The liquidation analysis is central to every form of consumer bankruptcy. Yet too many attorneys think the formula is
Assets minus Secured Debts minus Exemptions = Distributable estate
Not by a long shot. So let’s walk through the elements of a comprehensive liquidation analysis.
You need it if you’re assessing the vulnerability of assets to the trustee in a Chapter 7. It’s one of the confirmation tests (“best interests of creditors”) in Chapter 13. And it’s critical if you’re cramming down a Chapter 11 plan.
Assets, tangible and intangible
Tangible assets like homes and cars are easy to identify. A step less obvious, to your client at least, is money in the bank. And then there are legal rights that may be worth money, like interests in a probate estate, membership in a class action suit, or an employment-based claim.
All of those things are assets. And unless you find an exception in 541, they become assets of the estate.
But don’t forget assets that may be recovered under the avoiding powers of Chapter 5. The trustee’s ability to invalidate transfers is designed to swell the estate. These transfers may be voluntary, like the recent retitling of assets or the payment of insider loans before filing. Or they may be involuntary like the levy or the judicial lien.
But don’t fall into the trap of assuming the value of the avoidable transfer is the face value of the asset transferred. Most avoidable transfers are only recovered by dint of legal action and lawyers charge for that work. So it’s only the net of the transfer after settlement discounts or legal fees that will actually be available for a trustee to distribute.
There you have the gross value of assets for your liquidation analysis. On to deductions.
Liens lessen the total
It’s black letter law that unavoidable liens are paid from the collateral securing the lien. The trick becomes quantifying the lien.
Too few debtors enter bankruptcy current on their home mortgages. Ask the client how much he owes and, dollar to doughnuts, he’ll give you an approximation of the principal balance. Somehow, the arrears, the lender’s escrow advances, and other costs don’t figure in his calculation. But they need to figure in your calculation. Consider making a request for a payoff if your numbers are close.
Don’t forget property taxes, both delinquent and currently due.
Which brings us to judgment liens and statutory liens. Often what bankruptcy counsel is presented with is the original notice of lien. Unless the ink is still wet on that notice, there is undoubtedly interest that has accrued since the notice was issued. Add it up.
Exemptions shrink the pot
The first and easiest deduction in your liquidation analysis is exemptions. Out of that pot of values you calculated above, the debtor can extract from the estate the items which are exempt. Remember, too, that the debtor may claim an exemption in involuntary, prepetition preferences that are recovered. 522(g0.
Costs of administration come off the top
Part of the trustee’s calculation when considering whether to administer an assets is assessing the costs of that administration. He has to ask: will there be meaningful cash to distribute to creditors from the administration of this asset?
Commission Most obvious is the trustee’s commission, a declining percentage of the funds distributed to creditors. That can be a big number if the trustee is selling real estate. But, the trustee doesn’t get a commission on exemptions returned to the debtor.
Costs of sale If the asset in question must be sold, the transaction costs need to be deducted in your liquidation analysis. Think realtor’s commissions, auctioneer costs, brokerage fees. The costs of sale for real estate may also include fix up expenses.
Estate professionals The administration of the estate may require lawyers to pursue avoidable transfers, litigate objectionable claims, or evaluate possible litigation the debtor brings to the estate. Cha-ching. The bankruptcy estate is a tax-paying entity, so the trustee may need a tax professional. Or an appraiser, or an expert witness.
Taxes Finally, the estate may owe taxes on its income, including capital gains generated by the sale of assets. The big item, of course, is the sale of real property. To do a sound liquidation analysis you need to know the tax basis of the asset. Remember when dealing with commercial or rental property, that basis may be the purchase price (plus improvements) reduced by depreciation deductions.
The estate acquires the debtor’s tax attributes, like basis, but also any loss carryforwards the debtor is entitled to. Forget loss carryforwards, which operate to shield taxable income on account of prior losses, and the trustee may be able to sell low basis assets free of tax. Ouch.
Some assumptions required
Before a case is filed, you may not have firm numbers on some of these issues, and you inevitably have to make estimates of administrative expenses.
But a rough pass through the liquidation analysis before filing will tell you whether you need to wait for better information before selecting a chapter, or assessing your client’s ability to fund a plan.