Risk Management Manual of Examination Policies - FDIC

LOANS Section 3.2
only by the debtor's spouse or children, property
settlements are dischargeable); and submission of false or
incomplete financial statements. If a bank attempts to seek
an exception on the basis of false financial information, it
must prove the written financial statement was materially
false, it reasonably relied on the statement, and the debtor
intended to deceive the bank. These assertions can be
difficult to prove. Discharges are unavailable to
corporations or partnerships. Therefore, after a
bankruptcy, corporations and partnerships often dissolve or
become defunct.
Reaffirmation
Debtors sometimes promise their creditors after a
bankruptcy discharge that they will repay a discharged
debt. An example wherein a debtor may be so motivated
involves the home mortgage. To keep the home and
discourage the mortgagee from foreclosing, a debtor may
reaffirm this obligation. This process of reaffirmation is an
agreement enforceable through the judicial system. The
law sets forth these basic limitations on reaffirmations: the
agreement must be signed before the discharge is granted;
a hearing is held and the bankruptcy judge informs the
borrower there is no requirement to reaffirm; and the
debtor has the right to rescind the reaffirmation if such
action is taken within 30 days.
Classes of Creditors
The first class of creditors is known as priority creditors.
As the name implies, these creditors are entitled to receive
payment prior to any others. Priority payments include
administrative expenses of the debtor's estate, unsecured
claims for wages and salaries up to $2,000 per person,
unsecured claims for employee benefit plans, unsecured
claims of individuals up to $900 each for deposits in
conjunction with rental or lease of property, unsecured
claims of governmental units and certain tax liabilities.
Secured creditors are only secured up to the extent of the
value of their collateral. They become unsecured in the
amount by which collateral is insufficient to satisfy the
claim. Unsecured creditors are of course the last class in
terms of priority.
Preferences
Certain actions taken by a creditor before or during
bankruptcy proceedings may be invalidated by the trustee
if they result in some creditors receiving more than their
share of the debtor's estate. These actions are called
"transfers" and fall into two categories. The first involves
absolute transfers, such as payments received by a creditor;
the trustee may invalidate this action and require the
payment be returned and made the property of the bankrupt
estate. A transfer of security, such as the granting of a
mortgage, may also be invalidated by the trustee. Hence,
the trustee may require previously encumbered property be
made unencumbered, in which case the secured party
becomes an unsecured creditor. This has obvious
implications as regards loan collectability.
Preferences are a potentially troublesome area for banks
and examiners should have an understanding of basic
principles applicable to them. Some of the more important
of these are listed here.
• A preference may be invalidated (also known as
"avoided") if it has all of these elements: the transfer
was to or for the benefit of a creditor; the transfer was
made for or on account of a debt already outstanding;
the transfer has the effect of increasing the amount a
creditor would receive in Chapter 7 proceedings; the
transfer was made within 90 days of the bankruptcy
filing, or within one year if the transfer was to an
insider who had reasonable cause to believe the debtor
was insolvent at the time of transfer; and the debtor
was insolvent at the time of the transfer. Under
bankruptcy law, borrowers are presumed insolvent for
90 days prior to filing the bankruptcy petition.
• Payment to a fully secured creditor is not a preference
because such a transfer would not have the effect of
increasing the amount the creditor would otherwise
receive in a Chapter 7 proceeding. Payment to a
partially secured creditor does, however, have the
effect of increasing the creditor's share and is thus
deemed a preference which the trustee may avoid.
• Preference rules also apply to a transfer of a lien to
secure past debts, if the transfer has all five elements
set forth under the first point.
• There are certain situations wherein a debtor has given
a preference to a creditor but the trustee is not
permitted to invalidate it. A common example
concerns floating liens on inventory under the Uniform
Commercial Code. These matters are subject to
complex rules, however, and consultation with the
Regional Office may be advisable when this issue
arises.
Setoffs
Setoffs occur when a party is both a creditor and a debtor
of another; amounts which a party owes are netted against
amounts which are owed to that party. If a bank exercises
its right of setoff properly and before the bankruptcy filing,
the action is generally upheld in the bankruptcy
proceedings. Setoffs made after the bankruptcy may also
Loans (12-04) 3.2-60 DSC Risk Management Manual of Examination Policies
Federal Deposit Insurance Corporation