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Business Bankruptcy
South Texas College of Law Houston
Worley, John J.


Background to Business Bankruptcy

Prisoner’s Dilemma

Don’t Confess (A)

Confess (A)

Don’t Confess (B)



Confess (B)



· Round 1: Confess (A) x Confess (B) = -3/-3 à both lose
· Round 2: Don’t (A) x Confess (B) = 0/-5 à B walks and A gets 5 yrs
– Dominant Strategy
o Confess b/c 0 better than -1 if other doesn’t confess
o Confess b/c -3 better than -5 if other does confess
– Problem is that when both choosing optimal option both get third best
o If acting rationally then both should pick don’t confess; least jail time
o Coordination Problem
§ Each party decision affects another’s interest
– Common Pool Problem
o Tragedy of Commons (e.g., shared fishing pool)
o Individual owner more likely to preserve the resource
o Common owners have no incentive to act with restraint
– Problems relate to creditors aggressively pursue any action against an insolvent debtor
o Leads to the debtor being unable to continue business
o Harms the group as a whole and possibly individual creditors
– Policy for Bankruptcy Law
o To encourage creditors and debtors to act in manner beneficial to all related parties
o Look at problem as a whole so all creditors benefit
§ However, if liquidation value higher than going concern value, no reason not to

Reading Financial Statements
– Financial Statements
o Statements are prepared in-house and usually audited by external, independent accountants
o Note: bankruptcy insolvency is balance sheet insolvency
o Balance Sheet
§ Snapshot of the company’s financial position at one point in time
§ Assets (A) = Liabilities (L) + Shareholders’ Equity (SE)
§ Creditors entitled to assets ahead of shareholders
§ Book Value
· Value as recorded in the balance sheet / books
· Purchase price minus depreciation [accounting] · FMV could differ because of obsolescence, change in market value
§ Current Assets
· Cash/other assets reasonably expected to be realized in cash, sold, or consumed by the business within a year (or during the normal operating cycle of the business)
o E.g., cash in bank, product waiting to be shipped
o Non-current: everything else (e.g., machine, patent)
o Statement of Operation
§ AKA Income Statement (usually when actually have income)
§ For specific time period
§ Helpful to determine if business can generate a profit in the future
· I.e., Going Concern > Liquidation
§ Accrual Basis
· Attempt to match up (for same time period) the revenues with expenses
· Allows managers to determine if product is making a profit
o Accounting Methods
§ FIFO (First-In, First-Out):
· Think of one-way hall with first product pushed through first ones shipped
§ LIFO(Last-In, First-Out):
· Think of closet and keep replacing the widgets from the front of the closet

Business Failure: Business and Financial Aspects
– Problem 5-1 (pg 231)
o What are causes of Foam’s financial difficulty?
§ Growing to quickly
§ Negative cash flow – have to borrow money to compensate
§ Statement of Operations – spending more than making
· General and Admin Expenses are 8mil of only 30mil in Net Sales
– Altman Z-score
o Model to predict business failure
o Used in front-end, to determine if there are problems
o Also useful to determine if reorganization will be successful
§ Some lawyers use in plan confirmation phase, but more could benefit
§ Might be used to show bankruptcy judge feasibility of restructure
– Problem 5-2
o Part A: Z-score = 0.21
o Part B: With reorganization Foam would be in the safe zone
– Problem 5-4 (pg 242)
o Solvency/insolvency is a balance sheet question
o Viability – whether business is capable of making profit/money in the future
§ Not just building more debt
§ Z-score is bad for foam, but if expenses reduced and future revenue prediction high, then good future potential for the business


Eligibility, Venue, Authorization, and Parties

– Two Kinds of Bankruptcy Proceedings
o (1) Liquidation (Chapter 7)
§ Liquidation of D’s financial affairs
§ Applies both to individuals & businesses
§ Accumulate all assets owned by D & take them & pay out to creditors as much as possible
· Secured creditors get paid out of collateral, and
· Unsecureds gets paid out of what is left
· D gets discharged; business gets dissolved
o (2) Reorganization
§ Chapter 13
· Only for individuals w/ regular income (i.e., humans)
· Limitation à individual not eligible if it has debts in too great an amount
· Advantage à develop a reorg plan where debtor pays back some portion of debts
· Creditors have no vote of whether plan gets approved
§ Chapter 11
· Creditors get to vote on approval
· D negotiates w/creditors or creditors representative
· A lot of negotiation, compromise & settlement
§ Chapter 12
· Family farmers (mirrors Ch7 & Ch11)

– Eligibility for Chapter 11: § 109
o § 109(a): Who may be a debtor
§ “Only a person that resides or has a domicile, a place of business, or property in the US, or a municipality,” may be a debtor
· (1) Person residing in U.S.
· (2) Person domiciled, place of business, or assets in U.S., OR
· (3) Municipality
o § 109(b): Who may be debtor under Chapter 7
§ A person if not a RR, domestic ins co, savings bank, cooperative bank, S&L Ass’n, credit union, c

t venue
§ E.g., Enron filed for BR in S.D.N.Y; NY attys hired; they file for transfer of venue
§ Worley Cynical View
· Lawyers don’t want to send away a business/$$$
· Atty fees higher in NY & fees must be approved by judge, want to be in NY ct
– Filing the Petition and Accompany Forms
o Along with the petition, debtor must file—
§ Rule 1007(a): List containing the name and address of each creditor
· Unless petition accompanied by a schedule of liabilities
· Permits the court to send notice to the creditors of the filing
§ Rule 1007(d): List containing name, address & claim of holders of 20 largest unsecured claims excluding insiders (Official Form 4):
o Within 15 days after filing of petition, debtor must file—
§ Schedules (Official Form 6) and
§ Statement of Financial Affairs (Official Form 7)
o Compliance
§ Allow for plenty of time to comply w/ the filing requirements
· Especially if the debtor’s records are in poor shape
§ If fail to provide required info, US trustee may move for dismissal or conversion to Ch7
– “Debtor in Possession” (DIP)
o Filing entity and one that continues to make business and bankruptcy decisions
§ *When you read provision saying “a trustee” it also means “a DIP”*
o § 1107(a):
§ DIP shall have all the rights & powers, & shall perform all the functions & duties, of a trustee serving in a case
· Other than the right to compensation
· DIP has almost all of rights trustee would have (includes right to operate business)

Retention of Professionals

– § 327(a): Employment of Professional Persons
o Trustee, w/ ct’s approval, may employ one or more attys, accountants, appraisers, auctioneers, or other professional persons that—
§ Do not hold or represent an interest adverse to the estate, AND
§ Are disinterested persons, to represent or assist the trustee in carrying out the trustee’s duties
o Test
§ (1) Not Adverse Interest, AND
· No material adverse interest
· Standard à evidence suggests the likelihood of some actual dispute, strife, discord
§ (2) Disinterested Person
· Not a Creditor, Director, etc.
– “Disinterested”
o Majority à Bright Line Test
§ Whiteglove
· DIP’s atty w/outstanding fees as of petition date is a creditor
· Therefore not “disinterested”
§ § 327(d) Exception:
· DIP can be Atty / Acct