Caution:  Do NOT rely upon this publication as legal advice.   Consult an attorney.

August, 2009

Workouts With Creditors:  Bankruptcy Should Be The Last Resort

by

Stephen F. Matthews and Elizabeth S. Schilling*

In Missouri, as in the rest of the nation, a great many farmers are seriously in default on loan payments. These farmers, whose numbers include many excellent farmers with efficient farming operations, often are or may soon be facing various types of collection actions--such as foreclosures, terminations of contracts for deed, repossession actions, suits to obtain judgments on debts and pressure to sell off equipment, crops and livestock.

This factsheet discusses three options available to such farmers: non-bankruptcy workouts, bankruptcy liquidations and repayment plan bankruptcies. This sheet is not a substitute for consultation with an attorney. Do not rely upon this information as legal advice. Rather, it provides information which, ideally, will help the farmer become a more effective partner with his attorney. Consultation with a competent attorney is an important step in reliably assessing options.

COOPERATING WITH CREDITORS: NON-BANKRUPTCY WORKOUTS also known as a “Voluntary Workout”:

If a creditor voluntarily agrees to negotiate, any resulting agreement usually is called a "voluntary workout."   The voluntary workout is not the same thing as filing bankruptcy.  It is a negotiation between the farmer and his creditors.  The farmer may want to involve an attorney at the outset, in order to assist in the negotiation with the creditors. Therefore, the first course of action for a financially distressed farmer is to contact creditors (directly or through his representative) and try to work something out without resorting to legal action.

Since farmers who are in danger of losing key farm property because of loan default will need to develop a comprehensive plan for negotiating with creditors, it may be advisable to consult with an attorney or other trusted financial advisor in order to develop the comprehensive plan before contacting the creditors.

STEP 1:  The first step in developing such a plan is to gather accurate financial information about the farming operation. The farmer should prepare a complete list of all debts and assets with corresponding current fair market values, a record of actual expenses and revenue for the previous two or three years, and a realistic forecast of expenses and revenue for the next two or three years.

Most attorneys have forms for recording this information and request that the forms be filled out before their first conference with debtors.  This will make the meeting more productive.  This is often a difficult psychological step, but once it is accomplished, the debtor is closer to getting accurate information and the ability to make informed decisions.

STEP 2:  The next step is to evaluate the financial information. If the farmer believes his farming operation is profitable, he then will need to develop a realistic repayment plan. The plan should be based upon the amount that will be available for loan payments during the next two or three years--i.e., the difference between estimated revenues and estimated expenses, excluding loan payments.

When the debt payment schedule exceeds projected debt repayment capacity, you must explore with your creditors the various workout options.

Workout options for reducing debt payments include: alternative financing, debt restructuring or rescheduling, partial liquidation, and debt forgiveness.

Debt restructuring or rescheduling refers to changing the terms of loans, by reducing interest rates, postponing payments of principle, and spreading payments over a longer period of time.

Partial liquidation refers to selling some property and/or relinquishing some property to creditors. Partial liquidations may be accompanied by debt forgiveness. This occurs when a creditor accepts property worth less than the claim, yet cancels some or all the excess indebtedness. Whether partial liquidation is viable option depends upon several factors, including the probable income tax consequences of the conveyance or sale and the expected cash flow from remaining assets. The possibility of leasing back the liquidated asset from the purchaser or creditor may also be a consideration.

Any plan the farmer develops must insure that funds will be available for planting or other current operations. Thus, in most cases, negotiations with creditors also will include efforts to obtain binding (written) loan commitments or permission (written) to spend proceeds from the sale of farm products on current operations.

If a creditor voluntarily agrees to negotiate, any resulting agreement usually is called a "voluntary workout". Voluntary workouts, however, are not always a viable option. A farmer may have such a high debt-to-asset ratio and be so far behind on payments that he simply cannot develop a feasible repayment plan. Or creditors may be unwilling or unable to make any concessions, particularly after several prior but unsuccessful workout attempts with the farm debtor. Or, if foreclosure or repossession of essential assets is already in motion or likely to be, there may be insufficient time to negotiate. In such cases, bankruptcy alternatives may be considered. This does not mean, however, that the farm debtor is ahead by taking bankruptcy, even if foreclosure is a sure thing.

EXPLORING THE PROS AND CONS OF TAKING BANKRUPTCY

The United States Constitution gives Congress the power to enact bankruptcy laws. Thus, bankruptcies are governed primarily by federal statutes and federal rules, rather than state law. Missouri law comes into play when we consider "exempt property" where the debtor liquidates under Chapter 7.

Congress passed the first bankruptcy act in 1898. This act was frequently amended, the last bankruptcy act, the Bankruptcy Reform Act, being passed in 1978 (effective October 1, 1979). It is also called the “Bankruptcy Code,” and is codified as title 11 of the United States Code.  It has been amended several times since its enactment.  The most recent change occurred on April 20, 2005; the President Bush signed into law the Bankruptcy Abuse Prevention and Consumer Protection Act, which limits individual access to US bankruptcy courts. Some of the changes, which were effective October 17, 2005, included: new bans on Chapter 7, increased Chapter 13 repayment plans, different presumptions regarding debtors and increased penalties and the reduction of judicial discretion to balance competing interests.

Under the Bankruptcy Code, there are 4 basic alternatives to farmers--a liquidation option under Chapter 7 and a reorganization plan option under Chapter 11, Chapter 12 or Chapter 13. The same rules generally apply to both farmers and non-farmers. However, a farmer's creditors, unlike a non-farmer's creditors, cannot file a petition that forces the farmer into a bankruptcy proceeding.

The bankruptcy code defines a family farmer or family fisherman as an individual, an individual and spouse, corporation, or partnership engaged in farming or fishing operation that meets certain debt limits and other statutory criteria for filing a petition under chapter 12. 

The filing of a bankruptcy petition under Chapters 7, 11, 12 or 13 has the effect of a court order that prohibits creditors from taking any debt collection action against the debtor or his property due to the automatic stay provision. One of the most important protections that the Bankruptcy Process offers to debtors is the Automatic Stay.  The automatic stay is the legal way of temporarily halting creditors from trying to foreclose on property or collect on a debt. This means that all collection efforts, including foreclosures, repossession actions and lawsuits must stop.

The "automatic stay" allows the case and everything connected with it to be handled in an orderly fashion in one court. It also helps insure that aggressive creditors will not benefit at the expense of other creditors.

CHAPTER 7 LIQUIDATIONS

Any farmer may file a Chapter 7 petition, no matter how much or how little he owes, unless he has been granted a bankruptcy discharge under Chapter 7 within the previous eight years. Under Chapter 7, a debtor turns his business operation financial records and assets, along with his non-exempt personal assets, over to a bankruptcy trustee.

 In Missouri, the only assets an insolvent debtor may claim back from the trustee are limited amounts of equity in certain kinds of property, such as $3000 in an automobile, $15,000 in a homestead that is real estate and only $5,000 if the homestead is a mobile home and $3,000 in tools of the trade.  The trustee liquidates all other assets and distributes the proceeds to creditors.

At the conclusion of the proceedings, the court usually grants the debtor a "discharge" for debts listed in his petition. This means that creditors can no longer take any action to collect these debts. However, corporations and partnerships, which are generally dissolved after a liquidation proceeding, are not eligible for a discharge. In addition, some individual debtors, such as those who fraudulently conceal property or records, will not receive a discharge. Finally, certain types of debt--primarily alimony, child supports, student loans, income taxes, debts incurred by fraud, fines, penalties and punitive damages--cannot be discharged.

CHAPTER 13: WAGE-EARNER REORGANIZATION

Chapter 13 is an option for wage earners and sole proprietors with less than $336,900 and secured debts are less than $1,010,650.  These amounts are adjusted periodically to reflect changes in the consumer price index. Farmers who have debts in excess of these limits, as well as those who operate farms that are incorporated or run as partnerships, are not eligible for a Chapter 13 bankruptcy. However, they have a somewhat similar option under Chapter 11 and Chapter 12.

Chapter 13 bankruptcy allows a debtor to keep assets he would otherwise lose in a Chapter 7 liquidation by paying creditors, generally over a three year period, at least as much as they would receive in a Chapter 7 liquidation.

Under Chapter 13, the debtor proposes a plan for paying (primarily with future income): (1) all debt secured by property he wants to retain; (2) all "priority" debts (primarily past due income taxes); and (3) some or all unsecured debt (debts not backed by collateral or liens on property, such as most utility bills, medical bills and feed bills).

The plan must be filed with the debtor's petition or within 10 days thereafter, and it must be approved by the bankruptcy court. If the plan is approved and the debtor carries out the plan, the court will grant the debtor a discharge for any unpaid portions of debt scheduled in the plan. The only debts that are not covered by a Chapter 13 discharge are alimony, child support and debts that do not mature within the plan period, such as mortgage debt.

CHAPTER 11: REORGANIZATION

Chapter 11 is entitled simply "Reorganization". Any farmers, including those whose farms are incorporated or run as partnerships, may file a Chapter 11 petition. There is no need to have a regular (wage) source of income.

 Under this chapter, a debtor also may propose a plan for repaying debts over an extended period of time. However, the repayment period may be longer than the three to five year period that is permitted under Chapter 13, and the payments may come primarily from liquidation proceeds rather than from future income. In addition, the plan must be approved by a certain portion of the debtor's creditors before it can be approved by the court (the one exception is the "cramdown" provision).

If the plan is approved, the debtor and creditors provided for in the plan will be bound by the plan rather than by previous agreements. The court generally will grant the debtor a discharge when it approves the plan. A Chapter 11 discharge, however, is subject to most of the exceptions that apply to a Chapter 7 liquidation discharge.

CHAPTER 12: Family Farmer or Family Fisherman Bankruptcy

Chapter 12 was added to the Bankruptcy Code in 1986 as a temporary measure for the reorganization of family farms.  However, it became a permanent part of the Bankruptcy Code in 2005.  Chapter 12 resembles Chapter 13 because it is a repayment plan and is designed for wage earners.  It is tailored to farmers in that it allows a higher amount of debt to be restructured and therefore is more applicable to a farming operation than a Chapter 13.  Chapter 12 is considered to be designed for farming operations and was tailored to be less cumbersome than a Chapter 11 and as straightforward as a Chapter 13.

 The criteria for qualifying for relief under the Chapter 12 is as follows: The individual or husband and wife must  be engaged in a farming operation or a commercial fishing operation; the debts of the operation must not exceed $3,544,525 (for a farming operation) or $1,642,500 (for a commercial fishing operation); and at least 50% of the family farmer’s total debt (excluding his home) must be related to the farming operation, if  a family fisherman then at least 80% of the total debt (excluding his home) must be related to the fishing operation.  Additionally, 50% or more of the gross income of the individual or the husband and wife for the preceding tax year (or, for family farmers only, for each of the 2^nd  and 3rd prior tax years) must have come from the farming or commercial fishing operation.

OTHER THINGS TO CONSIDER WHEN CONSIDERING BANKRUPTCY

MARITAL STATUS:  A husband and wife who are jointly liable on their debts may file a joint petition under either Chapter 7, 11, 12 or 13.

TAX CONSIDERATIONS: If a debtor operates a farm as a sole proprietorship, the tax consequences of liquidating his assets will differ depending upon whether he is liquidating under Chapter 7/11, under Chapter 12/13, or under a voluntary workout.

When a sole proprietor files a Chapter 7 or 11 petition, his assets are considered a separate taxable entity called the bankruptcy estate. To the extent that the value of property liquidated in a Chapter 7 or 11 bankruptcy exceeds the debtor's tax basis in that property, the estate, not the debtor, is liable for any resulting tax.

In contrast, any tax liability resulting from a partial liquidation under Chapter 12 or 13 or a voluntary workout or from a foreclosure or repossession action outside of bankruptcy is borne by the debtor.

 On April 7, 1986 Congress passed a new income tax law that would eliminate the alternative minimum tax on farm-asset-generated preference income (capital gains) provided the taxpayer was a farmer, insolvent, and sold the entire farm business (after 1981).   It is recommended that you seek competent tax advice from a tax professional since the IRS rules change and legal cases can have the effect of changing the interpretation of internal revenue code rules.

EFFECT ON CREDIT RATING: A creditor's willingness to extend credit to someone who has gone through a bankruptcy proceeding will depend primarily upon the factors leading to the bankruptcy, the percentage of debts paid in the bankruptcy proceeding, and the debtor's financial management record since bankruptcy. For example, creditors may be more willing to extend credit to a farmer who got into financial trouble because of agricultural problems and large medical bills than to a farmer whose credit difficulties arose primarily from land or commodities speculation. In addition, many creditors are less reluctant to extend credit to a farmer who paid nearly all of his debts in a bankruptcy proceeding than to one who had a large portion of debts discharged.

LOCATING AN ATTORNEY

Let's assume you want to discuss further some workout options with an attorney. How do you locate one familiar with farming operations and interested in having farm clients? You may be fortunate enough to have a versatile attorney already, such as the one who did the legal work to buy the farm or write up your will. If not, or if this attorney is not satisfactory for these current farm legal problems, try asking your friends and neighbors for recommendations of good farm attorneys. Lawyers in Missouri are forbidden to advertise as specialists, such as "ag attorneys," so word-of-mouth can be your best source of information.

The Missouri Bar operates a "Lawyer Referral Service" at 1-800-392-8777 between 9:00 a.m. to noon and from 1:00 p.m. until 3:00 p.m. on weekdays. The operator will refer you to an attorney in your community, and you will need to make the appointment. There is a $25 fee for the first half hour of consultation, which goes to the Missouri Bar for costs of running the service. It will be up to you to make any future appointments or to authorize the attorney to take any action in your behalf. If you stay with that attorney, it is up to you and the attorney to agree upon the fee to be charged after that first half hour. 

The Missouri Bar Lawyer Referral service does not offer referrals in the Kansas City Area, the Springfield Area or the St. Louis Area.  Each of those areas has their own lawyer referral services.  The number for the Kansas City Area is 816-221-9472, Springfield area is 417-831-2783 and St. Louis is 314-621-6681.  The terms of these referral services may be different from the Missouri Bar Lawyer Referral Service.

PREPARING FOR CONSULTATION WITH AN ATTORNEY

Anyone exploring the bankruptcy option will want the time he spends with an attorney to be as productive as possible. When making the initial appointment, be sure you understand what information you should bring and, if you don't have this information, you should ask how and where you can obtain it. The following list illustrates the preparatory steps: 

(1) Make a complete list of debts with names and addresses of creditors; amounts currently owed, and descriptions of collateral;
(2) Prepare a list of all assets with current values;
(3) Gather together recent statements and notices from creditors;
(4) Pull together credit and loan documents, including notes, financing statements and security agreements;
(5) Bring all summonses served on the farmer in pending lawsuits;
(6) Bring Property tax statements;
(7) Record of projected expenses and revenues for the current year; and 
(8) Copies of income tax returns for the past several years.

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*Matthews is a professor and attorney with the Department of Agricultural Economics at the University of Missouri; Schilling is an ag law research assistant in the same department.