Caveat Lender: Bankruptcy Considerations for Shipping Lenders1 July 2020

Chapter 11 Considerations for Lenders

Who May File?

Foreign companies utilize chapter 11 to restructure due to the many debtor-friendly rules. The Bankruptcy Code’s liberal jurisdiction provisions allow any company that has property in the United States to file a chapter 11 proceeding. There is no requirement that the property has been in the United States for any particular amount of time, so the transfer of funds to a US account prior to filing is sufficient to create jurisdiction.

Automatic Stay

One powerful tool for debtors restructuring under chapter 11 is the imposition of an automatic stay on creditors. Immediately upon filing a bankruptcy petition, the worldwide automatic stay takes effect, staying all actions to enforce or collect pre-petition claims against the debtor and its assets.  As a result, creditors are forbidden from (1) terminating existing contracts, (2) commencing or continuing litigation or lien enforcement actions, and (3) taking any other legal actions against the debtor or its assets, without leave of the Bankruptcy Court. The stay is so broad as to not only preclude lenders from foreclosing on their collateral, but also prohibits sending notices of default or acceleration to the debtor.

Most loans contain termination clauses that are triggered by the borrower filing for bankruptcy.  These so-called “ipso facto” clauses are generally unenforceable in executory contracts (discussed further below) but may be enforceable in loan agreements.¹ Additionally, lenders cannot be forced to extend financing to a borrower in bankruptcy despite a previous agreement to do so.

SWAPs

The worldwide automatic stay has some limits. For example, the automatic stay does not prevent a financial institution that is party to a swap agreement from exercising its contractual right to offset or net out any termination value, payment amount, or other transfer arising in connection with the swap agreement. As such, swap participants may terminate a swap in the event of insolvency or bankruptcy. Additionally, an insolvency event of default entitles a swap counterparty to termination damages, and the counterparty may seize its collateral regardless of the automatic stay.

Credit Enhancements and Preferential Transfers

Lenders who are concerned about their borrower’s financial status often request additional security or payments from their borrower. For example, a lender may request that funds held in a blocked or pledge account be transferred to an account held in the lender’s name, out of concern that the debtor will use such funds for restructuring. If the debtor files a bankruptcy petition a month or two after such a transfer, that transfer may be challenged and clawed back from the lender into the bankruptcy estate as a “preferential transfer.”

Certain payments and transfers made by a debtor in the months, or even year, prior to filing a bankruptcy petition, are considered “preferential transfers” under the Bankruptcy Code.  Preferential transfers include any payment or transfer of an interest of the debtor, including a security interest in additional collateral, to a creditor on account of an existing debt made on or within 90 days (or one year if to an insider) before the filing of the bankruptcy petition.

There are a number of statutory defenses to preferential transfer claims. A transfer cannot be clawed back by the debtor if the transfer, inter alia, (1) was made in exchange for new value given to the debtor, (2) was made in the ordinary course of business (e.g., timely loan payment), or (3) created a security interest in property acquired by the debtor to the extent the security interest secured new value given by the creditor that was used to acquire the collateral property. For these purposes, “new value” can be money, services, or new credit, but does not include an obligation substituted for an existing obligation. Thus, forbearance likely does not constitute “new value” and any additional security provided to obtain lender’s agreement to forbear would likely be considered a preference.²

Cash Security

Creditors may be surprised to find that funds accumulated in a blocked account cannot be swept once a borrower declares bankruptcy. Even if the funds are swept into lender’s account prior to a bankruptcy, that sweeping might be considered a preference and clawed back. The funds in a pledged or blocked account are known as “cash collateral” because they are owned by the debtor, but the lender has a security interest in the funds. Cash collateral includes cash, negotiable instruments, securities, or deposit accounts in which both the debtor and a non-debtor (i.e., a creditor) have an interest. Usually, the debtor will seek court permission to use this cash collateral during the chapter 11 proceeding to pay bankruptcy and other expenses.

The Bankruptcy Code provides some protections for secured creditors who are, because of the automatic stay, prevented from foreclosing on cash and other collateral. These creditors may seek “adequate protection” of the value of their security if the debtor intends to use the collateral or pledged funds during the bankruptcy. Adequate protection is not specifically defined in the Bankruptcy Code and is often the subject of significant negotiations between the debtor and lenders, and could include a replacement lien on unencumbered property or payments of interest during the bankruptcy proceeding.

Forbearance Agreements

There are additional limitations on forbearance agreements in chapter 11 that should be considered by lenders. While a developing area of law in the United States, forbearance agreements – unlike loan agreements – are generally enforceable against lenders in the borrower’s bankruptcy when the parties use the forbearance agreement to afford the borrower the opportunity to avoid foreclosure. In other words, lenders must continue to forbear under the terms of the agreement even if the borrower files for bankruptcy during the forbearance period, because such agreements are considered “executory contracts.”

“Executory contracts,” although undefined in the Bankruptcy Code, generally include contracts where both parties have material unperformed obligations under the contract. If a debtor elects to assume, or continue, the executory contract, the debtor must first cure any defaults thereunder and assume the entire contract. If a debtor rejects an executory contract, the rejection is treated as a breach of the agreement, and the other party may make a claim against the debtor’s estate for damages.