A Dozen Things That A Business Lawyer Should Know About The Bankruptcy Abuse Prevention And Consumer Protection Act Of 2005 - Part II

Wednesday, March 1, 2006 - 01:00

Editor's note: Part I of this article appeared in the February issue of
The Metropolitan Corporate Counsel. Parts III and IV will appear in the
April and May issues, respectively.

"One of the prime purposes of the bankruptcy law has been ... to protect
creditors from one another."
-- Mr. Justice Black in Young v. Higbee
Co.
, 324 U.S. 204 (1945).

Prior to the adoption of BAPCA, the bankruptcy court was empowered to deny an
otherwise valid reclamation demand by ordering that the seller would instead
receive a monetary claim, either with administrative expense priority or secured
by a postpetition lien. This was the fate of many reclamation demands. The
provisions creating those alternatives have now been deleted. However, new
subparagraph (9) of §503(b) creates an administrative priority claim for the
"value" of any goods sold to the debtor in the ordinary course of business and
received by the debtor within 20 days before the commencement of the case.
Section 503(b)(9) imposes no requirement of insolvency, or of compliance with
§546(c); §546(c)(2) expressly provides that the administrative claim under
§503(b)(9) is not affected by the seller's failure to demand reclamation in
writing.

Again, these amendments are ambiguous and raise a number of questions.



  • What happens if the reclamation claim is avoidable as a fraudulent
    transfer under §548, or is subject to attack by an actual creditor under state
    law and therefore could be avoided by the estate under §544(b)? Can it then be
    defeated? Was this result intended by Congress?7


  • Is a showing that the goods were not received in the ordinary course
    of business the sole basis for attacking the administrative priority awarded by
    §503(b)(9)?


  • When must the estate pay the §503(b)(9) administrative expense
    claim? Is the timing affected by §503(a), which permits a creditor to request
    payment of an administrative expense?


  • What is the measure of "value" under §503(b)(9)? Is it the purchase
    price, the value of the goods to the debtor, or arm's-length market value?


  • Does the seller have an administrative expense claim even if the
    goods have been paid for? Even if the seller has successfully reclaimed the
    goods? The statute does not answer these "obvious" questions.
  • Notwithstanding §362(a)(6) (which provides that the automatic stay
    generally bars creditor action to collect or recover on a prepetition claim),
    exceptions articulated in §§362(b)(3) and 546(b) permit a vendor to assert a
    §546(c) reclamation demand post-filing. Reclamation under that section is
    limited to goods in the debtor's possession as of the petition date.



  • If the debtor resells the goods before the reclamation demand is
    propagated through the sales chain, what remedy does the creditor have?


  • Since the reclamation procedures don't supplant the automatic stay
    altogether, does the stay preclude taking physical possession of the goods?
  • The amendments also expressly recognize what was implicit in prior law:
    The rights of a reclaiming creditor extend only to inventory value in excess of
    prior valid security interests. Further, §546(h) has long permitted the estate,
    with the creditor's consent, to return goods for credit at the purchase price.
    These returns are exempt from the estate's avoiding powers, including §549(a),
    and are intended to ease the burden of general trade claims as well as
    reclamation problems. The BAPCPA amendment to §546(h) clarifies that any such
    return of goods is subject to the prior rights of secured creditors.



  • What rights does a reclaiming vendor have against a senior lien
    claimant who is clearly oversecured? Can the reclaiming vendor seek
    marshaling?8
  • In creating the Bankruptcy Reform Act of 1978, which established the
    framework of the present Bankruptcy Code, Congress expressed a crucial
    reservation about the reclamation rights of trade creditors. The legislative
    history stated that reclamation should be recognized in bankruptcy to the extent
    provided in §546(c), but should not be permitted to thwart a promising
    rehabilitation effort.9



  • Does that legislative history have any real meaning now? In deleting
    the former priority and lien alternatives to physical reclamation under §546(c),
    while introducing a free-standing administrative priority under §503(b)(9),
    Congress appears to have lost sight of this concern.10
  • Preferential Transfers

    BAPCPA's favorable treatment of vendors extends to a relaxed "ordinary
    course" sandard for the defense of prepetition transfers.

    The rights BAPCPA bestows on trade creditors are not limited to
    reclamation of goods and administrative priority claims. Vendors also enjoy
    broader protection in preference litigation.

    Section 547(b) of the Bankruptcy Code provides that the estate may
    recover any property that was transferred from the debtor to a creditor, on
    account of antecedent debt, within 90 days before the bankruptcy filing. The
    estate will pool such "preferential transfers" for pro rata distribution among
    all similarly situated creditors, but the Code also establishes several defenses
    for transfers that did not give the recipient a real advantage over other
    creditors.



  • Under former §547(c)(2), the estate could not prevail if the
    disputed transfer was (i) made in payment of a debt incurred in the ordinary
    course of the debtor's dealings with the vendor, (ii) made in the ordinary
    course of the parties' business, and (iii) made according to ordinary business
    terms ( i.e ., ordinary for the industry at issue).


  • The amendments leave the first element unchanged, but the defendant
    now need only satisfy one or the other of the last two elements. Thus, a vendor
    will have no preference liability if it can demonstrate either that the transfer
    was made in the ordinary course of the parties' business or that the
    transfer was consistent with industry standards.
  • Unless a transfer mirrored both a well-documented transaction history and
    readily available industry data, it was seldom easy to prove both of the
    elements that are now stated disjunctively. BAPCPA's relaxation of the
    ordinary-course defense thus substantially strengthens the vendor's position.
    The losers here will be the debtor's other unsecured creditors (and sometimes
    its senior lenders), which typically rely on preference settlements to bolster
    their own recoveries in the case.

    A few other refinements to the preference statute are applicable to
    business cases.



  • Under new §547(c)(9), business debtors can no longer seek to recover
    prepetition preferences if the value of the property transferred to a creditor
    is less than $5,000 in the aggregate.


  • Also new §547(i) appears to accomplish what Congress did not quite
    manage in prior amendments, which is to override the controversial holding of
    the Deprizio case.11
  • Fraudulent Transfers

    The fraudulent transfer recovery period has been extended, but the
    real news applies to employment contracts.

    Section 548, captioned "Fraudulent Transfers and Obligations,"
    principally addresses transactions in which the debtor transferred property or
    incurred an obligation to another party in exchange for less than reasonably
    equivalent value while insolvent (a "constructively fraudulent" transfer), or
    with actual intent to hinder, defraud, or delay creditors (an "actually
    fraudulent" transfer). This section was revised in several respects under
    BAPCPA.



  • The most conspicuous change is that the look-back period under
    §548(a), formerly one year prior to the commencement of the case, has been
    expanded to two years.12 This does not alter the estate's
    power under §544 to recover prepetition transfers pursuant to applicable state
    fraudulent conveyance laws, which often apply to even longer periods.


  • Less remarked upon but potentially more important is new
    §548(a)(1)(B)(ii)(V): Transfers made or obligations incurred to or for the
    benefit of an insider of the debtor under an employment contract, for less than
    reasonably equivalent value and not in the ordinary course of business, are now
    voidable regardless of whether the debtor was insolvent at the time of the
    transfer.13 As drafted, this is an invitation to challenge any
    significant employment arrangement.
  • A new subsection (e) also allows the estate to recover transfers to
    self-settled trusts under which the debtor is the beneficiary, if made within
    ten years of the petition date and made with actual intent to hinder, delay, or
    defraud any entity to which the debtor was or became indebted. For purposes of
    this provision, "transfers" include those made in anticipation of a money
    judgment, fine, or civil penalty related to a violation of securities laws, or
    to fraud, deceit, or manipulation in a fiduciary capacity or in connection with
    the purchase or sale of any registered security.

    Executive Compensation

    A last-minute addition to BAPCPA makes it more difficult to pay
    retention bonuses to key executives.

    Management and employee incentive and retention plans are common in
    Chapter 11 cases. There is certainly the potential for abuse, as debtors'
    proposals may be overgenerous or unrelated to the success of the reorganization
    effort, or may constitute a disguised payment of prepetition severance
    obligations. But the objections of other parties in interest usually act as a
    check on any such depredations.

    One of the questionable policy balancing effects of BAPCPA is that it
    imposes strict new limits on the amounts payable through key employee retention
    plans while at the same time increasing the risks of serving as a senior manager
    of an insolvent company. Fortunately, the main targets of the employee
    compensation amendments are executive retention and severance payments.



  • Retention payments are generally no longer permitted unless the
    employee has a bona fide offer of employment elsewhere and is providing services
    essential to the debtor's survival. The payment amounts are now capped based on
    the debtor's other payments to similar employees during the prior calendar year.


  • Severance payments are also capped and must be part of a program
    generally applicable to all employees of the debtor.


  • However, incentive plans based on clear performance targets, such as
    company earnings, cost control, and the outcome of a Chapter 11 plan or sale
    process, should still be permissible despite the new restrictions.
  • A related amendment likely to spawn litigation is the expansion of §548
    (the fraudulent transfer statute, described above) to address amounts paid and
    obligations incurred to an insider under an employment contract, without regard
    to the financial condition of the debtor at the time of the transfer.



  • This amendment can be read to apply to any employment agreement
    under which the debtor arguably received less than reasonably equivalent value.
    As a result, financially troubled companies may find it harder to recruit and
    retain good executives.
  • 7 The new text does not address the rights of a
    good-faith purchaser who would have been protected under Article 2 of the UCC,
    but expressly protects the rights of a holder of a security interest.

    8 Prior law holds that a reclaiming vendor is not a
    prepetition secured creditor, and thus cannot invoke marshalling. See
    Galey
    & Lord, Inc. v. Arley Corp. (In re Arico, Inc.), 239 B.R. 261(Bankr.
    S.D.N.Y. 1999).

    9 See House Report 95-595, pp371-372; Senate Report 95-989,
    pp. 86-87.

    10 See House Report 109-31, p.146.

    11 Levit v. Ingersoll Rand Fin. Corp. (In re Deprizio), 874
    F.2d 1186 (7th Cir. 1989), held that non-insider creditors could be subjected to
    the one-year insider preference look-back period in connection with an insider's
    guaranty of the debt. A 1994 amendment to §550 was not enough to extinguish all
    artifacts of this holding. New §547(i) took effect in all cases pending on April
    20, 2005, or commenced thereafter.

    12 This amendment applies only in cases commenced more
    than one year after BAPCA's date of enactment,
    i.e., after April 20, 2006.

    13 This amendment took effect on BAPCPA's date of
    enactment, April 20, 2005, but does not apply to cases filed before that
    date.

    David A. Honig and Patrick A. Murphy
    are corporate partners in Winston & Strawn's San Francisco office. Mr. Honig
    concentrates his practice in bankruptcy matters and related litigation in the
    telecommunications and technology industries. He can be reached at (415)
    591-1423. Mr. Murphy concentrates his practice in corporate reorganizations and
    insolvency law. He can be reached at (415)
    591-1500.

    Please email the authors at dhonig@winston.com or pmurphy@winston.com with questions about this
    article.