CHANGING THE CODE

After more than eight years of effort by various interest groups and lobbyists, President Bush signed into law the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (the "Act") on April 20, 2005. While much has been written and discussed about the effect of the Act on consumer bankruptcies, the Act also will have a significant impact on business bankruptcy cases.

After more than eight years of effort by various interest groups and lobbyists, President Bush signed into law the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (the “Act”) on April 20, 2005. While much has been written and discussed about the effect of the Act on consumer bankruptcies,1 the Act also will have a significant impact on business bankruptcy cases. Among other changes, the Act includes additional claims for certain trade creditors, lessors and employees, expanded defenses to recovery of alleged preferential payments, expanded grounds for dismissal of a Chapter 11 case or its conversion to Chapter 7, additional oversight and monitoring by the bankruptcy court and certain ombudsmen, limitations on bonuses and compensation available to senior management, additional reporting requirements for small business debtors and a new chapter of the bankruptcy code for international bankruptcy matters. Each of these changes is discussed herein.

Provisions of the Act go into effect at various times, with the majority of the provisions becoming effective on October 17, 2005. Exceptions to the October 17 effective date are noted below. This article summarizes some of the provisions of the Act that affect business cases, with emphasis on those provisions that we believe will be of particular interest to our clients. This survey, however, is not exhaustive and will not address all changes that may affect corporate cases.

Expanded Rights of Certain Trade Creditors and Lessors

Current bankruptcy law relies on the Uniform Commercial Code to allow a seller 10 days to seek to reclaim goods delivered to a debtor on credit. The Act expands this time period and provides that sellers may reclaim goods, or be granted an administrative claim for the value of goods, sold on credit during the 45-day period before bankruptcy. To take advantage of this expanded reclamation period, the supplier must provide written notice of an intent to reclaim the goods within 45 days of the debtor’s receipt of the goods, or no more than 20 days after the bankruptcy filing if the 45-day period expires after the bankruptcy filing. Reclamation rights are subject to the rights of a creditor holding a prior security interest or lien in inventory; however, if the senior lender’s security interest does not extend to all inventory, or if the lender is over-secured, reclamation claims may have value and should be asserted to preserve the potential priority claim of the supplier.

Similarly, trade creditors–that is, creditors who provide goods as opposed to, for example, a lessor or a lender–who have delivered goods to a debtor within 20 days prior to its bankruptcy filing are entitled to assert an administrative expense claim for the value of the goods if the sale was in the ordinary course of the debtor’s business, even where the seller fails to provide timely notice of reclamation. The potential for increased administrative claims of this nature will likely reduce the funds available to pay general unsecured creditors, since administrative claims must be paid in full before distribution to lower priority claims, including general unsecured creditors. Because of the clear benefit to particular trade creditors at the expense of others, the new reclamation and administrative claims provisions will likely be the subject of much litigation.

The Act also creates new rights for landlords leasing nonresidential real property to a debtor by requiring the debtor to reimburse actual pecuniary losses to the landlord for pre-petition non-monetary defaults under a lease of nonresidential real property. (By way of example, a non-monetary default might occur if a shopping center tenant violated a covenant to keep its storefront open.) The Act eliminates the question, under current law, whether non-monetary defaults must be cured in order for the debtor to assume a lease of non-residential real property, and allows a debtor to assume the agreement without curing non-monetary defaults to the extent that such defaults are impossible to cure, except that defaults arising from failure to operate in accordance with a lease must be cured through performance at and after assumption.

In addition to creating a new claim for certain landlords, the Act now limits the time available for the debtor to determine whether to assume or reject an executory contract or unexpired lease. Under current law, a debtor must assume or reject unexpired leases of real property within 60 days after filing its bankruptcy petition, but the bankruptcy court may, for cause, extend such time indefinitely. Courts routinely extend the time to assume or reject executory contracts and unexpired leases in business cases until confirmation of the debtor’s plan for reorganization. The amendments to the Bankruptcy Code created by the Act limit this period and require a debtor to assume or reject an unexpired lease within 120 days after a bankruptcy filing. The court may not extend this deadline beyond an additional 90 days unless the lessor consents in writing to such extension. This revision enables a landlord to know more quickly whether it will need to find another tenant for the property.

Limitations on Preference Actions

The Act includes several creditor-friendly modifications to current preference law. Under current law, a creditor who finds itself a defendant in an action to avoid and recover preferential transfers–that is, payments on account of an unsecured obligation made by a debtor within 90 days prior to the commencement of a case–is required to prove both that the payments made by the debtor during the 90 days prior to the bankruptcy were made in a manner consistent with the parties’ prior course of dealing and on terms that are ordinary in the debtor and creditor’s industry. The Act expands the availability of the “ordinary course” defense by requiring that the creditor prove only that the payment was made either in accordance with the parties’ prior course of dealing or in accordance with ordinary industry terms. In addition, the time period available to a secured party to perfect its lien without being subject to potential preference exposure has been increased from 10 days to 30 days after the debtor receives the property. Finally, the Act prohibits actions to recover transfers totaling less than $5,000 in business cases.

These changes will make it more difficult for a debtor in possession to recover alleged preferential transfers. And because preference and other avoidance actions are often the only source of distribution for unsecured creditors, the result will be that fewer funds will be available for distribution to all creditors. At the same time, some creditors who received payment shortly before the debtor filed bankruptcy will benefit by being allowed to keep what would otherwise have been avoidable transfers.

Expanded Bases For Dismissal, Appointment of a Trustee and Court Oversight

Under current law, the United States Trustee makes decisions as to the composition and operations of committees appointed in Chapter 11 cases to represent various creditor or equity security holder groups, without oversight or approval by the bankruptcy court. The Act changes this structure by giving the bankruptcy court more control over the composition of such committees. Specifically, the Act allows the court to order the United States Trustee to change the membership of a creditors’ or equity committee if necessary to ensure adequate representation or to increase the number of members to include a creditor who, although a “small business” concern (as defined later in this article), holds claims the aggregate of which is disproportionately large relative to the annual gross revenue of that creditor. Thus, creditors who may not be holding the largest claims of the debtor may nevertheless seek appointment to an official committee.

In addition to increased access to committee participation, the Act also provides for increased sharing of information with and participation by nonmember creditors by providing that the court may order additional reports or disclosures to the committee’s creditor constituents. While most attorneys representing a committee share non-proprietary information with committee members, committees and their counsel now have an affirmative duty to share and communicate with all creditors represented by the committee.

Under prior law, a party in interest or the United States Trustee could move to replace current management of the debtor company with a trustee, and the court was required to order the appointment of a trustee if certain factors, such as fraud or dishonesty, were present. The Act requires, for all cases filed after April 20, 2005, that the United States Trustee move for appointment of a Chapter 11 trustee if there are reasonable grounds to suspect that the debtor’s current management or board participated in fraud, dishonesty or criminal conduct in the management of the debtor or in public financial reporting.

The Act substantially expands the factors that constitute “cause” to convert a Chapter 11 (reorganization) case to Chapter 7 (liquidation), or to dismiss the case altogether. Many of the factors set out in case law that developed under prior law are now codified and include: (1) substantial or continuing loss or a diminution of the estate and no reasonable likelihood of rehabilitation; (2) gross mismanagement of the estate; (3) failure to maintain appropriate insurance; (4) unauthorized use of cash collateral; (5) failure to comply with court orders; (6) failure to pay post-petition taxes; (7) failure to comply with reporting requirements and pay statutory fees; and (8) failure to attain confirmation, revocation of confirmation orders, or material defaults under a confirmed plan. The court is now required to convert or dismiss a case upon a showing of any of these factors, unless there are unusual circumstances showing the relief is not in the best interests of creditors and a reorganization plan will soon be confirmed. In addition, if the debtor fails to file a tax return or obtain an extension for a return that is due after the filing of the case and the taxing authority requests that the court dismiss or convert the case, then if the debtor does not file the return within 90 days after such a request, the court again is required to dismiss or convert the case, whichever is in the best interests of creditors.

The Act creates a new provision concerning the payment of insurance benefits to retired employees

The Act creates two new ombudsman positions to monitor health care business cases and to protect the interests of individuals in cases where the debtor intends to sell personally identifiable information about persons, such as credit information.

The Act also substantially changes notice requirements and provides additional protection to creditors from inadvertent violations of the automatic stay provision of the Bankruptcy Code. Current law applies the provisions of the automatic stay, which prevents creditors from taking any action to collect, enforce or perfect their claims after a bankruptcy case is filed, without regard to actual notice to creditors that the debtor is in bankruptcy. The Act now requires that a debtor serve notice to each creditor at an address specified by the creditor in at least two communications sent to the debtor within 90 days before commencement of the bankruptcy. Notices that are not sent in accordance with the new provisions (which also require the debtor to provide account numbers and contact persons if previously identified by the creditor) will not be effective, and a creditor will not be liable for monetary damages for a violation of the automatic stay if it has not been served at the address it specifies.

Employee Claims and Limitations on Key Employee Retention Plans

The Act makes recoverable under the fraudulent transfer provisions payments to or for the benefit of an insider2 under an employment agreement and not in the ordinary course of business if they occurred within two years prior to the filing of the bankruptcy petition and the debtor receives less than reasonably equivalent value in exchange for the transfers. These changes are an attempt to enhance the recovery of excessive pre-petition compensation or severance to corporate insiders. These provisions apply to all cases filed after April 20, 2005.

In addition to the ability to recover payments made to corporate insiders, the Act provides that allowable administrative expenses do not include payments made to induce an insider of the debtor to remain with the debtor’s business post-petition, such as under a Key Employee Retention Program (KERP), without a showing that the employee is essential to the survival of the debtor, and that he or she already has a bona fide job offer elsewhere. Even if the debtor is able to satisfy these requirements for a particular employee, the amount of the KERP payment may not exceed 10 times the mean transfer to non-management employees during the calendar year preceding the KERP, or if there were no such transfers to non-management employees, the payment cannot be greater than 25 percent of what the employee could have received during the calendar year preceding the bankruptcy. Similar limits have also been placed on severance payments to an insider and now require that any such payment be made only pursuant to a program generally applicable to all full-time employees. Further, the amount cannot exceed 10 times the mean severance payment made to non-management employees during that calendar year.

In contrast to limits placed on senior management, a debtor’s employees are now entitled to priority claims of up to $10,000, up from the current limit of $4,925, for pre-petition wages, salaries, commissions, vacation, severance and benefits. And while former law limited the priority for wages and benefits to those accrued within 90 days pre-petition, the new amendments extend that period to 180 days before bankruptcy. The effect of this increased look-back period, which applies to all cases filed after April 20, 2005, is that more claims for vacation and other benefits that accrue over time will qualify as priority claims.

The Act also creates a new provision concerning the payment of insurance benefits to retired employees. Under the amendment, which applies to all cases filed after April 20, 2005, if a debtor modified its retiree benefits while it was insolvent and within 180 days prior to its bankruptcy filing, the court must reinstate the old benefits unless the balance of the equities favors the modified benefits. It remains to be seen whether this change will have any material effect, given that airline bankruptcies appear to be making new law in this area on a weekly basis, and bankruptcy courts seem inclined to allow such debtors at least partial relief from their burdensome defined-benefit retirement plans. We can expect significant litigation over this new provision, as retiree health care is one of the most costly issues facing certain industries.

Small Business Debtors

The Act reflects a number of revisions affecting “small business” bankruptcy cases. The revisions are intended to expedite the Chapter 11 process for small business debtors, which is relatively simple to do since such cases typically involve only one large creditor, and to provide more oversight of these cases, since small businesses tend to have less effective management in place.

The Act refines the definitions of “small business” case and “small business” debtor. A “small business” bankruptcy case is one filed by a debtor in which total debt for the debtor and affiliate debtors is less than $2 million exclusive of insider debt, and no creditors’ committee has been appointed or it is determined to be inactive. The Act imposes additional reporting requirements on small business debtors and requires that recent financial statements and federal income tax returns be filed within seven days of their bankruptcy filing, and that the debtor file periodic reports containing profitability information, projections of receipts and disbursements, comparisons of projections to actual results, and interim reports that include information on profitability, cash receipts and disbursement projections, comparisons of projections to actual, and data on compliance with the Bankruptcy Code and tax filings. The increased small business reporting requirements go into effect 60 days after the Judicial Conference prescribes and puts into effect new Federal Rules of Bankruptcy Procedure and Official Forms directing the required disclosures. Because small business cases do not have a creditors’ committee to monitor the progress of the case, the Act also requires that the United States Trustee investigate a small business’s viability, inquire about its business plan, attempt to develop an agreed scheduling order, visit the debtor’s business premises if appropriate and advisable, and review and monitor diligently the debtor’s activities, in order to determine as promptly as possible whether the debtor will be unable to confirm a plan.

A small business debtor must now file its plan of reorganization within 300 days of the commencement of the case, unless that period is extended by the court upon a showing that it is more likely than not that the court will confirm a plan within a reasonable period of time. Once filed, the plan must be confirmed within 45 days after it is filed, unless that period is extended, once again upon a showing that it is more likely than not that the court will confirm a plan within a reasonable period of time.

International Bankruptcy Matters

The Act repeals the current section of the Bankruptcy Code relating to cases ancillary to a foreign bankruptcy filing and creates a new chapter, Chapter 15, governing cross-border bankruptcy cases. This chapter is applicable when a non-U.S. debtor is the subject of a non-U.S. insolvency proceeding, but has assets located in the United States. Chapter 15 provides for direct access by a foreign representative of the debtor and by creditors to the U.S. bankruptcy court through the commencement of a case under Chapter 15 by the filing of a petition for recognition of a foreign proceeding. Once a petition is filed, the bankruptcy court may, at the request of the foreign representative and where relief is urgently needed to protect the assets of the debtor or the interests of creditors, grant provisional relief, including staying execution against the debtor’s assets in the United States. Upon granting recognition of the foreign proceeding, the court may also suspend the debtor’s right to transfer, encumber or otherwise dispose of any assets of the debtor; provide for the examination of witnesses, the taking of evidence or the delivery of information concerning the debtor’s assets, affairs, rights, obligations or liabilities; and grant any relief other than the special avoidance rights available to domestic trustees. This procedure does not commence a full bankruptcy case but merely enables a court to provide appropriate relief, including prevention of piecemeal distribution of a foreign debtor’s U.S. assets.

Conclusion

For some creditors, the recent amendments to the Bankruptcy Code may prove beneficial by allowing them to assert reclamation claims or successfully defend against avoidance actions. For others, the result may be a smaller pool for possible distribution to creditors. In any event, the significant changes effected by this legislation are certain to be subject to interpretation through litigation in the coming months and years in bankruptcy courts nationwide.

Endnotes


  1. For example, the Act creates a “means test” that limits the ability of individuals to file a “straight liquidation” Chapter 7 case, and will require more individual debtors to contribute some portion of their disposable income to creditors in a payment plan under Chapter 13. 
  2. The Bankruptcy code defines an “insider” of a corporate debtor as a director, officer or person in control of the debtor; a partnership in which the debtor is a general partner; a general partner of the debtor or a relative of a general partner, director, officer or person in control of the debtor.