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Spring 2005

The New Bankruptcy Law Amendments – The Effect on Chapter 11

By Michael Kogan

The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (the "Bankruptcy Act"), which adopts the most significant amendments to the bankruptcy laws in more than 25 years, was signed into law on April 20, 2005 by the President. The new law contains sweeping changes to consumer bankruptcies designed to shift many individual cases from Chapter 7 to Chapter 13 and, on balance, strengthen the position of creditors in dealing with consumer debtors. Although the consumer aspects of the Bankruptcy Act comprise a majority of the legislation, it also introduces new provisions affecting business reorganizations, and may have a significant impact in a number of Chapter 11 cases (please note that this is not an exhaustive list) as follows:

Creditors' Committees. The Bankruptcy Act grants the bankruptcy court express authority to order the United States Trustee to change the membership of an official committee if the court determines that the change is necessary to assure adequate representation. The battle for committee membership thus will shift from United States Trustee to the court, with attendant increases in cost and uncertainty. In addition, a creditors' committee (a) will be required to provide access to information to, and solicit comments from, non-committee member constituents, and (b) may be required by the bankruptcy court to make additional reports or disclosure to such creditors. It is currently typical for creditors' committees to receive confidential information and to maintain its confidentiality.

Exclusivity. The Bankruptcy Act imposes new outside limits on a debtor's exclusive periods for filing and soliciting votes on a plan of reorganization. The respective exclusive periods for a debtor to file and confirm a Chapter 11 plan cannot be extended beyond 18 and 20 months after the filing of a bankruptcy petition. There are no outside limits under current law.

Executive Compensation. Postpetition retention and severance payments to insiders (a term that includes officers of a corporate debtor) will be subject to tougher restrictions. Under current practice, Chapter 11 debtors routinely seek court authority for the approval of broad-based key employee retention plans as a means to minimize the loss of critical employees with institutional knowledge and client relationships as a result of the Chapter 11 filing. Under the Bankruptcy Act, a retention payment to an officer will only be authorized if the bankruptcy court finds, based on an evidentiary showing, that: (a) the payment is "essential" to retain the officer because the officer has a bona fide job offer from another business at the same or greater rate of compensation; (b) the officer provides services that are "essential" to the survival of the business; and (c) the amount of the payment cannot exceed ten times the amount of similar payments to non-management employees, or, if no such similar payments were made, the amount cannot be greater than an amount equal to 25% of the amount of any similar payment made to the person for any purpose during the calendar year before the year in which such payment is made.

Severance pay is similarly limited under the Bankruptcy Act to an amount not to exceed ten times the amount of the mean severance pay given to non-management employees, unless the severance pay is part of a program generally applicable to all employees. The Bankruptcy Act further prohibits payment or allowance of any other obligations to any officers, managers or consultants hired after the petition date that are outside the ordinary course of business unless they are "justified by the facts and circumstances of the case."

Fraudulent Transfers. Two important changes have been made to the fraudulent transfer provisions. The "look-back" period under the Bankruptcy Code's fraudulent transfer provisions is extended from one to two years. This provision takes effect one year after enactment. In addition, language is added to make clear that prepetition transfers to or for the benefit of an insider, or under an employment contract, outside the debtor's ordinary course of business, where the debtor did not receive reasonably equivalent value in exchange for the payment, may be subject to fraudulent transfer attack, without regard to the debtor's solvency.

Preferences Are More Difficult To Recover.Under current law, to defend a preference action as an ordinary course transaction, a creditor receiving payment from an insolvent debtor within 90 days prior to the commencement of a case must establish that the payment at issue was both in the ordinary course of business between the parties and made according to ordinary business terms (i.e., was paid within industry terms). The "ordinary course" defense for preference avoidance will now be available for payment of a debt incurred in the ordinary course of business or financial affairs of the debtor and the payee if the payment was made either (a) in the ordinary course of the business or financial affairs of the debtor and the payee, or (b) according to ordinary business terms.

Investment Banker Disinterestedness. An investment banker will no longer lose its status as a "disinterested person" by reason of having underwritten a prepetition securities offering by the debtor. Thus, such an investment banker is not automatically disqualified from acting as a postpetition financial advisor to the debtor.

Chapter 11 Trustees. The U.S. Trustee is now required to move for the appointment of a Chapter 11 trustee "if there are reasonable grounds to suspect" that any of the debtor's current directors, CEO or CFO "participated in actual fraud, dishonesty or criminal conduct in the management of the debtor or the debtor's public financial reporting." As under current law, however, the court will order appointment of a Chapter 11 trustee only for cause or if the court determines that appointment is in the best interests of creditors and the bankruptcy estate. This provision will likely lead to increased litigation and costs in the early stages of many cases where financial reporting has been deficient. Turnaround management and work-out firms may become the beneficiaries of any need to replace senior management in connection with a bankruptcy filing.

Real Property Leases. Under current law, a debtor must decide whether to assume or reject an unexpired lease of business property within 60 days after bankruptcy. The court may extend the 60-day period "for cause" and no limits exist on the number of extensions that the court may grant or on their length. Debtors, particularly in retail cases involving numerous leases, now receive periodic extensions from the bankruptcy court, often continuing until plan confirmation. The Bankruptcy Act changes the initial period for a debtor-lessee to determine whether to assume or reject an unexpired lease of nonresidential real property to 120 days, but the period can be extended by 90 days only once without the consent of the lessor. This is a significant shift in leverage to real property lessors, requiring debtors to decide quickly which leases to assume or reject, thereby threatening the viability of retail restructurings. In addition, administrative expense priority for damages arising from rejection of such a lease that was assumed postpetition is limited to the amount of two years' obligations under the lease.

Employee Priority Claims. The aggregate per employee limit for wage and employee benefit priority claims is increased from $4,000 to $10,000, subject to cost-of-living adjustments. This provision is effective with respect to all cases filed on or after the date of enactment.

Prepetition Retiree Benefit Reductions. Retiree benefits modified by an insolvent debtor during the 180-day period prior to the filing of the petition are reinstated as of the date of modification unless the bankruptcy court finds that the balance of the equities clearly favors such modification. This provision is effective with respect to all cases filed on or after the enactment date.

New Priority For Certain Trade Claims. A new ninth level of priority claim is established for the value of goods sold to the debtor in the ordinary course of its business and received within 20 days before the commencement of the case. Businesses that receive large ordinary course shipments (such as retail debtors) will now be burdened with substantial administrative liabilities that will require payment in full to successfully exit bankruptcy. Therefore, careful prepetition planning will be required to ensure that these additional liabilities do not destroy the reorganization before it starts. Also, vendors who make timely written demand are afforded reclamation rights for goods sold to the debtor in the ordinary course of business and received by the debtor while insolvent within 45 days before the commencement of the case. Sellers that do not send a timely reclamation demand may still claim administrative expense priority so long as their goods were received within 20 days of the bankruptcy filing. The Bankruptcy Act also appears to eliminate the option afforded debtors under current law not to return goods to a reclaiming creditor and instead provides such creditor an administrative claim or lien. Rather the Bankruptcy Act appears to suggest that the debtor must now literally return the goods to the reclaiming creditor. Thus, the new amendments could impose a significant burden on debtors who will be required to establish procedures to monitor reclamation demands and, possibly, to segregate and return reclaimed goods.

Utility Service. Under current law, a utility may cease providing service to the debtor unless it is provided "adequate assurance of payment" within 20 days after the date of the order for relief. Cases interpreting this section in many districts have held that courts must be afforded reasonable discretion in determining what constitutes adequate assurance and that availability of an administrative expense priority can constitute adequate assurance in some cases, with no additional deposit required. The Bankruptcy Act clarifies that an administrative expense priority does not constitute adequate assurance of payment and, consequently, a debtor may be required to provide a cash deposit, letter of credit or other form of security to obtain uninterrupted service. This change will likely impose significantly greater cash burdens on a debtor and must be considered in connection with pre-filing planning.

Taxes. The treatment of tax claims has been enhanced in several respects, including: (a) setting the rate for accrual of interest on administrative expense tax claims and post-confirmation installment payments on tax claims at the rate specified under applicable non-bankruptcy law; (b) changing the end date for cramdown installment payments of priority tax claims under a Chapter 11 plan to the fifth anniversary of the order for relief (previously, six years after assessment) and requiring that the payments be made in a manner not less favorable than the most favored general unsecured claim (other than a convenience class); and (c) exempting certain setoffs of tax refunds by governmental units from the automatic stay and authorizing governmental units to hold certain refunds for possible setoff pending resolution of tax disputes.

The Bankruptcy Act has an effective date of six months after its enactment or October 17, 2005, with the exceptions noted above, and its provisions will apply only to cases commenced after the effective date.

Michael Kogan is a partner at ECJ, where he serves as Head of the Bankruptcy and Reorganization Department. His practice focuses on corporate reorganizations representing debtors and creditors; commercial transactions and workouts. Michael was the subject of an article in the Los Angeles Daily Journal in March 1999, entitled "Trustee Has Sixth Sense for Sniffing Out Hidden Assets." He was profiled on his being "level-headed and result-oriented" in business and the natural path to his bankruptcy practice. He was frequently quoted throughout the article, commenting on being a trustee as well as a bankruptcy lawyer "Where else do you get to do everything: real estate law, litigation, liability, tax law and business?" According to his colleagues, another asset of Michael's practice that makes him a natural for bankruptcy work is his background as a tax attorney and a businessman. "He understands how to put a deal together, restructure a company and keep creditors at bay while doing it." In addition, Michael's intuitiveness about debtors' and creditors' motives allows him to "aggressively pursue the position he believes is correct and fair."

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The Bankruptcy and Reorganization Law Department provides assistance in a wide range of areas involving bankruptcy, restructuring, reorganization, out-of-court workouts debtors' and creditors' rights issues. Our clients include companies, individuals, developers and financial institutions. We represent secured and unsecured creditors, debtors, debtors-in-possession, trustees and creditors' committees in Chapter 11 cases, adversary proceedings, out-of-court workouts, reorganizations, complex Chapter 7 cases and related insolvency litigation. The goal of ECJ's Bankruptcy and Reorganization Law Department is to provide highly responsive yet cost-effective legal services in order to add value to clients' businesses. For more information about this department, or Michael S. Kogan, please visit our website at www.ecjlaw.com, or contact Mr. Kogan at 310.281.6317.