Member Article

The considerable publicity surrounding the new Bankruptcy Act has focused on the impact of the legislation on individuals seeking bankruptcy relief under Chapter 7 of the Bankruptcy Code.1 There are also important changes that will have a significant impact on business bankruptcy cases. The new provisions will require suppliers, lenders, debtors, landlords and other constituents to rethink strategies that have previously been routinely employed in business bankruptcy cases. Indeed, some of the changes may have broader reaching implications causing some companies to establish new or different general business procedures, for example, when entering into executive compensation agreements. I. Business Chapter 11 Provisions Administrative Priority for Creditors Selling Goods to Debtor Within 20 Days Prior to bankruptcy and Other Provisions Requiring Increased Initial Cash. §503(b)(9);§366;§§507(a)(4) and(5). Section 503 of the Bankruptcy Code has been amended to include a provision granting administrative expense priority for “the value of any goods received by the debtor within 20 days before the date of commencement of a case under this title in which the goods have been sold to the debtor in the ordinary course of such debtor’s business.”2 Comment: Prior to the Act, a supplier was a general unsecured creditor for all unpaid goods delivered prior to the date a customer filed for relief under Chapter 11. Now, the supplier will receive an administrative priority claim for the value of goods received by a debtor for the twenty days preceding the Chapter 11 filing. It appears that one of the purposes of this provision is to encourage suppliers to continue to ship goods on credit to financially troubled suppliers. Whether the law will have this effect in practice is unknown. The law is clear that in order to confirm a plan of reorganization, all administrative claims must be fully paid. Other provisions will not have a direct impact on most creditors, but will increase the cash needs of Chapter 11 debtors. For example, prior to the Act, the fact that a debtor had obtained post-petition financing was often ruled by courts sufficient to protect utilities for payment of post-filing utility services and did not require the debtor to make a cash deposit. Section 366 of the Bankruptcy Code has been modified by the Act to explicitly require the debtor to post a cash or cash equivalent deposit. Another example is in §§507(a)(4) and (5), which previously granted administrative priority treatment for wages and employee benefit plans in the total amount of $4,925 per claimant which had accrued in the 90 days prior to the commencement of the Chapter 11 case. Under the Act, this amount has been raised to $10,000 per employee accruing within 180 days prior to filing. While the Bankruptcy Code treats the employee claims as administrative expenses which theoretically do not have to be paid until confirmation of a plan in a Chapter 11 case, many Debtors seek to pay accrued wages and benefits at the outset of the case to maintain employee relations. Provisions Creating Greater Scrutiny on Officer and Other Insider Compensation. §§548, 503(c)(1), 503(c)(2), and 503(c)(3). There are a number of provisions throughout the Act that will bring greater scrutiny to officer compensation. An important example is in §548, the fraudulent conveyance section of the Bankruptcy Code. It provides that the trustee may avoid “any transfer to or for the benefit of an insider under an employment contract” made or incurred by the debtor within two years of the petition date if the debtor received less than reasonably equivalent value in exchange for the transfer or obligation and “[m]ade such transfer to or for the benefit of an insider, or in ocurred such obligation to or for the benefit of the insider, under an employment contract and not in the ordinary course of business.” Unlike other fraudulent conveyance actions brought under §548, there is no requirement to establish that the Debtor was insolvent at the time the contract was executed. Other amendments include: §503(c)(1), which establishes evidentiary standards that must be met before the court will authorize payments made to the insider for inducing such person to remain with the debtor’s business (ordinarily referred to as Key Employment Retention Agreements or “KERPS”); §503(c)(2), which limits whether severance payments can be paid to an insider and, if allowed to be paid, the amount that may be paid; and §503(c)(3), which adds a broad provision that provides that “transfers or other obligations 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” will not be allowed or paid. Comment: It is clear that employment contracts with insiders entered into within two years of the bankruptcy, or sought to be entered into upon a bankruptcy, are going to be closely scrutinized. An example of the scrutiny or even hostility to employment contracts entered into prior to bankruptcy is the amendment to §548 quoted above. This is the only instance under traditional fraudulent transfer statutes when a party to a transaction (the employee entering into an employment contract) with a company that subsequently files bankruptcy, without the intention to hinder, delay or defraud a creditor, is subject to a fraudulent transfer claim even if the debtor was solvent at the time the contract was entered into. It appears that the trustee would only have to prove that the employment agreement was not in the ordinary course of business and that the debtor did not receive reasonably equivalent value. These amendments will likely make it more difficult for companies that may not view themselves on the brink of bankruptcy, but nevertheless need to improve performance, as well as those that need to restructure, to compete for or retain top level executives who have other opportunities available to them with less risk. The Act may result in increased costs for companies entering into executive employment agreements because executive employees may insist on independently prepared fairness opinions or ask for other mechanisms to protect compensation payments. Shorter Time for Debtors to Maintain Exclusive Right to File and Confirm a Plan. §1121. The Act limits the time a debtor can have the exclusive right to file a plan to 18 months and to achieve votes to confirm the plan to 20 months. Comment: Prior to the Act, Bankruptcy Judges could exercise discretion to allow a debtor to retain exclusivity for periods of time believed by the Court reasonable to allow a debtor the exclusive right to file a plan. The new provision limits the Court’s discretion, and will place greater pressure on debtors in large complex cases to bring them to a conclusion much more quickly than has been achieved in many such cases. Preference Laws—Act Eases Burden Creditor Must Prove for Ordinary Course Defense; Sets a Minimum for Commercial Preference Claims; Establishes Venue for Where Smaller Claims Can Be Brought. 28 USC §1409(b) and §547. The Act changes the standards for the ordinary course of business defense in preference cases, making such defense easier to establish. With the Act’s changes, to successfully establish the ordinary course defense, the defendant now only has to establish either that payments were made in the ordinary course of business between it and the debtor or in accordance with ordinary business terms (industry standards), rather than, as under pre-Act law, having to establish both. The Act establishes a floor for preference actions in nonconsumer cases. The trustee cannot avoid a transfer if the aggregate amount sought to be avoided is not greater than $5,000. The venue provisions are amended to restrict where actions for under $10,000 may be brought. The amendments require that lawsuits for under $10,000 must now be brought where the defendant “resides,” and not necessarily where the debtor’s case was filed. Comment: Prior to the Act, the burden on a preference defendant was to prove that payments alleged as preferential met both the ordinary course of business between the debtor and the creditor and were made in accordance with industry standards. This was a very difficult burden, and, especially if an expert had to be hired, very expensive. Having to prove only one of the standards will be a substantial benefit to the creditor/preference defendant. Previously there was no minimum limit to the amount for bringing a preference claim and the action could always be brought where the debtor’s bankruptcy case was pending. While preference claims are always a source of frustration to creditors subject to such claims, it is particularly burdensome to creditors to defend actions for de minimis amounts in cases across the country from where the creditor resides. Eliminating preference claims for less than $5,000, and requiring the trustee to bring preference claims for under $10,000 in courts where the defendant resides, should significantly reduce the number of small preference claims with which creditors have to deal. Time to Assume or Reject Non-Residential Real Property Leases. §365. The debtor will have until the earlier of (a) 120 days after the order for relief (which is the bankruptcy petition date) or (b) the date of plan confirmation to assume or reject nonresidential leases. The court can extend the 120 day period only for up to another 90 days but no longer. Previously, §365 required the debtor to assume or reject such leases within 60 days unless the court granted extensions, and there were no stated limits as to how many times or for how long the court could grant extensions. Often courts would grant the debtor an extension of time through confirmation of its plan to assume or reject leases, which in large cases could result in multiple year extensions. As under the previous law, in order for a debtor to assume a lease, the debtor has to pay all pre-petition amounts owing. In apparent contemplation of the large administrative claims arising from a debtor quickly assuming a lease due to the tightened timeframe for decision and later rejecting the lease, the Act limits the landlord’s administrative expense claim under such circumstances to a maximum of two years rent under the lease. Comment: This change is important and will require business debtors to make quicker decisions regarding assumption or rejection of real property leases. It enhances the bargaining position of landlords and could make it much more difficult for commercial tenants, particularly those with numerous leased properties, such as a retailer, to reorganize without significant pre-bankruptcy planning. II. Single Asset Real Estate Cases. §§101(51B) and 362(d). Prior to the Act, there were special provisions that related to real estate projects (of over 4 units) that had secured debt of less than $4 million. Under the Act, the secured debt limitation has been eliminated. Under §101(51B) of the Act, a “single asset real estate” is defined as “real property constituting a single property or project…which generates substantially all of the gross income of a debtor who is not a family farmer and on which no substantial business is being conducted by a debtor other than the business of operating real property and activities incidental.” Section 362(d)(3) is now applicable to all single asset real estate cases. The automatic stay will be lifted on the later of 90 days after the case starts or 30 days after the Bankruptcy Court determines the case is a single asset real estate case, whichever is later, unless, within such 90 days the Bankruptcy Court, for cause, extends the period. At the end of the period as determined by the prior sentence, the stay will be lifted unless (i) the debtor has filed a plan of reorganization that has a chance of being confirmed within a reasonable period of time, or (ii) the debtor begins monthly payments to the mortgagee (which may be made from rents of the project) in an amount equal to the nondefault rate of interest stated in the loan documents. If the mortgagee is oversecured the interest on the debt will be paid. If the mortgagee is undersecured, the interest will be paid based on the value of the property. If a court finds that a case was filed to hinder, delay or defraud the mortgagee, either by a transfer of the property without the consent of the mortgagee or the court, or because of multiple bankruptcy filings, the stay will not apply for two years after the entry of an order making such findings. In order for the debtor in a subsequent case to gain the benefit of the stay, the debtor will have to file a motion and convince the court that there are changed circumstances or other good cause to impose the stay. These provisions should eliminate or greatly reduce serial real estate filings. III. Conclusion The Act creates multiple changes to business provisions of the Bankruptcy Code, only a few of which we are able to highlight and comment upon in this memorandum. Many of the changes appear designe to streamline the bankruptcy process. However, like with many new complex laws, there are likely to be many questions raised over interpretation or application of the law resulting initially in increased litigation. If you have any questions or would like a more in-depth presentation on the Act, please do not hesitate to contact any of Dykema’s Bankruptcy and Restructuring practice group.