What Happens to Chapter 11 Cases?

Some Bankruptcy Participants Get a Leg Up

The credit card companies that pushed the consumer bankruptcy abuse provisions were not the only group with lobbyists working overtime in Congress. Several other participants in the bankruptcy process also made gains in the new legislation. These include utilities, vendors that deliver goods shortly before bankruptcy, landlords, unpaid employees, retirees, and taxing authorities. Here is how they benefit:

Utilities

A revised ' 366 requires a debtor to provide adequate assurance to utilities in the form of a cash deposit, letter of credit, certificate of deposit, surety bond, prepayment, or other form mutually agreed to by the utility and the debtor. An administrative expense priority is no longer sufficient, and the court may not consider the debtor's timely pre-petition payments, nor the availability of an administrative expense claim in setting adequate assurance. However, the debtor will have 30 days, rather than the current 20 days, to provide the assurance.

Vendors

A change to ' 546 creates a federal right of reclamation in favor of a seller of goods received by the debtor within 45 days before the commencement of the case. The seller must demand reclamation within 45 days after delivering the goods, or within 20 days after the filing of the case if the 45-day period would have expired subsequent to the filing. (Congress seems to have created a logical puzzle with its drafting here: When would the 45 day period not expire subsequent to the filing?) The amendment to ' 546 also deletes the provision that allows a court to deny reclamation if it grants an administrative expense claim to the reclaiming creditor. (We wonder how many vendors really want their goods back, and whether some might not agree to forego their reclamation right in return for an administrative expense claim if those claims appear likely to be paid in the future.) Revised ' 546 also makes clear that the reclamation right is subject to the rights of a secured creditor. In a separate win for trade vendors, a change to ' 503 accords an administrative expense claim for the value of goods delivered to the debtor during the last 20 days before the filing, whether or not the vendor demands reclamation.

Landlords

As discussed in the article by Daniel A. Lowenthal, infra, debtors will no longer be able to obtain lengthy extensions of the time to assume or reject leases of non-residential real property, and debtors will be required to compensate landlords for any pecuniary loss resulting from nonmonetary defaults that cannot be cured.

Employees and Retirees

Amendments to ' 507 increase the cap on priority wage claims to $10,000, and extend the time of accrual to 180 days before the filing. A corresponding change raises the cap on employee benefit claims to $10,000 per covered employee. A revised ' 1114 mandates, upon a motion by a party in interest, that the court undo any modification made to retiree benefits during the 180 days prior to the filing if the debtor was insolvent at the time of the modification, unless “the court finds that the balance of the equities clearly favors such modification.” These changes are effective immediately and will apply to any case filed on or after April 20, 2005.

Taxing Authorities

Our representatives in Congress obviously know where the money comes from to pay their salaries. Sections 346 and 1129 have been amended, and a new ' 511 has been added, to keep the tax coffers full. The price for the benefits that Congress has conferred on the parties listed above will be substantially higher cash needs for debtors, both early in the case and at confirmation. This cash is likely to reduce the distributions to general unsecured creditors. It may also mean that more debtors will be forced to liquidate rather than reorganize.

Cleaner and Quicker Cases?

Several provisions of the new law take aim at the perception of fraud, abuse, or simple loitering in Chapter 11. A change to ' 1104, which applies to any case filed on or after April 20, 2005, requires the UST to move for the appointment of a trustee if there are grounds to suspect fraud, dishonesty, or criminal conduct in the current management of the debtor or its public financial reporting. A revised ' 1112 makes it more difficult for a court to deny a motion to convert or dismiss a Chapter 11 case. Section 1112 previously provided that the court “may” convert or dismiss a case, and listed 10 possible causes. The amendment to ' 1112 directs that the court “shall” convert or dismiss a case if the movant proves any one of 16 (non-exclusive) enumerated acts or omissions that constitute “cause.”

There are three exceptions to the mandated dismissal:

• If “unusual circumstances specifically identified by the court … establish that the conversion or dismissal is not in the best interests of creditors and the estate”;
• If: 1) the cause for dismissal is an act or omission of the debtor; 2) there is a reasonable justification for the act or omission; 3) the act or omission will be cured within a reasonable time fixed by the court; and 4) there is a reasonable likelihood that a plan will be confirmed within a reasonable period of time;
• If the court determines that appointment of a trustee or examiner, rather than conversion or dismissal, is in the best interests of the estate.

Revised ' 1112 also requires the court to commence a hearing on the motion to convert or dismiss within 30 days after the motion is filed and to decide the motion within 15 days thereafter unless the movant expressly consents to a continuance or compelling circumstances prevent the court from meeting the time limits.

'Self-Regulatory Organization'

Among the many new exceptions to the automatic stay are provisions allowing investigations and actions by a “securities self-regulatory organization,” the enforcement of orders (other than monetary sanctions) obtained by such an organization, and the delisting of a debtor's stock.

To combat a practice that few parties have seen as abusive, the law amends ' 503 to place new restrictions on a debtor's use of key employee retention plans. Under the revised section, a debtor may not pay or agree to pay any amount to an insider for the purpose of inducing such person to remain with the company unless: 1) the person already has a bona fide job offer from another business at the same or greater rate of compensation; and 2) the services of the person are “essential to the survival of the business.” Even if these two requirements are met, the amount of a transfer or obligation allowed under a KERP cannot exceed 10 times the average comparable transfer or obligation paid to non-management employees (for any purpose) during the preceding calendar year. If there were no such transfers or obligations made to non-management employees during the preceding year, the limit is 25% of any similar transfers or obligations made to the insider during the preceding calendar year.

The new ' 503(c) also limits severance payments to insiders. Such payments will be allowed only if they are part of a program applicable to all full-time employees. The amount paid to an insider may not exceed 10 times the average severance pay given to non-management employees during the preceding year. Even if an employee is not an insider, new ' 503(c)(3) prohibits all “other transfers or obligations that are outside the ordinary course of business and not justified by the facts and circumstances of the case, including transfers made to, or obligations incurred for the benefit of, officers, managers, or consultants hired after the date of the filing of the petition.” This change may be of little consequence, as courts typically require such findings already.

The new law also expresses a dislike by Congress for extended stays by a debtor in Chapter 11. In addition to the limitation on the time to assume or reject leases referred to above, ' 1121 has been amended to limit extensions of a debtor's plan exclusivity (that change is discussed in the article by Laurie Selber-Silverstein and Theresa V Brown-Edwards, infra). Also, ' 105 requires, rather than allows, the court to hold status conferences if requested and necessary to “further the expeditious and economical resolution of the case.”

Finally, the new law contains some changes that will make the “pre-pack” route through Chapter 11 a bit faster. Under the amendments, ' 41 allows the court to dispense with the first meeting of creditors if the debtor has filed a prepackaged plan, and ' 1125 allows a debtor that solicited votes pre-petition to solicit the same parties post-petition if both solicitations comply with applicable non-bankruptcy law.

Changes in Bankruptcy Sales

The new law makes a couple of small changes relating to sales outside the ordinary course of business. In one of several new provisions throughout the Code relating to privacy and identity theft, ' 363 now requires the court to appoint a “consumer privacy ombudsman” if a motion to sell personally identifiable information (such as would be found in a debtor's customer list) would violate the debtor's privacy policy in existence as of the commencement of the case. The court may still approve a sale in violation of such a policy, but not in violation of any applicable nonbankruptcy law. Another amendment provides that '363(f) does not authorize a sale free and clear of claims and defenses relating to consumer credit transactions and contracts, such as those under the Truth in Lending Act.

Fraudulent Transfer Actions Expanded and Preference Actions Limited

Revised ' 548 provides for the avoidance of fraudulent transfers made within 2 years (rather than 1) prior to the commencement of the bankruptcy case. This change will apply only to cases filed more than 1 year after April 20, 2005. Another change to ' 548 makes clear that payments and obligations to an insider under an employment contract are avoidable. This change will apply to any case filed on or after April 20, 2005.

Two changes in particular represent a big win for the credit manager community. First, changes to ' 547 expand the availability of the “ordinary course of business” defense, and prohibit preference actions for transfers aggregating less than $5000 in non-consumer cases. A revised 28 U.S.C. ' 1409 requires that a proceeding to recover a debt of less than $10,000 from a non-insider be brought only in the defendant's district of residence.

Revised ' 547 also gives secured creditors 30 days to perfect their security interests. It also protects non-insiders who might otherwise be sued for transfers made more than 90 days pre-petition to or for the benefit of insiders. This change fine-tunes the Deprizio fix that Congress enacted in a prior set of amendments.

Procedural and Technical Fixes

The new law includes a variety of clarifications, tweaks, and procedural changes.

• Jurisdiction: A revised 28 U.S.C. ' 158 allows an appeal of a bankruptcy court's order to be taken directly to the court of appeals under some circumstances. Also, 28 U.S.C. ' 1334 adds all claims or causes of action relating to ' 327 to the district court's exclusive jurisdiction.
• Notices: Section 342 adds specific requirements for addressing notices to creditors and will provide that non-conforming notices will not be effective.
• Creditor Committees: A revised ' 1102 requires creditor committees to share information with the creditors they represent, and to solicit input from those creditors. Also, ' 1102 authorizes the court to order the UST to change the membership of the creditor committee, including by placing a small business on the committee if that creditor holds a claim that is large in comparison with its own annual gross revenues (take a look at the new language and you will see that this change is a prime example of imprecise drafting).
• Professional Retention: A change to ' 328 clarifies that professionals may be retained on a fixed or percentage fee basis, in addition to the existing hourly and contingent fee bases.
• Plan Amendments: Section 1127 clarifies that a modified plan is subject to the same requirements as an original plan and that the modified plan requires disclosure under ' 1125 as directed by the court, notice and a hearing, and the approval of the court.

Conclusion

Time will tell what impact the new law will have on all of our practices. We all will get used to the changes, of course, but we think they generally will not be for the better. First, the changes are largely solutions in search of problems that do not exist. Second, the changes, more often than not, represent wins for narrow special interests at the expense of Chapter 11 estates and their creditors generally.

This Special Edition of The Bankruptcy Strategist is devoted entirely to the recently enacted “Bankruptcy Abuse Prevention and Consumer Protection Act of 2005,” which makes the most sweeping changes to the Bankruptcy Code seen in the last 20 years (although the law does nothing to address some significant issues that have been much debated, such as asbestos, forum shopping, and pension liability). The legislation primarily takes aim at perceived consumer bankruptcy abuses, but will also affect numerous aspects of business bankruptcy practice.

This article analyzes key changes to the Bankruptcy Code that will be important to most business bankruptcy participants. Other articles in this issue address in detail the changes related to cross-border insolvencies, executory contracts, financial contracts, investment bankers, and plan exclusivity. Neither we nor the other contributors to this edition have attempted to address the substantial changes affecting only individuals who file for Chapter 11 relief, or changes to the special provisions for “small business” and “single asset real estate” debtors, as those terms are defined in the Code.

The new law generally becomes effective on Oct. 17, 2005 (180 days after its April 20, 2005 enactment), and most of the changes will apply only to cases filed on or after that date. Particular provisions have different effective dates, however, and some of the changes will apply to pending cases. The changes outlined below appear to be intended to solve perceived problems in the existing state of Chapter 11 practice. Whether such problems actually exist, and whether the changes fix them, remains to be seen.

Some Bankruptcy Participants Get a Leg Up

The credit card companies that pushed the consumer bankruptcy abuse provisions were not the only group with lobbyists working overtime in Congress. Several other participants in the bankruptcy process also made gains in the new legislation. These include utilities, vendors that deliver goods shortly before bankruptcy, landlords, unpaid employees, retirees, and taxing authorities. Here is how they benefit:

Utilities

A revised ' 366 requires a debtor to provide adequate assurance to utilities in the form of a cash deposit, letter of credit, certificate of deposit, surety bond, prepayment, or other form mutually agreed to by the utility and the debtor. An administrative expense priority is no longer sufficient, and the court may not consider the debtor's timely pre-petition payments, nor the availability of an administrative expense claim in setting adequate assurance. However, the debtor will have 30 days, rather than the current 20 days, to provide the assurance.

Vendors

A change to ' 546 creates a federal right of reclamation in favor of a seller of goods received by the debtor within 45 days before the commencement of the case. The seller must demand reclamation within 45 days after delivering the goods, or within 20 days after the filing of the case if the 45-day period would have expired subsequent to the filing. (Congress seems to have created a logical puzzle with its drafting here: When would the 45 day period not expire subsequent to the filing?) The amendment to ' 546 also deletes the provision that allows a court to deny reclamation if it grants an administrative expense claim to the reclaiming creditor. (We wonder how many vendors really want their goods back, and whether some might not agree to forego their reclamation right in return for an administrative expense claim if those claims appear likely to be paid in the future.) Revised ' 546 also makes clear that the reclamation right is subject to the rights of a secured creditor. In a separate win for trade vendors, a change to ' 503 accords an administrative expense claim for the value of goods delivered to the debtor during the last 20 days before the filing, whether or not the vendor demands reclamation.

Landlords

As discussed in the article by Daniel A. Lowenthal, infra, debtors will no longer be able to obtain lengthy extensions of the time to assume or reject leases of non-residential real property, and debtors will be required to compensate landlords for any pecuniary loss resulting from nonmonetary defaults that cannot be cured.

Employees and Retirees

Amendments to ' 507 increase the cap on priority wage claims to $10,000, and extend the time of accrual to 180 days before the filing. A corresponding change raises the cap on employee benefit claims to $10,000 per covered employee. A revised ' 1114 mandates, upon a motion by a party in interest, that the court undo any modification made to retiree benefits during the 180 days prior to the filing if the debtor was insolvent at the time of the modification, unless “the court finds that the balance of the equities clearly favors such modification.” These changes are effective immediately and will apply to any case filed on or after April 20, 2005.

Taxing Authorities

Our representatives in Congress obviously know where the money comes from to pay their salaries. Sections 346 and 1129 have been amended, and a new ' 511 has been added, to keep the tax coffers full. The price for the benefits that Congress has conferred on the parties listed above will be substantially higher cash needs for debtors, both early in the case and at confirmation. This cash is likely to reduce the distributions to general unsecured creditors. It may also mean that more debtors will be forced to liquidate rather than reorganize.

Cleaner and Quicker Cases?

Several provisions of the new law take aim at the perception of fraud, abuse, or simple loitering in Chapter 11. A change to ' 1104, which applies to any case filed on or after April 20, 2005, requires the UST to move for the appointment of a trustee if there are grounds to suspect fraud, dishonesty, or criminal conduct in the current management of the debtor or its public financial reporting. A revised ' 1112 makes it more difficult for a court to deny a motion to convert or dismiss a Chapter 11 case. Section 1112 previously provided that the court “may” convert or dismiss a case, and listed 10 possible causes. The amendment to ' 1112 directs that the court “shall” convert or dismiss a case if the movant proves any one of 16 (non-exclusive) enumerated acts or omissions that constitute “cause.”

There are three exceptions to the mandated dismissal:

• If “unusual circumstances specifically identified by the court … establish that the conversion or dismissal is not in the best interests of creditors and the estate”;
• If: 1) the cause for dismissal is an act or omission of the debtor; 2) there is a reasonable justification for the act or omission; 3) the act or omission will be cured within a reasonable time fixed by the court; and 4) there is a reasonable likelihood that a plan will be confirmed within a reasonable period of time;
• If the court determines that appointment of a trustee or examiner, rather than conversion or dismissal, is in the best interests of the estate.

Revised ' 1112 also requires the court to commence a hearing on the motion to convert or dismiss within 30 days after the motion is filed and to decide the motion within 15 days thereafter unless the movant expressly consents to a continuance or compelling circumstances prevent the court from meeting the time limits.

'Self-Regulatory Organization'

Among the many new exceptions to the automatic stay are provisions allowing investigations and actions by a “securities self-regulatory organization,” the enforcement of orders (other than monetary sanctions) obtained by such an organization, and the delisting of a debtor's stock.

To combat a practice that few parties have seen as abusive, the law amends ' 503 to place new restrictions on a debtor's use of key employee retention plans. Under the revised section, a debtor may not pay or agree to pay any amount to an insider for the purpose of inducing such person to remain with the company unless: 1) the person already has a bona fide job offer from another business at the same or greater rate of compensation; and 2) the services of the person are “essential to the survival of the business.” Even if these two requirements are met, the amount of a transfer or obligation allowed under a KERP cannot exceed 10 times the average comparable transfer or obligation paid to non-management employees (for any purpose) during the preceding calendar year. If there were no such transfers or obligations made to non-management employees during the preceding year, the limit is 25% of any similar transfers or obligations made to the insider during the preceding calendar year.

The new ' 503(c) also limits severance payments to insiders. Such payments will be allowed only if they are part of a program applicable to all full-time employees. The amount paid to an insider may not exceed 10 times the average severance pay given to non-management employees during the preceding year. Even if an employee is not an insider, new ' 503(c)(3) prohibits all “other transfers or obligations that are outside the ordinary course of business and not justified by the facts and circumstances of the case, including transfers made to, or obligations incurred for the benefit of, officers, managers, or consultants hired after the date of the filing of the petition.” This change may be of little consequence, as courts typically require such findings already.

The new law also expresses a dislike by Congress for extended stays by a debtor in Chapter 11. In addition to the limitation on the time to assume or reject leases referred to above, ' 1121 has been amended to limit extensions of a debtor's plan exclusivity (that change is discussed in the article by Laurie Selber-Silverstein and Theresa V Brown-Edwards, infra). Also, ' 105 requires, rather than allows, the court to hold status conferences if requested and necessary to “further the expeditious and economical resolution of the case.”

Finally, the new law contains some changes that will make the “pre-pack” route through Chapter 11 a bit faster. Under the amendments, ' 41 allows the court to dispense with the first meeting of creditors if the debtor has filed a prepackaged plan, and ' 1125 allows a debtor that solicited votes pre-petition to solicit the same parties post-petition if both solicitations comply with applicable non-bankruptcy law.

Changes in Bankruptcy Sales

The new law makes a couple of small changes relating to sales outside the ordinary course of business. In one of several new provisions throughout the Code relating to privacy and identity theft, ' 363 now requires the court to appoint a “consumer privacy ombudsman” if a motion to sell personally identifiable information (such as would be found in a debtor's customer list) would violate the debtor's privacy policy in existence as of the commencement of the case. The court may still approve a sale in violation of such a policy, but not in violation of any applicable nonbankruptcy law. Another amendment provides that '363(f) does not authorize a sale free and clear of claims and defenses relating to consumer credit transactions and contracts, such as those under the Truth in Lending Act.

Fraudulent Transfer Actions Expanded and Preference Actions Limited

Revised ' 548 provides for the avoidance of fraudulent transfers made within 2 years (rather than 1) prior to the commencement of the bankruptcy case. This change will apply only to cases filed more than 1 year after April 20, 2005. Another change to ' 548 makes clear that payments and obligations to an insider under an employment contract are avoidable. This change will apply to any case filed on or after April 20, 2005.

Two changes in particular represent a big win for the credit manager community. First, changes to ' 547 expand the availability of the “ordinary course of business” defense, and prohibit preference actions for transfers aggregating less than $5000 in non-consumer cases. A revised 28 U.S.C. ' 1409 requires that a proceeding to recover a debt of less than $10,000 from a non-insider be brought only in the defendant's district of residence.

Revised ' 547 also gives secured creditors 30 days to perfect their security interests. It also protects non-insiders who might otherwise be sued for transfers made more than 90 days pre-petition to or for the benefit of insiders. This change fine-tunes the Deprizio fix that Congress enacted in a prior set of amendments.

Procedural and Technical Fixes

The new law includes a variety of clarifications, tweaks, and procedural changes.

• Jurisdiction: A revised 28 U.S.C. ' 158 allows an appeal of a bankruptcy court's order to be taken directly to the court of appeals under some circumstances. Also, 28 U.S.C. ' 1334 adds all claims or causes of action relating to ' 327 to the district court's exclusive jurisdiction.
• Notices: Section 342 adds specific requirements for addressing notices to creditors and will provide that non-conforming notices will not be effective.
• Creditor Committees: A revised ' 1102 requires creditor committees to share information with the creditors they represent, and to solicit input from those creditors. Also, ' 1102 authorizes the court to order the UST to change the membership of the creditor committee, including by placing a small business on the committee if that creditor holds a claim that is large in comparison with its own annual gross revenues (take a look at the new language and you will see that this change is a prime example of imprecise drafting).
• Professional Retention: A change to ' 328 clarifies that professionals may be retained on a fixed or percentage fee basis, in addition to the existing hourly and contingent fee bases.
• Plan Amendments: Section 1127 clarifies that a modified plan is subject to the same requirements as an original plan and that the modified plan requires disclosure under ' 1125 as directed by the court, notice and a hearing, and the approval of the court.

Conclusion

Time will tell what impact the new law will have on all of our practices. We all will get used to the changes, of course, but we think they generally will not be for the better. First, the changes are largely solutions in search of problems that do not exist. Second, the changes, more often than not, represent wins for narrow special interests at the expense of Chapter 11 estates and their creditors generally.