what happens in a bankruptcy case

The information below applies to corporate bankruptcies. Special conditions involve the bankruptcy assets of natural persons, in particular consumers. For more information on the latter, please contact acknowledged credit counseling centers.

 
 

Settlement of creditor claims

The basic concept behind a bankruptcy is to settle all claims of the creditors by liquidating the assets of the debtor (debtor firm): One either distributes the proceeds among the creditors or complies with an alternative regulation set forth in a bankruptcy plan, especially to continue the company (see §1 of InsO). A bankruptcy process also serves to achieve order. For example, regardless of any settlement with creditors, all liability claims are verified and executed, business documents are assessed and stored for the legally stipulated periods, income tax returns are filed, etc.

 
 

Filing for bankruptcy

Receipt of a bankruptcy petition kicks-off the bankruptcy proceedings or petition. The court first verifies permissibility of the petition, whereby it differentiates between petitions filed by the debtor firm (voluntary bankruptcy petition) and by third parties (involuntary bankruptcy petition by creditors). Revenue and/or social security departments are the most frequent third-party petitioners. However, any creditor can file a petition. If the petition is deemed permissible, the court frequently appoints an expert in situations where the competent judge is unable to obtain a complete picture from the documents submitted. Normally, the expert is charged to report within a set period on whether there are grounds for a bankruptcy. The debtor firm receives a copy of the judgment appointing the expert. In addition to a report, the expert must promptly inform the court of the situation at hand and any aspects that may necessitate court orders or other safeguards in the opinion of the expert (§§21 and 22 of InsO).

Immediately following the appointment, the expert thus contacts the debtor firm, usually by phone. At the same time, the expert researches the firm and relevant sectors, while gathering information on the firm from third parties, especially banks. A court can naturally institute safeguards right after reviewing the petition. The expert issues a report soon after collecting all relevant information. Yet, an expert can rarely meet the deadline set by the court, because of the complexity in clarifying the assets and liabilities of a debtor firm. A court generally extends the deadline upon request by the expert.

Unless the court defines specific issues (usually in exceptional circumstances), the expert’s report states the legal and commercial aspects of whether the firm is actually bankrupt or, if relevant, whether there is the risk of an imminent bankruptcy or excessive indebtedness. The report also answers the question whether the costs of the bankruptcy proceedings are likely to be covered: this is a crucial issue for a mature bankruptcy, since the court has to decide on either commencing bankruptcy proceedings or dismissing the case for lack of funds. Moreover, unless the expert is granted other powers by the court or appointed as an interim bankruptcy administrator, he/she serves purely as an expert in a civil process. Beyond this, the expert has no other special powers and, in particular, is not authorized to issue statements on behalf of the debtor firm or accept statements directed at the firm.

 
 

Safeguards

If it is necessary to secure the assets, the court will issue orders to the extent deemed appropriate to prevent loss of assets, called safeguards in bankruptcy proceedings. The most common safeguards are injunctions against individual debt enforcement actions or appointing an interim bankruptcy administrator. Depending on the case, the court may also take other actions such as sealing, seizure of items or rooms, a ban on third parties from collecting on claims assigned by the debtor firm, or picking up any equipment owned by the debtor firm. Such safeguards are quite extensive, and they help form the basis to effectively hinder an outflow of assets and permit company operations to sail ahead in calm waters, thereby allowing the firm to continue at least temporarily.

Safeguards are rarely instituted for reasons of mistrust of the debtor firm or its representatives. Such measures are essentially designed to hinder uncontrolled actions by specific creditors, in the interests of all creditors as a whole – especially to enable a firm to continue operations at the time. This approach ensures that rash actions do not lead to irreversible facts, for instance, when lessors have already picked up machinery from the firm needed to continue operations. The court notifies the debtor firm of its safeguarding judgments. Any safeguards that limit the power of disposal of a debtor are also publicized online via the judicial portal of the federal and state governments at www.insolvenzbekanntmachungen.de, and recorded in the commercial register.

The appointed interim administrator has a very wide range of duties governed by the circumstances. In any event, the administrator has to open up an escrow account, henceforth to be used for all incoming and outgoing financial transactions of the debtor firm, including its claims. The administrator records and takes an inventory of existing assets. For an ongoing operation, the administrator contacts (key) suppliers to ensure continued flow of supplies. The administrator also gets in touch with major customers to clarify further sales, and at an employees’ meeting seeks to inform all staff about the bankruptcy process and payment of wages/salaries. The administrator – together with company management and any works council – above all checks the outlook for reorganization and/or continuing the operations, while initiating necessary restructuring measures. At the same time, the administrator seeks any required investors and negotiates with them.

If the debtor firm’s operations are continued, the administrator closely monitors its liquidity and makes sure that all liabilities approved by him can be serviced. Neither the debtor firm nor the interim administrator is permitted to service any liabilities approved prior to the latter’s appointment. This may contradict the prevailing principle of equal treatment of all creditors, since there may not be sufficient funds to settle with all creditors. Undue preference of creditors could, in fact, be punishable (§283c of StGB – German Penal Code).

 
 

Decision on the bankruptcy petition

Once the court receives the expert’s report, it takes due consideration to quickly decide on how to proceed. Possible decisions are to institute bankruptcy proceedings, or dismiss the petition for lack of funds or because it is not justified or impermissible. This decision terminates the bankruptcy petition process. If the decision is to institute bankruptcy proceedings, the petition or initiation process flows into the actual bankruptcy process. The bankruptcy process is instituted if a permissible petition was filed and the court is convinced that there are grounds for a bankruptcy and funds are available to cover process costs. If the costs are not likely to be covered, the court dismisses the petition for lack of funds. A judgment on dismissal for lack of funds is not based on current funds on hand, but rather on the funds likely to be available during the process, which naturally includes all claims, sale proceeds, etc. The petition is dismissed as unjustified, in the event there are no relevant grounds at all for filing bankruptcy, or if the court is unconvinced of such grounds. If the bankruptcy petition is later deemed unjustified, it will be dismissed as impermissible – unless the problem has somehow been resolved in the meantime.

 
 

Following a bankruptcy order

Once the bankruptcy process has been instituted, the court appoints a bankruptcy administrator, who is not necessarily the same as the former interim administrator or expert. Under this process, the bankruptcy administrator is authorized to manage the bankrupt firm and its debts. The court – or on its behalf the bankruptcy administrator – sends the bankruptcy order to all (known) creditors. Unless the court orders written proceedings, which it may in simple situations, this order schedules the reporting date and the claim/debt verification hearing. The reporting date is set no longer than three months after the bankruptcy order, and in this document the administrator reports on the process so far and pending actions down the road. The creditors use the findings herein to meet and decide on how to proceed, especially on whether an ongoing operation should continue or be stopped. The bankruptcy order includes a precise agenda.

When the bankruptcy order is delivered, the creditors are also required to notify the administrator of their respective claims. These claims that the bankruptcy court addresses at the claim/debt verification hearing, form the basis for subsequent settlement payouts to creditors. During this hearing, each creditor (besides the bankruptcy administrator and debtor) has the opportunity to object to a claim made by any of the other creditors, an aspect of minimal relevance in practice. The process at this hearing does not, as one may suppose from the designation, really involve verification of the claims filed: the court only records all objections raised by the administrator, debtor, and other creditors. Resolution of any disputed claims does not occur in the bankruptcy court, but instead in trial courts – assuming no out-of-court settlement could be reached.

The tasks facing the administrator under a bankruptcy order are quite as complex as that of running the business itself. Depending on the circumstances, the administrator will continue the operations to reorganize them or dispose of healthy assets of the firm by way of a transfer to a rescue company. In this connection, the administrator weighs the option of preparing a bankruptcy plan. If it is not feasible to continue operations, the administrator discontinues it in an orderly manner, usually after drawing down production. The administrator also issues documents for employees, particularly certificates of their bankruptcy payments and employment. Finally, the administrator strives to clarify and execute all conceivable claims.

In the event the firm cannot be continued, the administrator disposes of the existing material and immaterial assets, adding the proceeds to the bankruptcy assets – of which the administrator is a trustee. The administrator has to separate out any items that are not a part of these assets, such as leased items or goods received under a simple lien, and hand these over to their rightful owners – clearly after verifying appropriate third-party rights. The administrator also has to check all other rights in the debtor company’s items held by third parties, including lessor liens, chattel mortgages (transfers of property by way of security), etc. The administrator separately settles – in legal parlance – claims of all relevant security recipients (or chattel mortgagors) from the sale proceeds, to the extent the third-party rights are protected under the bankruptcy code. In other words, the administrator may dispose of the items under a lessor’s lien, but must sweep the majority of the proceeds to the lessor to the extent of the lien. The administrator also verifies all contracts executed by the debtor firm. In the event of contracts not fulfilled by both parties, the administrator has the right to either enter into the contract and fulfill it, quid pro quo, or reject any further fulfillment thereof.

In making such a choice, the administrator must obviously do what is best for the creditors as a whole. Another task for the administrator is to verify and execute the rights to challenges and liabilities. Particularly here, the administrator must clarify if the debtor firm’s assets were shifted contrary to valuations under the bankruptcy code or possibly also paid out to specific creditors. In a bankruptcy, any such discrimination of creditors should be rescinded as far as possible. Additionally, the administrator has numerous other duties to fulfill under public law, such as those involving taxation and social security.

In most bankruptcy cases, not all claims and disputes can be settled out of court. This lies in the nature of the business, in view of the complexity of the matter at hand and because bankruptcy is an unknown territory for most of those concerned. With this backdrop, courts often have to be invoked to clarify legal issues and claims – sometimes over several levels of jurisdiction. For these reasons, corporate bankruptcies typically stretch over two to four years, or much longer in major cases or those involving prolonged legal disputes.

 
 

Final Distribution

The final distribution occurs soon after all assets have been disposed of. Creditors receive their pro rata share of the claims. For example, let’s assume that a debtor firm has € 10 million in liabilities and the administrator manages to compile liquid assets of € 5 million at the end of the process. Now, ignoring the process costs for simplification purposes, each creditor would then receive 50% of the respective claim. This means that if the debtor firm owed a creditor a total of € 100,000, that creditor would receive € 50,000 in settlement. In Germany, the bankruptcy distribution rate – and this should not be withheld – lies around 2–4%. This low figure is, however, caused by a large number of small proceedings that end up not making any settlement payouts at all.