The Bankruptcy Abuse Prevention And Consumer Protection Act Of 2005: The Impact On Chapter 11 Re-Organization - Part II

Thursday, June 1, 2006 - 00:00

Section III. Amendments Affecting The Formulation Of A Reorganization Plan (continued)

B. Amendments Affecting Relationships with Creditors' Committees

The majority of businesses operating under chapter 11 protection have a creditors' committee appointed by the United States Trustee. The creditors' committee has the power to hire professionals to protect the interests of the unsecured creditors in the bankruptcy proceeding, and has standing to negotiate and/or propose a plan of reorganization. Under the Bankruptcy Code, in order to alter the composition of the creditors' committee, creditors have to petition the United States Trustee; and, the bankruptcy court will rarely order the United States Trustee to alter the makeup of the creditors' committee on its own.

Under the Act, the bankruptcy court is provided with authority to order the United Sates Trustee to change the membership of the creditors' committee after notice and hearing, if the court determines that such change is necessary to assure adequate representation.12 Additionally, the bankruptcy court is authorized to appoint a small business concern creditor to the creditors' committee under certain circumstances to represent the interests of the small businesses. Moreover, under the Act, the members of the creditors' committee have the obligation to provide case information to non-members of the creditors' committee.

Although it remains to be seen whether these amendments will effectively increase creditor involvement, and there are no real guidelines as to the types of information the creditors' committee is required to share with non-members, these amendments will give small businesses an increased role in the reorganization process.

C. The Plan Exclusivity Period

Pursuant to section 1121 of the Bankruptcy Code, the debtor has the exclusive right to file a plan of reorganization during the first 120 days following the filing of the bankruptcy petition (the "Exclusivity Period"). Prior to the Act, it was commonplace for the debtor to seek numerous extensions and to obtain a bankruptcy court to approve numerous extensions of the Exclusivity Period for months or even years. Once the Exclusivity Period ends, any party in interest, including the creditor's committee, may propose a plan of reorganization. The exclusive right to propose a plan is an important element of control over the chapter 11 process.

The Act amends the Exclusivity Period provision to provide that the debtor is not permitted to seek an extension of the Exclusivity Period beyond eighteen months from the date of the filing of the bankruptcy petition. Because creditors now know that the debtor may not extend the Exclusivity Period beyond that time period, creditors' committees and/or other significant creditors may refuse to negotiate with the debtor and instead wait to propose their own plan. This amendment may reduce the duration of some of the larger chapter 11 cases.

D. Conversion to Chapter 7/Dismissal

As a general matter, a business operating under chapter 11 protection remains in possession and control of the business. The Bankruptcy Code provides that a bankruptcy court may convert a chapter 11 matter to a chapter 7 liquidation or dismiss a case for cause.13 The current law provides an enumerated list of grounds that constitute cause.

The Act supplements the list and provides that a bankruptcy court must convert or dismiss a case if a party in interest establishes cause on additional specified grounds, including the failure to maintain appropriate insurance, the unauthorized use of cash collateral, the failure to comply with a court order and the failure to timely pay taxes, unless the debtor proves that it can cure such conduct and it is likely to confirm on a plan of reorganization. As such, in these circumstances, the Act has shifted the burden of proof to the debtor to show that it should be allowed to remain in chapter 11.

Section IV. Amendments Affecting Avoidance Actions

A. The Ordinary Course of Business Defense to Preference Actions

Section 547 of the Bankruptcy Code provides the debtor with the authority to avoid certain transfers for the payment of debt the debtor made to its creditors prior to the filing of the bankruptcy petition.14 In order to recoup such transfers, the debtor must file a lawsuit, typically called a preference action, and establish that each transfer: (a) was made to or for the benefit of the creditor, (b) was made on account of antecedent debt, (c) was made while the debtor was insolvent, (d) was made in the ninety days before the filing of the bankruptcy petition, and (e) enabled the creditor to receive more than they would have if such transfer had not been made and the debtor were liquidated under a hypothetical chapter 7.

The creditor may assert as an affirmative defense to the preference claim that the transfer was made in the action in the "ordinary course." Prior to the Act, the burden of proof was on the defendant to provide evidence that the transfer was: (a) in payment of a debt incurred by the debtor in the ordinary course of business or financial affairs of the debtor and the transferee, (b) made in the ordinary course of business or financial affairs of the debtor and the transferee, and (c) made according to ordinary business terms in the industry. Often, industry standards were different from the course of dealing between the parties and expert testimony was required to distill industry norms.

The Act amends section 547(c)(2) of the Bankruptcy Code and establishes a less burdensome standard for the "ordinary course" defense requiring that the creditor show that the transfer was: (i) made in payment of a debt incurred by the debtor in the ordinary course of business or financial affairs of the debtor and the transferee and (ii) the transfer either was made in the ordinary course of business or financial affairs of the debtor and the transferee, or made according to ordinary business terms in the industry. As a result, the amendments to section 547(c)(2) of the Bankruptcy Code will provide creditors with a statutory defense which is easier to prove and less costly.

B. Fraudulent Conveyances

Pursuant to section 548 of the Bankruptcy Code, a trustee may avoid any transfer of an interest of the debtor, or obligation incurred by the debtor, made within one year of the filing of the bankruptcy petition if the debtor made such transfer with the actual intent to defraud creditors or where the debtor received less than reasonably equivalent value in exchange for such transfer and was insolvent or would become insolvent as a result of such transfer.

First, the Act expands the types of transfers that may be avoided as fraudulent conveyances to include any transfer made to or for the benefit of the debtor's insider "under an employment contract if (a) the transfer or obligation was not in the ordinary course of business and (b) the debtor did not receive reasonably equivalent value in exchange for such transfer or obligation." Although "ordinary course of business" is not defined in the Bankruptcy Code, courts commonly focus on the debtor's ordinary pre-bankruptcy business and the ordinary practices within the industry. Further, the Act extends the look back period for fraudulent conveyances to two years.15 The result of this amendment is that debtors will not be able to avoid the new post-petition KERP restrictions by entering into a more favorable deal with insider senior management employees prior to the bankruptcy filing and then either making enhanced pre-bankruptcy payments or assuming the enhanced contract in bankruptcy.

Second, the Act extends the reach-back period under federal law from one to two years. The result of these amendments is that creditors will carefully analyze the debtor's internal transactions for the two years prior to the filing of the bankruptcy petition to make sure that all transactions to insiders are not extraordinary.

Section V. Amendments Affecting Health Care Insolvencies

The Act contains several amendments designed to protect the confidentiality and privacy of patients in the event of a health care business bankruptcy by imposing new duties on health care businesses.

A. Patient Care Ombudsman

Under section 333 of the newly amended Bankruptcy Code, within 30 days of the filing of a health care case under chapter 7, 9 or 11, the court shall order the appointment of a disinterested patient care ombudsman to monitor the care of the patients and to represent the interests of the patients, unless the court finds that the appointment is unnecessary for the care of the patients under the specifics of each case. The ombudsman duties include the monitoring of the quality of patient care, which may require interviewing patients and physicians. Within 60 days of the appointment and then within 60-day intervals, the ombudsman must report to the court, after providing notice to parties, either in writing or at a hearing on the quality of care being provided to the patients. If the ombudsman determines that the level of care is declining significantly or is otherwise being materially compromised, the ombudsman must immediately file a report or a motion, with notice to parties, with the court. Any information acquired by the ombudsman that relates to patients is to be maintained as confidential. The ombudsman may not review confidential patient information, unless approved by the court along with appropriate restrictions protecting the confidentiality of those records.

B. Patient Records

If the debtor is a health care business and if the debtor or trustee does not have the funds to store patient records in the manner required by federal and state law, then the debtor or trustee is required to publish a notice that the records will be destroyed if they are not claimed by either the patient or the insurance provider within one year.16 The debtor or trustee must also mail a notice to each affected patient and insurance provider at their last known address within 180 days of issuing the published notice. At the end of the one-year period, the trustee is required to make a written request to the appropriate federal agencies to request permission to deposit the unclaimed patient records with that agency. If the request is denied, the trustee shall destroy the records according to the method prescribed by the statute.

C. Consumer Privacy Issue

The Act amends Bankruptcy Code section 363(b)(1) to provide that if a debtor has disclosed a policy in connection with offering a product or service, that prohibits the transfer of personally identifiable information to persons not affiliated with the debtor, then any section 363 sale or lease: (a) must be consistent with such policy, or (b) the court approves such sale after the appointment of a consumer privacy advocate, having taken into account the facts, circumstances and conditions of such sale or lease, and having found that the sale or lease would not violate applicable non-bankruptcy law. The U.S. Trustee will need to determine whether the debtor has personally identifiable information as defined in section 101(41A) of the Bankruptcy Code, whether the debtor previously disclosed a policy prohibiting the transfer of personally identifiable information which remains in effect as of the filing of the bankruptcy case, and whether the debtor intends to sell or lease such information. If so, then the U.S. Trustee also must determine whether the sale is consistent with the privacy policy. If it is not, the U.S. Trustee may be expected to request the court to direct the appointment of the ombudsman if the debtor fails to so request the court. Further, pursuant to section 332(c), a consumer privacy ombudsman is prohibited from disclosing any personally identifiable information obtained by the ombudsman.

Section VI. Conclusion

The Act continues a trend providing creditors with greater control over the reorganization process and making reorganization under chapter 11 and the Bankruptcy Code more costly and challenging for distressed companies. These companies will need to identify problems sooner and engage in greater pre-bankruptcy planning under the Act.12 Section 1102 of the Bankruptcy Code.
13 Section 1112 of the Bankruptcy Code.
14 The Act sets $5,000 as the minimum amount a debtor may sue a creditor for in a preference action. Further, the Act provides that for all preference actions seeking less than $10,000 the suit must be brought in the jurisdiction where the creditor's principal place of business is located, not where the debtor's bankruptcy matter is pending.
15 Effective October 17, 2006.
16 Section 351 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.

Editor's Note: Part I of this article appeared in the May issue of The Metropolitan Corporate Counsel.