Articles Posted in Tax and Bankruptcy

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You have fresh goods delivered to your largest customer daily, as has been the case for as long as you can remember.  You noticed over the last few months that payments have become less frequent—weekly instead of twice weekly—and occasionally have been paid over a week late.  On top of that, rumor in the industry is that your customer is suffering liquidity problems and may ultimately file bankruptcy. So, what do you do? Stop deliveries, despite the fact that you are still receiving timely payments, and possibly exacerbate your customer’s cash flow problems? Or, do you continue delivering goods and accepting payments, which, if your customer ends up filing for bankruptcy, runs the risk of having a bankruptcy trustee seek to claw back any payments you received for an entire 90-day period before the bankruptcy was filed?

It is a scenario that is all too common in the insolvency world, which, thankfully, has been addressed with vendors in mind by the courts.  The facts in the recent Eleventh Circuit case of Kaye v. Blue Bell Creameries, Inc. (In re BFW Liquidation, LLC), 899 F.3d 1178 (11th Cir. 2018) are not unlike our hypothetical.  Blue Bell delivered fresh ice cream daily to Bruno’s Supermarkets, a 60-store grocery chain located in Alabama and Florida.  Bruno’s payments to Blue Bell began to slip, going from twice weekly to weekly, but Blue Bell continued its deliveries up until the point that Bruno’s filed for bankruptcy.  After the filing, Blue Bell found itself in the unfortunate position of being on the receiving end of a lawsuit from the bankruptcy trustee to recover all payments made to Blue Bell during the 90-day pre-bankruptcy period as “preferences” under 11 U.S.C. § 547.

Congress—recognizing that vendors should be encouraged, rather than discouraged, to extend credit to financially troubled entities—included in the Bankruptcy Code what is known as the “new value” defense, which is found in 11 U.S.C. § 547(c)(4).  In short, the new value defense prevents a trustee from clawing back payments made to the vendor when the vendor has provided subsequent “new value” to the bankrupt customer (e.g. in the case of Blue Bell, new ice cream deliveries).

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One important attribute of any successful entrepreneur or business owner is knowing when to enter a new line of business or invest in equipment or employees to bolster an existing, growing service line. Another (perhaps even more important) attribute is knowing when to stop spending time, money and effort on a venture that will likely never work out or is not proceeding as planned. These two decision points—when to move forward and when to make a strategic retreat—are central to the success of any venture.

It is extremely hard to walk away from a project in which an executive is personally and financially invested. But the future viability of the organization always requires clear thinking, with all sentimentality, preconceptions, and vested interests cast aside. This inability or refusal to make a sensible, financial, and analytics-driven decision after a significant investment has been made in a project or an idea is known as the “sunk-cost fallacy.” As one textbook puts it:

“The sunk cost fallacy is the view that sunk costs should matter. Whenever issues involving sunk costs arise, it is always seems natural to think that it would be a pity to waste all the money that has been spent already. But that natural tendency does not lead to the best decisions. . . .”[i]

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As we learned during the downturn in 2008, the economic climate can change rapidly. When things are going well, many businesses forget the lessons of the past. No matter what industry your business is in, there may be occasions when you are asked to enter into a relatively long-term contract, i.e. longer than three years. Such agreements are sometimes favorable because of the stability and predictability they can provide. However, before entering into such an agreement, you should consider that the longer the contract, the greater the risk of a change in the contract counterparty’s financial situation. A safe credit risk in 2017 might find itself filing for bankruptcy by 2020.

If your response is: “I am not concerned about the other party filing bankruptcy. I had my attorney include a bankruptcy termination clause in our agreement,” then you may want to think again. The U.S. Bankruptcy Code has a lot to say about the rights of both the debtor and the non-debtor party once a bankruptcy is filed – often to the chagrin of the non-debtor party.

It is true that many business agreements contain clauses which provide that a party filing bankruptcy is deemed to have breached the agreement, and the other party may terminate the agreement (a “Right to Terminate” clause). Or the provision might say that if one party files bankruptcy, that party’s rights terminate automatically (an “Automatic Termination” clause).

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We asked some of our financial advisor colleagues to give us brief read outs on what they felt 2017 has in store for us now that we have gotten beyond the inauguration and into the first weeks of the Trump administration.  Their thoughts follow:

https://www.southerncaliforniabankruptcylawyersblog.com/files/2017/02/2012-03-31-10.05.15-214x300.jpgWe have been seeing a lot of highly leveraged deals that impact the performance of the business. These deals are leading to reduced spending on capital expenditure, marketing and even experienced management.  Once new ownership is in place, these strictures prevent the company from operating with the same efficiency as in the past, let alone growing.  Another scenario we have been encountering is companies getting beyond the management ability of the founder as the company increases revenues from $25M to $50M and then to $100M or more. In either case, increasing interest rates will cause dislocation, because it does not take much to push these companies into a zone where they are showing significant financial stress.

That being said, we are also seeing that lenders are still being lenient because it’s really hard to get a full recovery in a liquidation, and appraisal firms always seem to be the first to hedge on their ability liquidate inventory en masse.  Also, my sense is that lenders don’t really want to sell their loans to exit a credit as it hurts their reputation.  Still, we are finding that lenders keep getting surprised with over-advances for many reasons.  When we are called in to assist in such situations, we focus our efforts on trying to fix the operating issues of the businesses and make a reasoned re-allocation of limited resources.

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Any property owner which has experienced the bankruptcy of a tenant is doubtless keenly aware of the limitation on damages which the Bankruptcy Code imposes on the landlord. A new decision by the Ninth Circuit bolsters the position of landlords in this long-running tussle.

Section 502(b)(6) Cap Refresher

Before getting to the Ninth Circuit’s recent opinion, here is a quick review for those who have not confronted the issue recently: Bankruptcy Code section 502(b)(6) generally “caps” a landlord’s claim for “damages” against a bankrupt tenant when a lease is terminated before or during the bankruptcy case to (a) the greater of the next year of rent due, or 15% of all the remaining rent due up to 3 years of the remaining term, and (b) any unpaid rent owing as of the date of the bankruptcy, or the date the tenant lost possession of the premises if prior to bankruptcy.  Fairly or not, the policy justification for the cap is that large claims of landlords, which are by their nature long-term and hard to calculate, should not overwhelm the claims of other trade creditors.

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On December 1, 2016, something extraordinary happened. No, it was not president-elect Trump visiting another Carrier air conditioning factory in Indianapolis. It was an event that made no headlines and caused no stir.  The Federal Rules of Bankruptcy Procedure were silently amended to remove all references to “core” and “noncore” proceedings.

So what’s the big deal?

Besides eliminating one of the last tools I possessed to sound smarter than my non-bankruptcy colleagues, the change reflects the final chapter in a 34-year saga regarding bankruptcy court jurisdiction and the constitutional authority of bankruptcy judges.

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Editor’s note: this blog post was recently published in Law360.

Shareholders of financially troubled S corporations may now be able to avoid the flow-through of taxes when the S corporation or its subsidiary files bankruptcy.  In In re Majestic Star Casino, LLC, 716 F.3d 736 (3rd Cir. 2013), the Third Circuit Court of Appeals ruled that an S corporation shareholder, who may have received the benefit of years of flow-through income tax treatment from the S corporation, may avoid the flow-through of taxable gain or income in bankruptcy simply by revoking the S corporation election.   The revocation converts the corporation into a C corporation, thereby trapping at the corporate level all income tax liabilities that the corporation incurs in bankruptcy.  The losers are the corporation’s unsecured creditors, whose claims will now only get paid after the tax claims the corporation incurs in bankruptcy.

In Majestic Star Casino, one of the debtors was a corporate subsidiary of an S corporation for which a qualified S corporation subsidiary (QSub) election had been made, thereby causing the debtor QSub to be treated as a disregarded entity for federal income tax purposes (akin to a division of the S corporation parent).  After the debtor QSub filed chapter 11 bankruptcy, the S corporation’s shareholder revoked the S election for the parent (which was not in bankruptcy).  This also revoked the QSub election for the debtor QSub, with both the parent and the debtor QSub becoming C corporations.