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

Workouts With Creditors:  Bankruptcy Should Be The Last Resort

by

Ann Henderson and Stephen F. Matthews*

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 The first course of action for a financially distressed farmer is to contact creditors and try to work something out without resorting to legal action. Farmers in danger of losing key farm property because of loan default will need to develop a comprehensive plan for negotiating with creditors.

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. Some attorneys have forms for recording this information and request that the forms be filled out before their first conference with debtors.

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

tax consequences of liquidations are discussed in Factsheet #9 "Bankruptcy and Non-Bankruptcy Liquidations: Tax Consequences". 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).

The Bankruptcy Reform Act offers two basic alternatives to farmers--a liquidation option under Chapter 7 and a reorganization plan option under Chapter 11 or Chapter 13. The same rules generally apply to both farmers and nonfarmers. However, a farmer's creditors, unlike a nonfarmer's creditors, cannot file a petition that forces the farmer into a bankruptcy proceeding.

For definitional purposes of the Bankruptcy Code, a "farmer" is a person who, during the previous tax year, received over 80% of his gross income from a farming operation he owned or operated.THE AUTOMATIC STAY: A TEMPORARY HALT TO FORECLOSURES

The filing of a bankruptcy petition under Chapters 7, 11 or 13 has the effect of a court order that prohibits creditors from taking any debt collection action against the debtor or his property. This means that all collection efforts, including foreclosures, repossession actions and lawsuits must stop. This "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 six 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 $500 in an automobile, $8,000 in a homestead and $2,000 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 7

bankruptcies are described in more detail in AG LAW PUBLICATION # 1986-7, "Chapter 7 Bankruptcy: Farm Liquidation."

CHAPTER 13: WAGE-EARNER REORGANIZATION

Chapter 13 is an option for wage earners and sole proprietors with less than $100,000 in unsecured debt and less than $350,000 in secured debt. Farmers who have debts in excess of these limits, as well as those who operate farms that are incorporated or run as partnerships, however, have a somewhat similar option under Chapter 11.

Chapter 13 is entitled "Adjustment of Debts of An Individual With Regular Income". It 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 13 bankruptcies are described in more detail in AG LAW PUBLICATION # 1986-8, "Chapter 11 and 13 Bankruptcies: Reorganization Plans."

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 11 bankruptcies are described in more detail in AG LAW PUBLICATION # 1986-8. "Chapter 11 and 13 Bankruptcies: Reorganization Plans."

JOINT PETITIONS

Husband and wife who are jointly liable on their debts may file a joint petition under either Chapter 7, 11, 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 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 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). The tax consequences of liquidations are discussed in more detail in AG LAW PUBLICATION # 1986-9, "Income Tax Consequences of Liquidating the Farm."

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 9:30 a.m. and 3:30 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 $20 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.

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) Don't forget summonses served on the farmer in pending lawsuits;
(6) 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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* Henderson is an attorney and ag law research associate, and Matthews is an attorney and professor of agricultural law; both are with the Department of Agricultural Economics, University of Missouri-Columbia. Prepared April 10, 1986.