Banks, Clients Face Difficult Choices in Chapter 11 Weighing Legal, Practical, Strategic Considerations
by Victor Owens
Union Bank of California NA; Irvine, Calif.
When a company or an individual makes the transition into chapter 11, a myriad of legal, practical and strategic decisions must be made. One of the toughest decisions a debtor-in-possession (DIP) must make is whether or not to stay with its current bank.
A debtor’s decision to move a banking relationship can depend on a variety of circumstances, including the use of cash collateral or offset rights. It may be prudent for a debtor to maintain its existing operating relationship, especially when cash-management structures are in place or if the same bank provides crucial financing to maintain the firm’s deposit accounts.
On the other hand, it may be wise for a debtor to move its relationship to coincide with the filing of the voluntary petition. Such a change can provide a clean break or fresh start and may be strategically necessary.
Several other factors should be weighed in deciding whether or not to change banks. What is the bank’s approval status in the district in which the bankruptcy is filed? Can the bank provide the necessary banking services, including requisite reporting to the U.S. Trustee? Can the bank provide immediate and ongoing collateralization of DIP deposits?
First Thing’s First
Upon written or verbal notification that a client has filed bankruptcy—including through a public newscast—U.S. Bankruptcy Code §542A requires a bank to turn over all of the company's assets and property to the DIP. This requirement often results in the placement of the accounts into a “post-credits-only” status.
The post-credits-only restriction allows funds to be deposited into an account, but prohibits debit transactions. Contrary to what many debtors think, the accounts, technically, are not frozen. A bank simply must wait for notification on how to transfer the assets of the estate to the DIP. The post-credits-only restriction prevents pre-petition debts from being paid with post-petition funds, which are property of the bankruptcy estate. Payment of these items would violate the Bankruptcy Code's automatic stay.
This limitation on transactions continues until the debtor either opens new DIP accounts or the bank receives a first-day order specifying that the debtor has bankruptcy court permission to maintain its existing bank accounts and cash-management systems. If the debtor chooses to terminate the existing banking relationship, a wire transfer or a cashier’s check in the name of the DIP is provided.
A bank has no legal duty to continue providing banking services to a new chapter 11 entity, and may not find the complications or requirements of maintaining DIP accounts manageable. Like any other service provider, a bank must make a business decision on whether it is in its best interest to continue a relationship by providing new DIP-related services.
There are inherent and often unavoidable costs to a bank in managing DIP accounts. These include additional reporting requirements, risk-management procedures, legal procedures and consultation, compliance issues, and the direct expense of posting collateral. Generally, these costs are passed on to a DIP through lower rates on interest-bearing accounts, lower earnings allowances for non-interest-bearing accounts, and nonnegotiable pricing on bank services.
A bank’s decision on whether to continue a relationship when an existing client files chapter 11 depends on several factors: outstanding credit, cash collateral, history and the overall size of the relationship.
A bank’s reaction to the news of a customer's chapter 11 filing is based primarily on its fundamental desire to mitigate risk. Risk can come in the form of loss of fees, loss of payments that are in the process of settlement via automatic clearing house (ACH), wires, controlled disbursement clearings, internal zero balance accounts (ZBAs) and potential violations of the automatic stay.
Go or Stay?
A DIP must decide initially whether to maintain the existing account structure or open new DIP accounts. A DIP often petitions the bankruptcy court for permission to maintain its existing account structure and cash-management systems – especially if it has a complicated cash-management structure. This action preempts the requirement to close all pre-petition accounts and open new DIP accounts.
While this tactic is often the most practical, it does pose certain difficulties. First, the Bankruptcy Code requires pre-petition debt to be segregated from post-petition assets. Other than the usual allowance to pay pre-petition wages, bankruptcy courts rarely give a DIP carte blanche to pay all checks written pre-petition from what is now a DIP account. A court may authorize specific payments other than payroll, but a bank will want to see a court order detailing these payments.
Subsequently, the DIP must place stop-payment orders on all outstanding pre-petition checks not authorized by the bankruptcy court. In addition, the bank may require an amendment to the court order that holds the bank harmless if a non-authorized pre-petition debit is paid inadvertently.
A DIP may find it necessary or beneficial to move its entire banking relationship to another institution. In addition to strategic considerations, there are practical reasons for the DIP to form a new banking relationship, including:
- a desire for a new account structure to preempt the need to monitor the clearing of pre-petition checks and other debit activity
- the approval status of the depository bank to provide the requisite reporting to the U.S. Trustee
- the ability of the depository to collateralize bankruptcy deposits
- the ability or willingness of the depository to provide a wide range of treasury management services.
Unless exempted by a bankruptcy court order, a DIP is required by the U.S. Trustee to close all existing bank accounts immediately upon filing bankruptcy. The debtor must also provide the U.S. Trustee with copies of all new bank signature cards, together with evidence of the amounts transferred to the new accounts.
Typically, three basic accounts are required: a general account, a tax account and a payroll account. This basic account structure can be enhanced to include a more complex treasury management structure when necessary.
ZBAs are simple checking accounts that are tied to a master concentration account located at the same bank. An automatic transfer from the master account covers checks drawn against a ZBA at the end of each business day. Although some banks view offering ZBA accounts to DIP as a risk, this valuable cash-management tool can be provided safely.
Each approved depository holding DIP balances must report monthly or quarterly the status of funds held to the appropriate U.S. Trustee region. The data must include:
- the DIP account number
- individual account balances
- the amount of collateral posted for each account exceeding the maximum coverage by the Federal Deposit Insurance Corp. (FDIC)
All bankruptcy accounts with aggregate balances exceeding the $100,000 FDIC limit must be collateralized by obligations whose principal and interest is unconditionally guaranteed. As a result, only U.S. government-backed obligations or, where allowed by the U.S. Trustee, surety bonds are deemed acceptable instruments for purposes of collateralization.
Bank Policies
Banks often react to notice of a client’s chapter 11 filing by canceling substantially all treasury management services that are crucial to successful cash management. This response is an attempt to mitigate real or perceived risk.
In reality, most pre-petition cash-management services can be provided to a DIP without the bank assuming undue risk. Services such as ACH debits and credits (including direct deposit for payroll), lockbox, controlled disbursement accounts, ZBAs, online banking and information reporting, and cash vault services should not be refused automatically.
Risk-management considerations address:
Uncollected Funds. Generally a bank provides no availability to uncollected funds to a DIP. Therefore, it is often beneficial for the client to consider receiving payments via the ACH system or by wire to optimize cash flow.
Overdrafts. Covering overdrafts is an extension of credit and simply is not allowed. Only available funds can be used to honor checks presented for payment.
ACH Credits/Debits. All ACH credits (payments) originated by a DIP, including direct deposit for payroll, must be pre-funded. ACH debits, a means to draw funds in from remote locations via a cash-concentration system or the collection of payments, typically require a security account in the form of a pledged certificate of deposit for the amount of the average daily debit. Authorization to take a security interest in assets of the bankruptcy estate must be obtained from the bankruptcy court.
Letters of Credit. Standby letters of credit can be facilitated in the same manner as ACH debit activity, via a pledged certificate of deposit.
Merchant Card Services. Charge-backs or credit card fraud present genuine credit risks to a bank, and requests for merchant-card services are generally declined. However, if a DIP has an existing merchant-card account with its bank prior to filing, the bank may not be able to cancel the service unilaterally.
Treasury management considerations include:
Cash Deposits. Typical waivers of currency deposits in excess of $10,000 for businesses that routinely do a large volume of business with cash may not be available to a DIP.
Lockbox. A lockbox can facilitate the rapid collection of a DIP’s receivables and improve the speed by which credit to the customer’s account can be made.
Electronic Cash Concentration. Electronic cash concentration via the ACH system minimizes excessive bank balances, pools funds, simplifies cash management, improves control and reduces transfer costs.
Check 21. Check Clearing for the 21st Century Act (Check 21), the most significant legislation affecting the banking industry in years, allows for both business and consumer checks to be truncated and turned into electronic images by anyone along the check-clearing trail.
All checks written on DIP accounts are paid only against collected funds to avoid any extension of credit. An alternative to using local checks to meet obligations is the establishment of a controlled disbursement account, which is a type of ZBA. One of its principal advantages is that it allows a DIP to calculate daily cash requirements early enough to reposition cash to the disbursement bank from the funding source or to invest excess cash.
The use of controlled disbursement accounts, internal ZBAs and lockboxes are all effective methods of managing various types of float. Similarly, ZBAs fund only the amount necessary to cover daily check presentments from a concentration account and offer a way to analyze check presentment patterns by payees.
Electronic payments made either through the federal wire system or ACH are an effective method for a DIP to disburse and receive funds. With appropriate controls and audit procedures in place, electronic payments can offer the DIP improvements in both productivity and cash management.
If new accounts are established upon filing, and depending on how close to the payroll date a filing occurs, paper checks will likely be required for the initial payroll. This is due primarily to the lead-time required by a bank to set up direct deposit of payroll services (offered through the ACH system). Other factors affecting payroll implementation may include internal or external payroll preparation by a third-party vendor. If the DIP receives court permission to maintain the existing payroll accounts, the implementation of this service can be expedited significantly.
Technological developments have extended and enhanced the use of electronic commercial payment and financial information systems so that nearly all bank transactions can be initiated, viewed and retrieved online. Standard banking transactions such as wires, ACH debits and credits, stop payments and internal account transfers can all be managed directly from the customer’s office. With the proper security controls and authorities established, these popular cash-management services should all be readily available to a DIP.
Upon confirmation of a reorganization plan, a former DIP has the choice of maintaining its existing accounts or opening new operating accounts. There is no legal requirement to open new accounts as there is with the initial filing. Continued use of existing accounts and cash management products and services promotes a smooth and less-burdensome transition back into mainstream banking activities.
Special Knowledge
When a company or individual transitions into chapter 11, it is crucial to identify personnel within the bank who are thoroughly versed in providing banking services, including the legal issues involved, to work with the DIP.
There are many rules, regulations, guidelines and legal and risk-management considerations involved in providing banking services for DIPs. However, a resourceful bankruptcy banker can duplicate nearly all pre-petition depository and cash-management services enjoyed by a customer prior to its entry into chapter 11.