Chapter 4 Key concepts underlying the Use of Liquidation vehicles

JurisdictionUnited States

Chapter 4 Key concepts underlying the Use of Liquidation vehicles

This chapter provides an overview of liquidation vehicles and is intended as an introduction to this subject matter for people with no prior background in this area. It includes an introduction to many of the concepts addressed in more detail elsewhere in this Practice Guide.6

Liquidation trusts are only one form of liquidation vehicle. To better understand liquidation trusts and their relevancy to resolving bankruptcy matters, other forms of liquidation vehicles are briefly discussed. The advantages and disadvantages of bankruptcy and of liquidation trusts are then addressed. Alternative forms of liquidation trust are defined, and the scope of the liquidation trustee's role as a fiduciary is introduced.

A. Alternative Forms of Liquidation

Many creditors are unaware that numerous alternatives to bankruptcy exist for dealing with an insolvent business. Other options such as assignments for the benefit of creditors, state court receiverships, federal equity receiverships, and the use of out-of-court workouts and agreements all offer alternatives that need to be discussed and analyzed.

1. Assignments for the Benefit of Creditors7

Although governed by state law, assignments for the benefit of creditors are generally out-of-court proceedings used to consolidate and liquidate a debtor's property for the sole purpose of repaying creditor claims. Under an assignment, the debtor (or "assignor") voluntarily transfers title of all assets through a trust agreement to a trustee (or "assignee"), who liquidates the assets and distributes the proceeds on a pro rata basis among the creditors. While the trust agreement is not necessarily recorded with the state court, the assignment may be recorded in the county where it was executed.

Some states regulate the assignment. Most, however, operate under common law precedent to determine the standards of performance for an assignee. Generally, the assignee's duties include the following:

• controlling the debtor's cash, accounts receivable, inventory, real property and other assets;
• identifying fraudulent transactions that can be prosecuted under state statutes;
• liquidating the debtor's assets by selling assets through the ordinary course of operations, going concern sales of businesses, private sales and/or public auctions; and
• distributing proceeds from the liquidation to creditors.

Although creditors are the beneficiaries of the trust, their consent is not required to validate the trust. Obtaining the support of creditors is often the most difficult problem impeding the use of assignments. Most states do not require formal acceptance by the creditors, and creditors are not necessarily asked for their consent; however, creditors must refrain from filing an involuntary bankruptcy petition for an assignment to be effective. Asset-turnover provisions of the Bankruptcy Code in § 543(c)(3) and (d)(2) generally limit this action to within 120 days after the execution of the assignment. Generally, if no creditor has taken action within 120 days, the assignment is considered binding. However, if the debtor is unable to obtain the support of all significant creditors, it will be impossible to proceed with an effective and binding assignment.

Assignments may be faster, simpler and less expensive than bankruptcy cases. They essentially only involve execution of the trust agreement and do not include the forms, schedules, hearings and other activities necessary to commence a bankruptcy case. Although assignments vary in length, they generally conclude faster than chapter 11 or chapter 7 liquidations, lasting between six weeks and eight months. Finally, assignments do not involve the litigation of bankruptcy proceedings and are often less expensive. On the other hand, assignments may be viewed by the creditor body as attempts to conceal transactions or avoid liability. In addition, many states do not allow assignments without some type of judicial supervision.

2. State Court Receiverships

State court receiverships provide more supervision over the appointment of the receiver, the selection of other professionals, the conduct of the liquidation and the distribution of the proceeds obtained from the liquidation to the creditors. The receiver is appointed at the state court's discretion as a fiduciary to preserve assets pending the liquidation of the debtor's business operations. Requests for appointments of receivers typically occur when a secured creditor with a mortgage in the debtor's real property commences a foreclosure action on the mortgage. The receiver is appointed in the county where the foreclosure action was brought. The receiver is generally appointed if the following conditions are met:

• The property is in danger of being lost, removed or materially injured;
• The property may not be sufficient to discharge the mortgaged debt;
• The secured creditor has requested the appointment of a receiver;
• All or a portion of the property is leased;
• Rents or profits in controversy are in danger of being lost, removed or materially injured; or
• The corporation is insolvent, in danger of being dissolved or has otherwise forfeited its corporate rights.

The receiver is empowered to bring and defend actions with respect to the property, to take possession of the property, to receive rents, to collect debts, and to perform all other acts with respect to the property that the court authorizes to ensure that adequate security is maintained for the mortgagor. As such, the receiver is required to provide an accounting to the state court of the assets and liabilities involved, and any use of the assets must be approved by that court. The receiver is not permitted to sell property without the consent of the secured lender and the court, since the receiver is appointed to preserve and protect the property from loss or destruction. The debtor's consent to a property sale will also be required unless a successful foreclosure has been achieved by the secured lender.

In the event that a bankruptcy is filed, Bankruptcy Code § 543(b) requires that the receiver turn over control of the property to the bankruptcy trustee. In the event that the debtor is in control of its own assets, the receiver must turn over control of the property to the debtor for the purpose of preserving the debtor's right to propose a plan of reorganization while controlling its assets. If the debtor is not likely to reorganize, has no long-term interest in preserving the assets, and the prospect for reorganization is remote, then the bankruptcy court may permit the receiver to continue controlling and operating the assets under § 543(d). A bankruptcy trustee may also be appointed, even during the pending sale of the debtor's property, to marshal other assets, administer claims, pursue preference and fraudulent conveyance actions, and make creditor distributions.

Benefits of receivership primarily include: (1) the court supervises the property; (2) assets are more quickly sold or disposed of, and the secured lender's collateral is more quickly adjudicated; (3) notification of creditors is simplified; (4) the lender has greater control over the disposition of assets and management of the case since the lender compensates the receiver; (5) distributions to secured creditors generally proceed faster since subordinate classes of creditors typically receive no distribution; (6) the lender is shielded from liability to third parties for negligence resulting from possession; and (7) the time required to eject a borrower is shortened under a receivership versus a foreclosure action.

3. Federal Equity Receiverships

The scope of federal equity receiverships has changed with the expansion of federal bankruptcy and state receivership statutes and due to the shift away from bankruptcy as a form of creditor liquidation. Today, federal receivers are most often utilized in connection with stockholder derivative suits or at the request of government officials regarding specific legislation matters such as Securities and Exchange Commission (SEC) regulatory enforcement or prosecutions of federal racketeering cases. Federal receivers are also used in businesses such as interstate motor carriers, railroads or pipelines where the debtor's fixed property extends into different states. Cases where the U.S. is a property-holder or lien claimant may also qualify for federal receivership.

As in state court receiverships, any creditor demonstrating an existing interest in the property, such as secured creditors, lien-holders and mortgagees filing a foreclosure action, may...

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