WILLIAM N. LOBEL : The Boom in Bankruptcies : Law That Allows Debtors to Buy Time Subject to Abuse

Bankruptcy is as much a part of Orange County as surfers, swimming pools and high housing prices. The federal bankruptcy court in Santa Ana--along with its counterparts in Los Angeles, Ventura and Riverside counties--takes in more bankruptcy filings than any other region of the United States.

The companies that have run into trouble and turned to the bankruptcy court include some big local names, including Smith International and Care Enterprises. The list of companies filing for bankruptcy keeps getting longer. Earlier this month, National Lumber & Supply filed for Chapter 11 bankruptcy protection, citing intense competition from warehouse retailers and a slowdown in local housing and home-repair markets. Just two days before National Lumber waved the white flag, car dealer Friendly Ford filed for Chapter 11 too after it was slapped with a $20-million state lawsuit that alleges misleading sales tactics.

Many of the county’s largest bankruptcies are handled by the Irvine law firm of Lobel Winthrop & Broker. Partner William N. Lobel has handled many bankruptcies, including retailer Maui & Sons, which is about to emerge from Chapter 11. Lobel, 46, was chairman of the Orange County Bankruptcy Forum in 1988-89 and a director of the California Bankruptcy Forum in 1989-90.

He has given many lectures on bankruptcy, including “Strategies for Dealing with Customers and Suppliers in Bankruptcy,” which was presented to the Orange County CFO Forum last year.

He recently spoke about his bankruptcy practice with Times staff writer Gregory Crouch.

Q. How common are bankruptcies in Orange County?

A. The Central District of California, which includes Ventura, Los Angeles, Orange and Riverside counties, has the largest number of filings of any district in the country. In fact, it has more filings than the two next-largest districts combined--one in New York and one in Texas.

Q. Why is that?

A. Because Southern California is populated by more risk-takers than any other section of the country. There is more creativity, coupled with a tremendous amount of accumulated wealth and a local culture that causes people to be willing to take a chance to make big money. Those that make it buy houses on the water, and those that don’t come see me. It makes it a wonderful place to practice bankruptcy law. It also is however the reason we have so many scams in Southern California where people lose their investment because even older people are willing to risk their retirement income to get an 18% or 20% return.

Q. What are the options under the federal bankruptcy law?

A. There are three types of bankruptcies that are commonly utilized. The first is Chapter 7, a liquidating bankruptcy. It is done when the intent is not to reorganize your debts and keep your assets, but rather to give up your assets and start over. So you have more debts, and the only assets you have are those you are allowed to exempt. And you begin life anew with those exempt assets as your grubstake. The non-exempt assets of a person or company are turned over to a trustee. The trustee sells those assets. The creditors file claims, and the trustee pays the proceeds of the sale to the creditors according to certain priorities established in the bankruptcy code. So in other words, the Internal Revenue Service gets paid before unsecured creditors. And if the bankruptcy filing is for an individual, state law allows you to keep certain assets and not turn them over to the trustee. For example, if you own a house and are married, you are allowed to keep $45,000 in equity in the house, you are allowed to keep furniture, clothing etc., up to certain values. The trustee, for instance, will sell the house if there is more than $45,000 equity in it.

Q. And what is a Chapter 11 bankruptcy?

A. That is the type of bankruptcy we do almost exclusively. The Chapter 11 petition is normally filed by a business corporation or partnership, but it can be filed by an individual. The purpose of a Chapter 11 is to propose a plan to your creditors to pay them either less than the full amount you owe or to pay them over a longer period of time, or some combination of those two. Very often, the payments are made either from a sale of your assets in the future or more commonly from future profits to be made in the operation of your business. The benefit of a Chapter 11 to a business is it allows the business to stay open.

Q. How do companies get themselves into such a debacle?

A. Generally these companies have incurred more debts than they have the ability to pay at the time they are due. In this area, we often find companies that were once profitable and that have overexpanded and are losing money because they are too big and too inefficient.

In a Chapter 11, all of the unsecured creditors are prevented from attempting to collect the debts owed to them by the debtor, while the debtor restructures its business in a way that it can then be profitable. It then proposes a plan to pay back its debts out of the profits of the business that is now profitable.

One of the examples I frequently give to clients is that this is like peeling back the layers of an onion, and what they do in a Chapter 11 is to continue to peel back the layers of that onion until they get to a core business that is profitable. If there is a core business that is profitable, virtually any company can successfully reorganize in a Chapter 11 by paying its creditors some amount on their debts from the future profits of the core company.

How much is paid on those debts often depends upon how many layers of the onion you have to peel back, and therefore how much profit in the future will there be to pay whatever back debts have been accrued.

For example, suppose you have a company that, when it had 20 employees and one location, was successful. They were so successful they decided to expand, so now they have 100 employees and five locations. They borrowed money from a bank to provide the money for the expansions. And because they are now inefficient, they are losing money. At least in theory, if the company goes back to one location and 20 employees, it could once again be profitable, and from those profits it can pay the debts of the larger company.

But if for example the small company could make only $25,000 a year in profits and the debts incurred when it got big were $1 million, the plan would likely pay a small percentage of the $1 million over time. If the company has pared back and is making a $200,000 profit, then it would be more likely it would pay 100 cents on the dollar to creditors over five years. Or it can pay over seven years in order to pay interest. Some plans pay interest, some don’t.

Q. Do you have a local example here in Orange County?

A. Yes. An example of a company that was very successful when it was small and overexpanded and became unprofitable is Irvine Ranch Market. When it was one store in Irvine it was profitable. When it was two or three stores, everything could be watched closely and it was profitable. When it expanded to eight or 10 stores that were not in the same geographic area, it became unprofitable. There are a lot of examples of overexpansion and insufficient cash reserves--those are the two most common reasons for a Chapter 11.

Q. Finally, what is Chapter 13?

A. Chapter 13 can only be filed by an individual. There are limits to the amount of debt an individual can have and still file a Chapter 13. It is similar to a Chapter 11, in that the purpose of a Chapter 13 is to allow a debtor to continue to own all of his assets and to propose a plan to pay the creditors a portion of what they are owed in order to completely discharge the debt.

Q. Why would an individual file for Chapter 13 rather than Chapter 11?

A. It is much less expensive, it is simpler and it is quicker. But it is limited to individuals who have total unsecured debt of less than $100,000 and total secured debts of less than $250,000. A secured debt is one whose repayment is protected by a lien on real property or personal property. The most common example of a secured debt is a trust deed on a house, what we call a mortgage in California. Most people don’t own their house free and clear, so most people have as a secured creditor, a bank or a savings and loan, which has a lien on their house. Other common secured creditors are banks who have liens on cars. An unsecured creditor is a creditor who is owed money but does not have a lien on anything. The most common example is a credit card creditor. If someone had debts within the limits of Chapter 13, they could still file a Chapter 11, but the Chapter 13 is cheaper and quicker. Chapter 13 can be done for $750. Just the filing fee for a Chapter 11 is $500. And lawyers require retainers generally ranging from a low of $20,000 to a high of $75,000 or $100,000. When Maxicare (the Los Angeles-based health maintenance organization) last year filed for Chapter 11 in Santa Ana, the retainer was $2.5 million.

Q. Some creditors claim the bankruptcy laws favor the debtor.

A. When the federal bankruptcy code was enacted in 1978, it was a complete rewrite of what was previously called the Bankruptcy Act. The bankruptcy code swung the pendulum in favor of debtors and against creditors, as compared to the way things were under the Bankruptcy Act, which was the law before 1978. It was in part the changes in the law that occurred in 1978 that has resulted in a tremendous increase in the number of bankruptcy filings we now see. The creditors main complaint is that in the bankruptcy court the rules are such that they favor the debtors unfairly.

Q. For example?

A. If you hold a mortgage on an apartment house and the owner of the apartment house files a bankruptcy, during the term of the bankruptcy the owner is not required to pay you interest, provided the property is not declining in value. Creditors complain it is unfair in a bankruptcy that may take up to a year or longer for the creditor to be receiving no money during the pendency of the case. That is one of the main complaints. Another complaint is the amount of time the bankruptcy court allows a debtor to propose a plan to pay its creditor: six months to a year if it’s an operating business. During that period they are generally paying no interest to their secured creditor, and until they propose a plan they pay nothing to their unsecured creditors.

Q. Why is the bankruptcy code not harsher?

A.Because the purpose of the bankruptcy is to allow businesses to be rehabilitated, because Congress viewed that the overall good for society would best be served if businesses were given a fair opportunity to reorganize rather than liquidate. That is because the consequences of a liquidation is that people lose their jobs, assets get sold for less than their real value and the benefit to society that was being served by the business when it operated is eliminated. It is really a matter of balancing the legislative intent to give debtors an opportunity to reorganize against the rights of the creditors to get paid. And I personally believe that the pendulum is where it ought to be in that regard.

Q. Does everyone feel that way?

A. Creditor attorneys tend to think the pendulum is too far in favor of the debtor and debtor counsel . . . given the purposes of the bankruptcy code. The real problem lies in the abuses of the system.

Q. Such as?

A. The most commonly complained of abuse is a Chapter 7 filed by someone who is making a lot of money but has no assets or very few assets and has a lot of debt. The law is that everything they earn from the minute they file the Chapter 7 forward is theirs. So you have creditors owed a lot of money, and a person making $400,000 or $500,000 a year can get a way with not paying them.

Q. What else?

A. Another abuse is that it is not uncommon in a Chapter 7 for debtors to fail to list all of their assets. It’s a crime but it happens all of the time. The trustees for Chapter 7 bankruptcies have so many cases that it’s unreasonble to expect them to do a sufficient investigation in every case to determine whether all of the assets have been listed. The level of the trustee’s inquiry is normally limited to asking the debtor to swear he has listed all of his assets on his schedules, and that can be very abusive.

Q. What is the most common abuse of Chapter 11?

A. Well, take a case of a business that is not working. In other words, it is probably impossible to propose a plan that will work, and yet the case stays in Chapter 11 and the owner of the company draws a salary during the case, even though the debtor is losing money every month. In that circumstance, that case should be converted to a Chapter 7 and the assets sold, with the proceeds of that sale used to pay the creditors. If the case remains in Chapter 11, there are fewer and fewer assets with which to pay the creditors. Sometimes a company is losing money, and sometimes it makes sense to lose money for a short period of time in order to have the time necessary to turn it into a profitable entity. But where the company can never be profitable but stays in a Chapter 11 anyway, that is abusive.

Q. Some people say Chapter 11 can serve as an umbrella for crooks.

A. What happens is that the Chapter 11 shields the individual for some period of time from facing the consequences of a scam he or she has perpetrated. For instance, the filing of a Chapter 11 stops all lawsuits filed against somebody who ran a pyramiding scheme. This happens frequently. I don’t like it, but the problem is that when the case is first filed, it’s very difficult for a judge to determine whether the business is a legitimate business that can make a profit or is a scam.

Q. What eventually happens?

A. Once the judge determines that it is a scam, the Chapter 11 does the individual no more good because then the judge will convert it to a Chapter 7 or order the appointment of a trustee, which removes the individual from control of the company, and if the trustee discovers there are things being done wrong that are violations of criminal law, the trustee will report that to the appropriate authorities. So it’s most accurate to say that Chapter 11 acts as a temporary shield for a scam operation, but it rarely is effective in the long run.

Q. Why do scam operators turn to Chapter 11 and what can be done to stop it?

A. They always feel that if given a sufficient amount of time, they can figure out a way to make it work. They’re just buying time. I think the system needs more federal funding so that you can have more people who are watchdogs, which would result in fewer abuses.

Q. Are you seeing any new trends in the bankruptcy business?

A. One of the areas that is causing more and more big filings is the area of leveraged buyouts. An LBO by its nature often shackles a company with more debt than the company reasonably can expect to pay. That debt is often in the form of junk bonds. When the junk bonds were issued in connection with the original leveraged buyout, it was the expectation of the parties that they would be able to refinance those junk bonds when they came due. The junk bond market is now such that refinancing is often impossible. The result is the company has to file a Chapter 11, because it can’t pay its junk bonds when they come due. We are all expecting the bankruptcy business in the area of large Chapter 11s to get very busy because the heyday of junk bond financing of leveraged buyouts lasted five years, and those junk bonds are just now starting to come due.

Q. Any final thoughts?

A. In most large Chapter 11 bankruptcies, the system works the way it is supposed to. The employees stay employed, the doors of the business stay open and to the customer at large there is no difference. In spite of what you hear, almost always if a company did not file Chapter 11, it would otherwise have to go out of business.