount specified in the workout? If it is not specified in the workout contract, then a court will look at the totality of the agreement to discern the original intention of the parties.
Assignment for the Benefit of Creditors (ABC)
An assignment for the benefit of creditors (ABC) is the voluntary liquidation of a debtor's executable property that is effected by transferring those assets to a neutral 3rd party custodian so that the property can be sold for the benefit of the assenting creditors.
The ABC began as a common law device, based on the debtor's property rights rather than by contract, but is now governed by statutes in most states. Some states that have statutes governing ABCs may also permit a common law ABC. In some states, court approval for an ABC is required, but in others, the ABC can be set up contractually.
To form an ABC, the debtor transfers all its executable property to the assignee, who then sells it for the benefit of the debtor's creditors. However, the assignee acquires no greater rights to the property than what the debtor had; hence, all liens on the property and any other 3rd party rights remain.
On the effective date of the assignment, the property is considered to in legal custody (in custodia legis) and cannot be levied for the individual collection of debt. Some states require a recording for the effective date. However, most states consider the effective date to be when the assignment instrument or the property has been delivered to the assignee, or when the assignee has accepted the property.
Once the assignee has the property, he then notifies creditors to file claims, sells the property, then pays the creditors based on their claims. The assignee must post a surety bond to ensure performance according to both the assignment instrument and state law. Some states may require a filing of the inventory and appraisals of property, and financial accounts.
States can't grant discharges of debt, since this would infringe on the federal bankruptcy power, but the creditors may agree to the discharge of their debts if the ABC is successfully carried out. However, the agreement to a discharge must be entirely voluntary; it cannot be stipulated as a condition for joining the ABC, since many courts consider this to be an act of bad faith and some states forbid such a stipulation.
However, almost all ABC debtors are businesses, so they would not qualify for a liquidation discharge even if they filed for Chapter 7 bankruptcy, since a discharge under Chapter 7 is available only to individual debtors—liquidating businesses simply cease to exist.
Non-assenting creditors may challenge the validity of the ABC if:
- the debtor does not transfer all its nonexempt property to the ABC;
- if the debtor tries to retain control or exercise rights over the transferred assets, such as revoking or stipulating the use of the property, or takes too long in providing for its liquidation;
- or if the debtor makes preferential payments in exchange for a release of its debts or excludes specific creditors.
If the creditor decides to participate by filing a claim, then it is bound to the terms of the ABC. If the creditor decides not to participate, then it can pursue it own collection actions, but it cannot levy upon any property in the ABC, unless there is a flaw that cannot be corrected. However, since the debtor must transfer all its nonexempt property to the ABC, a creditor that doesn't participate will probably not be able to get its debt repaid.
A creditor or group of creditors could use the ABC as the grounds to file an involuntary petition for Chapter 11 bankruptcy, if the other requirements of an involuntary petition are satisfied. There are advantages for creditors of bankruptcy over an ABC:
- the bankruptcy trustee is not selected by the debtor as an assignee is;
- the trustee has greater powers to set aside preferences (payments to preferred creditors), adding additional money for non-preferred creditors;
- and taxes have a lower priority in bankruptcy than in ABCs, with more money available to creditors with higher priority.
However, the bankruptcy court may decide that the best interest of the debtor and the creditors is served by the ABC rather than bankruptcy, so the court may abstain from the case and dismiss the involuntary petition.
Most states have laws that assign priorities to the payments from the ABC. Secured creditors with perfected liens in their collateral are paid first. However, if the secured creditors did not perfect their liens by filing the necessary documents in the public records to give constructive notice to 3rd parties then they lose their security interest since the assignee has a higher priority over unperfected security interests. The result is that the assignee will be able to sell the property free of the unperfected security interests and previously secured creditors will get a pro rata share of the proceeds along with unsecured creditors.
The 2nd priority is the expenses of the ABC. The rest of the payments are governed by priority established by law, with United States taxes having the highest priority, whereas in a bankruptcy federal taxes would have only an 8th priority. The rest of the proceeds is paid pro rata to the unsecured creditors, much as it would be in a bankruptcy. Although unlikely, anything left is paid to the debtor.