The Bankruptcy Abuse Prevention And Consumer Protection Act Of 2005: The Impact On Chapter 11 Reorganization - Part I

Monday, May 1, 2006 - 00:00

Editor's Note: Part II of this article will appear in the June issue of The Metropolitan Corporate Counsel.


On October 17, 2005 (the "Effective Date") the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (the "Act") went into effect.1 Although the majority of the analysis to date has focused on the impact the Act will have in the consumer sector,2 the Act makes significant changes to the United States Bankruptcy Code (the "Bankruptcy Code")3 that will greatly influence the commercial sector as well.

The Act is the most comprehensive overhaul of the Bankruptcy Code since 1984 and makes significant changes to how businesses will reorganize under chapter 11 of the Bankruptcy Code. It is clear that, with few exceptions, the Act continues the trend since 1978 that each amendment to the Bankruptcy Code favors various creditor constituencies to the detriment of debtor companies. Many of the amendments to the Bankruptcy Code under the Act are intended to decrease the overall time a business takes to reorganize and limit the cost of the reorganization process. Although it remains to be seen whether the Act will succeed in these goals, it does appear that under the Act creditors have more tools to influence how a business reorganizes and negotiate a more favorable position. It is likely that, at least in the short term, litigation and costs will rise as debtors and creditors test the new provisions of the Bankruptcy Code provided by the Act in practice.

Below is a summary of certain of the amendments to the Bankruptcy Code under the Act that will impact debtor businesses and their creditors in the reorganization process.4 Section I focuses on the amendments likely to increase costs to a debtor creating more of a burden for a debtor in successfully reorganizing. The amendments that deal directly with management compensation and retention polices are discussed in Section II. Section III examines the amendments with regard to the formulation of a business plan and managing a reorganized business. The amendments that alter the law with regard to avoidance actions are presented in section IV. Finally, section V focuses on the amendments that relate to health care insolvencies.

Section I. Amendments Increasing Costs, Reducing Cash Or Restricting Use Of Cash

A. Reclamation

Pursuant to the Uniform Commercial Code, and as applied through the Bankruptcy Code, an unpaid seller of goods may reclaim goods sold to an insolvent buyer in the ten days prior to filing as long as the seller makes a written demand for reclamation before ten days after receipt of the goods by the debtor or within twenty days after receipt of goods by the buyer if the buyer filed for bankruptcy within the initial ten day period.5 Although in a better position than unsecured creditors, a creditor seeking reclamation generally has its claim subordinated to secured creditors. Additionally, in practice, courts usually only provide a seller of goods either an administrative claim or the right to reclaim the goods, not both. Furthermore, bankruptcy courts have the authority to grant sellers of goods seeking reclamation a lien or a priority claim instead of allowing for the seller to reclaim the unpaid goods.

The Act provides the seller of goods seeking reclamation greater rights by granting such a seller of goods an administrative claim in an amount equal to the value of the unpaid goods for transactions that took place in the twenty days prior to the filing of the bankruptcy petition.6 This administrative claim must be paid in full on the plan's effective date. Further, the seller of goods seeking reclamation has an extended period of time, up to forty-five days, to make a written request for reclamation under the Act. Subject to a secured creditor's perfected interest in the goods at issue, a seller of goods may give written demand for reclamation for unpaid goods sold to the debtor within the forty-five days before the debtor's bankruptcy filing, or within twenty days of the bankruptcy, whichever is later. As a result, the seller of goods has the right to both reclaim unpaid goods sold up to forty-five days before the debtor's filing and be given an administrative claim for unpaid goods sold in the twenty days prior to the debtor's bankruptcy filing.

The result of these amendments may be that debtors will be forced to pay out large administrative claims to trade creditors for goods received prior to the bankruptcy filing. Such large claims could jeopardize the debtor's ability to confirm a plan and reorganize.

B. Utility Service Providers

Section 366 of the Bankruptcy Code governs the adequate assurance of utility payments to such providers. Prior to the Effective Date, debtors were required to furnish adequate assurance to utility providers, usually in the form of an administrative expense priority. Generally, when a debtor had a history of paying such providers on time and was administratively solvent, such administrative priority was adequate.

The Act enhances the adequate assurance a debtor is to provide utilities by requiring a cash deposit, letter of credit, certificate of deposit, surety bond or prepayment or another form of security that is mutually agreed on between the utility and the debtor or the trustee. An administrative priority is no longer adequate. A debtor is given an increased number of days to do so under the Act, expanding the time for providing such assurance from 20 to 30 days.

C. Employee Wage and Benefit Claims

Prior to the Act, employees could assert as priority claims in the bankruptcy case (100% distribution in cash) claims for unpaid wages and benefits in an amount up to $4,925 per employee with the remainder of the claim being treated as an unsecured claim. Under the Act, this amount has been increased to $10,000 per employee.7

The affect of these amendments under the Act could be significant to industrial debtors and debtors with high utility costs as such debtors will need an increased amount of cash available at the time of the filing to devote to utility deposits.

Section II. Amendments Affecting Management Compensation And Retention And Corporate Control

A. Key Employee Retention Programs

In many chapter 11 cases it is common for the debtor to provide retention bonuses and/or severance packages to senior management so that they will remain with the debtor's business through the reorganization process. These key employee retention programs, or KERPS, have been provided to senior managers under the assumption that these senior managers could obtain employment elsewhere. Senior management KERPS have been criticized in recent years as excessive given that wage concessions are requested from rank and file employees.

The Act provides specific rules for approval of KERPS to officers, directors and other debtor insiders.8 Retention payments offered to induce a senior manager insider to remain with the debtor's business may only be made if the payment is "essential to retention of the person because the person has a bona fide job offer from another business at the same or greater rate of compensation" and the "services provided by the person are essential to the survival of the business." In addition, severance payments made to senior management insiders will only be upheld if such payment is available to all full time employees. Retention and severance payments are capped under the Act.

The goal of these amendments is to restrict the debtor from enriching senior management during the first days of bankruptcy, thereby making the debtor's senior management more accountable to the creditors. It is likely, however, that these amendments could force many senior managers to seek employment outside of the reorganizing business, leaving the debtor without key leadership in a time of great need.

B. The Appointment of a Trustee

Pursuant to section 1104 of the Bankruptcy Code, any party in interest may move the court for the appointment of a bankruptcy trustee for cause or if it is in the best interests of the creditors.

The Act does not change the standards for the appointment of a trustee, however, it requires that the United States Trustee move for the appointment of a trustee if there are "reasonable grounds" to suspect that current members of the debtor's governing body participated in fraud in the management of the debtor or the debtor's financial reporting.9 The Act does not define what constitutes "current" members, or what evidence of fraud the U.S. Trustee must obtain to be compelled to file the motion. In order for a trustee to be appointed, however, the bankruptcy court still must find that current management engaged in fraud, dishonesty, gross mismanagement or incompetence and that the appointment of a trustee is in the best interests of the creditors and the estate. This amendment to the Bankruptcy Code is likely to lead to an increased number of motions for such appointments and increased litigation costs. Commentators have observed that boards of directors will be more inclined to remove management rather than risk trustee motion litigation.

Section III. Amendments Affecting The Formulation Of A Reorganization Plan

A. Commercial Real Property Leases

Pursuant to section 365(d)(4) of the Bankruptcy Code, the debtor has sixty days from the filing of the bankruptcy petition to decide whether to assume or reject a nonresidential real pro-property lease.10 The debtor may seek unlimited extensions of this period by a showing of cause to the bankruptcy court. Motions seeking extensions are typically granted in order to give the debtor time to reorganize effectively. In this situation, a landlord's only recourse is to file a motion to compel the debtor to make a decision whether to assume or reject the lease; however, these motions are only granted upon a showing of some tangible harm to the landlord or that the debtor is not performing its obligations under the terms of the lease.

The Act changes the debtor's ability to extend the time to assume or reject a nonresidential real property lease. Under the Act, the debtor must assume or reject such a lease within 120 days of the filing of the bankruptcy petition (or confirmation of the plan, whichever is earlier). The bankruptcy court may grant an extension up to ninety days upon a motion of the debtor or landlord for cause, but any further extensions will only be granted with the landlord's consent. The result of the amendments to section 365(d)(4) of the Bankruptcy Code is that many debtors will have to make decisions with regard to commercial rental property before a plan of reorganization has been formulated and will be forced to negotiate directly with the landlords, giving the landlords the upper hand in negotiating favorable terms in exchange for such an extension.

Prior to the Effective Date, many courts did not allow a debtor to assume an unexpired lease or executory contract when a noncurable nonmonetary default existed. Under the Act, however, a debtor need not forfeit a real property lease solely because of the existence of an incurable default.11 The landlord will need to be compensated for any pecuniary loss sustained from such noncurable default. The Act, however, does not assist a debtor who has such an incurable nonmonetary default under a personal property lease, license or other type of executory contract. This means that even if a debtor has a personal property lease or executory contract that is essential to its business, the debtor will not be able to assume the lease or contract no matter what as the result of such a noncurable nonmonetary default.

1 Certain of the amendments went into effect immediately when President Bush signed the bill into law on April 20, 2005. Those amendments include, among others, an extended look back period to allow avoidance of transfers to insiders, the district court's exclusive jurisdiction over professionals employed in bankruptcy and the appointment of a trustee for fraud.
2 Some of the changes that will impact the consumer sector include: implementation of the means test standard for chapter 7 eligibility, mandatory credit counseling, exemption law changes, reduced superdischarge under chapter 13, special protections for support obligations, enhanced requirements for reaffirmation agreements, landlord protection, limited serial filings, no cram down for purchase money security interests and the expansion of the automatic stay exception.
3 Title 11, United States Code 101 et seq.
4 The Act amends several key areas that are not discussed at length in this article including, but not limited to: tax provisions, transnational insolvencies, financial contracts, chapter 12 farmers, involuntary petitions, retiree benefits, single asset real estate and consumer credit disclosures.
5 Section 546 of the Bankruptcy Code.
6 Section 503 of the Bankruptcy Code.
7 Section 507 of the Bankruptcy Code.
8 Section 503 of the Bankruptcy Code.
9 This provision was effective April 20, 2005.
10 If the debtor rejects a lease, the effect of such rejection amounts to a prepetition breach, thereby giving the landlord a prepetition claim, subject to a cap. On the other hand, if the debtor assumes a lease the debtor must first cure all prepetition defaults in full, and if the debtor later rejects the assumed lease, the landlord is entitled to administrative priority for rejection damages as a result of the breach. The Act limits such administrative priority for rejection damages to the amount of rent reserved under the lease for the two year period following the later of the date of the lease rejection or the date of the actual turnover of the premises.
11 Section 365(b) of the Bankruptcy Code.

Andrew C. Kassner is Executive Partner and a Managing Partner of Drinker Biddle & Reath LLP, a member of the firm's Business and Finance Department, and the Co-Head of the firm's Finance and Restructuring Practice Group. He is the regional partner in charge of the firm's Wilmington, Delaware office.

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