United States: Congress Overhauls the Nation’s Bankruptcy Laws

Last Updated: June 20 2005
Article by Craig E. Reimer and Michael P. Richman

Originally published April 21, 2005

Overview of the 2005 Act

After nearly ten years of ups and downs in the legislative pipeline, President Bush on April 20, 2005 (the "Enactment Date") signed into law the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (the "2005 Act"). The 2005 Act is the most extensive revision of the Bankruptcy Code since its enactment in 1978 and surpasses, in both its breadth and substance, the scope of reform sought by Congress the last time it amended the Bankruptcy Code in 1994. While the 2005 Act will have a significant effect on the rights and interests of both creditors and debtors in consumer and business bankruptcy cases, the changes to the Bankruptcy Code under the 2005 Act are largely evolutionary, rather than revolutionary— the general structure of liquidations under chapter 7, reorganizations under chapter 11 and other primary features of the Bankruptcy Code, such as the imposition of the automatic stay, the order of priority for different types of claims and requirements for confirming a plan, remain intact.

The media has focused almost exclusively on how the 2005 Act changes consumer bankruptcy law. However, fully half of the 500-plus pages of legislation comprising the 2005 Act will have an impact on commercial bankruptcy practice. Although some business-oriented revisions are related to the recent corporate scandals and the ensuing bankruptcy filings that were the largest in U.S. history, the vast majority of the business-oriented amendments to the Bankruptcy Code that are contained in the 2005 Act were first introduced in Congress before cases like WorldCom and Enron made news.

In this context, it remains to be seen whether and to what extent the 2005 Act will affect the balance of often competing interests of debtors and creditors. Some provisions appear quite deliberately designed to shift that balance with respect to certain issues and processes in commercial chapter 11 practice. For example, while the 2005 Act contains provisions that will help debtors by facilitating expedited reorganization through confirmation of a pre-packaged or pre-arranged plan, there are other provisions that may punish debtors and make consensual plans more difficult to achieve for those debtors who have failed to determine strategies concerning their commercial leases prior to commencing a bankruptcy case. The ability of debtors to achieve consensual reorganizations may also be negatively impacted by new provisions which restrict the time that the debtor may maintain the exclusive right to propose and obtain confirmation of a plan.

Except for a few provisions which are noted in the following analysis, the 2005 Act becomes effective 180 days after its enactment, which will be October 17, 2005 (the "Effective Date"). In general, the 2005 Act will only apply to cases filed on and after the Effective Date, although a few parts of the legislation (most notably the "Deprizio fix" discussed on page 9) apply to cases that were pending as of the Enactment Date.

Analysis of Key Amendments from the 2005 Act Affecting Commercial Bankruptcy Practice

Executory Contracts and Leases

Time to Assume or Reject Leases of Nonresidential Real Property

The amendments in the 2005 Act will alter the way in which a debtor deals with assumption or rejection of its unexpired leases. Under the current Bankruptcy Code, a debtor has 60 days from the commencement of its case to decide whether to assume or reject its commercial real property leases. This time can be and often is extended (numerous times) by the court during the course of a bankruptcy proceeding (and particularly in very large cases with many leases) ultimately deferring any assumption or rejection decision until the plan confirmation hearing which may be a year or more after the filing. This is not surprising because lease assumption and rejection decisions may well be material to a debtor’s business model and exit strategy. Under the 2005 Act, the initial decision period is extended from 60 days to 120 days, but thereafter the court may extend this period only once more for up to 90 days upon the motion of the trustee, debtor-in-possession, or lessor for cause (unless the landlord consents). The court is not given discretion to vary this time limit for any reason. In effect, absent consent of the landlord, debtors will have a maximum of 210 days from commencement of the case to make the assumption/rejection decision.

Whether landlords will consent to further extensions or not will almost certainly be a function of the relevant lease market at the time the decision has to be made. If the lease is at a below-market rent in a market where alternative tenants are available, there is no reason for consent to be provided because the landlord would have the opportunity to find a new tenant at a higher rent. Conversely, if the lease is at or above the market, consent would likely be given (if requested) in the interests of certainty. In some cases, the consequences of forcing the debtor to decide by a certain deadline, without the possibility of further extension, may well drive up the administrative expenses of a chapter 11 case and imperil its success. Debtors may be forced prematurely to assume, and to continue to pay the rent, only to determine later that the early assumption was improvident. The economic consequences of this kind of decision are discussed below.

Post-Assumption Breach or Rejection

Having put debtors in the position of making lease assumption decisions that might later be shown to have been economically improvident because they were driven by a premature deadline, Congress further amended the Bankruptcy Code to limit the administrative claim damages that a landlord may recover if the debtor rejects a commercial lease which it had previously assumed. The 2005 Act imposes a two-year cap on the amount of administrative expense damages that may be claimed under an assumed lease. Under current law, there is no such cap and once assumed, if later rejected, the estate will be burdened by the full amount of rent that remains due under the lease as an administrative expense. The 2005 Act limits the administrative expense status to all payments due under an assumed and then rejected lease for two years after the rejection date or property turnover date (whichever is later), excluding "going dark" fees and other penalty provisions. Though enacted in connection with the "small business" section of amendments in the act, this amendment applies to all business cases, regardless of their size. The amendment also provides that setoffs or reductions against the allowed administrative amount can only be taken for amounts actually received or to be received by lessors from other third parties (i.e., replacement tenants). Payments due under the lease after the two-year window are treated like other damage claims arising from a rejected lease (i.e., they are unsecured claims) and are capped pursuant to Section 502(b)(6) of the Bankruptcy Code (the rent reserved by the lease for the greater of (i) one year and (ii) 15%, not to exceed three years, of the remaining term of the lease).

Other Changes to Section 365

The 2005 Act contains a few other amendments of note that impact the treatment of contracts and leases under Section 365 of the Bankruptcy Code. One amendment addresses a controversy under the case law as to whether a debtor, in order to assume a lease, has to cure all "non-monetary" obligations (for example, a common requirement for the protection of mall tenants that a tenant not cease business and "go dark."). Once a tenant has "gone dark," there is no way for this default to be cured retroactively. Some courts have refused to permit debtors to assume leases where, as in the example here, they were unable to effect a cure of the non-monetary default. The 2005 Act ends the controversy by providing that a debtor (or its trustee) does not have to cure non-monetary defaults arising under its leases (e.g., the failure to maintain and repair the premises, the failure to provide financial statements and environmental reports, the failure to deliver insurance certificates, etc.) if it is impossible to remedy such default at and after the time of assumption. With respect to defaults arising from a breach of a prohibition against "going dark," the amendment allows a debtor to remedy such default provided it does not "go dark" from and after the date of assumption. In addition, the amendment requires an "economic cure" of any non-monetary default by providing that the debtor must compensate the lessor for the actual economic loss it sustains as a result of such breach.

With the airline industry crowding many bankruptcy court dockets, the 2005 Act will eliminate Sections 365(c)(4) and 365(d)(5)–(9) of the Bankruptcy Code, which provided for special treatment for airport operators and generally made it more difficult for airlines to realize the economic value of their terminal and gate leases. Under those sections, a bankrupt air carrier could not assume or assign its leases of one or more terminals or gates to more than a single party at an airport without first obtaining the consent of the airport operator. Those sections also shortened the time period an air carrier in bankruptcy would have to make its decision to assume or reject its leases with an airport operator if certain events (such as the conversion of its case to chapter 7) occurred.

Single Asset Real Estate Bankruptcy Cases

In a tilt toward secured creditors, the 2005 Act restricts the debtor’s ability to make use of the automatic stay in single asset real estate cases. By amending the definition of "single asset real estate" cases to remove what had been a $4 million debt cap, Congress has provided that these automatic stay limitations will now apply to all cases in which the debtor’s primary business is the ownership and operation of a single real estate asset.1

Under the 2005 Act, Section 362(d)(3) is amended to provide for the automatic stay to be lifted on the request of a party in interest and after notice and a hearing in a single asset real estate case unless the debtor has, by the latest of (a) 90 days after its petition date, (b) a date determined by the court within that 90-day period or (c) 30 days after the court determines that the case is a single asset real estate case, either filed a confirmable plan or commenced making monthly payments to creditors with security interests in the real estate. The new provision also requires the debtor to pay interest at the nondefault rate specified in the debtors’ contracts, rather than at the "current fair market rate on the value of the creditor’s interest in the real estate," as is now the standard under Section 362(d)(3). As a result of the amendments, secured creditors in single asset real estate cases that are not quickly resolved by plan confirmation may now be able to receive interest payments at the contract rate, which may significantly exceed the market rate of interest by the time the bankruptcy case is filed. Another important amendment permits such payments to be made with the secured creditor’s cash collateral, i.e., pre-petition or post-petition funds generated by the encumbered property. An important question not answered directly by these changes is the extent to which, if at all, they are intended to take away a secured creditor’s rights to seek adequate protection in any way different or greater than the interest payments made from cash collateral.

Case Administration

Limitations Imposed on Extension of Plan Exclusivity Periods

Similar to the time restrictive policies that underlie the changes made to Section 365 that, as discussed above, will limit a debtor’s time to make the decision to assume or reject commercial leases (regardless of how large or complex its case may be and irrespective of whether forcing such decision may diminish the ultimate recovery of the estate’s creditors), another key amendment in the 2005 Act imposes time limitations on the exclusive periods during which the debtor may file and seek confirmation of a plan of reorganization.

Under current law, a debtor has the exclusive right to file a plan for the first 120 days of the case and the first 180 days to solicit acceptances to such plan. That period can be extended (an unlimited number of times) by the court for cause, upon the request of a party in interest (usually the debtor) and after notice and a hearing. These exclusivity periods are an important source of leverage used by debtors to obtain concessions from their creditor constituencies during the negotiation of a plan. The 2005 Act eliminates the court’s discretion to extend the debtor’s exclusivity period for filing a plan beyond a date that is 18 months after an order for relief has been entered and the exclusive period for soliciting acceptances to the plan would likewise be limited to 20 months.

While it is difficult to take issue with the premise that debtors should be discouraged from lingering in chapter 11, the lack of judicial discretion to extend the exclusivity period beyond 18 months in an appropriate case may have troubling consequences, including the forced conversion and liquidation of some businesses that might have been able successfully to reorganize if given additional time. The termination of plan exclusivity does not, however, force a liquidation nor end the debtor’s right to file and seek acceptances to a plan; instead, it provides other parties in interest with such opportunities. Some argue that this kind of plan competition may lead to better results for debtors and creditors alike, but this remains to be seen.

Grounds for Appointment of a Trustee, Conversion or Dismissal of Cases

Another example of express restriction on judicial discretion is contained in the amendment to Section 1112(b) of the Bankruptcy Code, which provides the grounds on which the bankruptcy court is required to convert or dismiss a chapter 11 bankruptcy case. Current provisions permit courts to convert or dismiss a case for "cause" among other things, but under the amendments, the courts will be required to convert or dismiss a case (depending on which is in the best interests of creditors and the estate) if a party seeking conversion or dismissal establishes "cause." Several new grounds for showing "cause" are enumerated (e.g., gross mismanagement of the estate, unauthorized use of cash collateral substantially harmful to one or more creditors), and the court is now required to "commence a hearing" not later than 30 days after the a conversion or dismissed motion is filed and must "decide the motion not later than 15 days after commencement of such hearing," unless either the moving party consents to a continuance or there are "compelling circumstances" that prevent the court from meeting the prescribed time limits. The amendment provides that requests to convert or dismiss shall not be granted if the debtor objects and establishes that "it is more likely than not" that a plan will be confirmed within the mandated time period and the grounds on which conversion or dismissal are sought include an act or omission of the debtor for which "reasonable justification" exists and which will be cured within a reasonable time fixed by the court. The amendment also directs the court to appoint a trustee or examiner if cause for conversion or dismissal exists but where neither would be in the creditors’ best interests.

U.S. Trustee Required to Move for Appointment of a Trustee

In addition to expanding the grounds on which a case may be converted or dismissed, the 2005 Act also increases the circumstances under which a chapter 11 trustee may be appointed. The 2005 Act amends Section 1104 of the Bankruptcy Code by requiring the U.S. Trustee to "move for the appointment of a [chapter 11] trustee if there are reasonable grounds to suspect that current members of the governing body of the debtor, the debtor’s [CEO, CFO] or members of the governing body who selected the [CEO or CFO], participated in actual fraud, dishonesty or criminal conduct in the management of the debtor or the debtor’s public financial reporting." This is one of a handful of recent amendments in the 2005 Act and therefore should be viewed as Congress’ attempt to respond to the public outcry that arose after the spectacular degree of corporate fraud in cases like Enron and WorldCom was brought to light. While the U.S. Trustee is compelled by this amendment to act on the basis of mere "suspicion," the standard by which a trustee should be appointed remains unchanged and a court still would be required to find that actual fraud, dishonesty or criminal conduct has taken place. Thus it is not clear that this amendment actually will lead to more frequent appointments of a trustee but instead could merely serve to increase litigation costs and divert attention away from reorganization efforts while the debtor responds to such a motion. The problems that may be created by this amendment will be most acute in the early stages of a bankruptcy case when, on the one hand, the U.S. Trustee may file its motion based on incomplete or inaccurate information of suspected fraud and the debtor has yet to stabilize itself from the chaos caused by its filing.

Restrictions on Key-Employee Retention Plans and Severance Payments

Another material change made to the current law by the 2005 Act are provisions that directly address and regulate the circumstances for approval of so-called "key-employee retention plans" and related severance payments. Under the 2005 Act, in order to obtain approval of a key employee retention plan, the debtor must establish that a retention or stay bonus is "essential" to induce the insider to continue to render services to the debtor. In order for the insider to become entitled to such a bonus, he or she must have an actual, comparable "bona fide" job offer from another business. Another provision requires that the insider’s services be "essential to the survival of the business." Under this new section, the measure of acceptable retention bonuses and severance pay for such insiders is linked to (i.e., is a multiple of) the bonuses and severance packages that are available to non-management employees. Thus, even if it is proven that the key person in question is essential to the success of the debtor and that this person has another equal or better opportunity awaiting him or her, the retention bonus and severance package cannot exceed the levels set forth in the new provisions. Specifically, the bonus cannot exceed ten times the amount paid to non-management persons within the year in which the transfer is made or, in the absence of such non-management bonuses, cannot exceed 25 percent of the amount of bonuses transferred to the insider himself during the year prior to the retention bonus. Other transfers to, or debts incurred for the benefit of, officers, managers and consultants after the filing of the bankruptcy case will not have administrative priority status if they are outside of the ordinary course of business and not justified by the facts and circumstances of the case.

These restrictions could negatively impact business reorganizations by leading to the departures of management that would otherwise be critical to a successful reorganization. In particular, requiring that insiders have other comparable job offers to be eligible for retention bonuses will induce management to undertake a job search at a time when their focus is needed for reorganization purposes, and may further induce them to take a new position (though not one that is necessarily more lucrative) because of the certainty of employment that a new job may provide, versus the uncertainty of staying the course in chapter 11. The restrictions on bonuses and severance packages may also dampen the enthusiasm of key personnel for continued employment with the debtor.

Encouraging Fast-track chapter 11 Cases

The 2005 Act includes provisions that should make it easier for debtors to implement pre-arranged plans (i.e., a plan which has not been approved by solicitation pre-petition, which would be a pre-packaged chapter 11 case, but instead involve pre-petition lock-up agreements with creditors who agree to vote in favor of a plan filed post-petition that is consistent with the terms contained in the lock-up agreement). Under current law, a debtor may not solicit votes post-petition in favor of its plan unless and until it obtains approval of a disclosure statement. The 2005 Act will authorize a debtor to continue soliciting lock-up agreements with its creditors who were first solicited before commencement of the case. More specifically, the amendment states that acceptance or rejection of a chapter 11 plan may be solicited post-petition from a holder of a claim or interest if: (1) the solicitation complies with applicable nonbankruptcy law; and (2) if such holder was solicited before commencement of the case in a manner complying with applicable nonbankruptcy law.

This issue garnered much attention after Delaware Bankruptcy Judge Walrath’s 2002 decision in In re NII Holdings, Inc. back in 2002. In that case, the debtor negotiated lockup agreements with several creditors and shareholders before filing for chapter 11. However, several parties were unable to execute an agreement until after the bankruptcy petition date. The court held that postpetition lockup agreements of this kind were not permitted, and disallowed all votes of parties to such agreements. Pursuant to the revised bill, a postpetition lockup agreement of this kind would be permitted, thereby greatly facilitating the speed with which a debtor may be able to achieve confirmation of its pre-arranged plan.

Another related amendment allows the court, on request of a party in interest, to order that the U.S. Trustee not convene a meeting of creditors or equity security holders if the debtor has filed a plan for which acceptances have been solicited before the commencement of the case. This creates an exception to the requirement that a "341 meeting" of creditors take place in prepackaged bankruptcy situations. This should also help facilitate confirmation of prepackaged bankruptcy cases since, in some jurisdictions, it is necessary for a meeting of creditors to be held before solicitation of a plan may commence.

Adequate Assurance to Utilities

The 2005 Act substantially revises Section 366 of the Bankruptcy Code. That section governs the rights and obligations of utilities which provide post-petition services to a debtor. Under current law, a utility is required to continue to provide service to and may not discriminate against a debtor based on non-payment of pre-petition bills, provided the debtor provides "adequate assurance" that it will stay current on its post-petition bills from the utility. To a large extent, under current law, the determination of whether a debtor had demonstrated such "adequate assurance" was largely within the court’s discretion. As long as a debtor had good, post-petition liquidity, and a decent pre-petition payment history, courts tended to find that there was adequate assurance of payment based solely on the administrative expense status such payment obligations enjoy under Section 503(b) of the Bankruptcy Code. In this environment, it is not surprising that utility companies found the special protection that Section 366 of the Bankruptcy Code was intended to provide to them was regularly being diluted if not outright marginalized by judicial fiat. The 2005 Act significantly curtails the role that judicial discretion may play in the analysis of whether adequate assurance has been provided by a debtor and materially increases the overall leverage of utilities.

Section 366 is amended by the 2005 Act by specifically listing the steps a debtor may take to establish adequate assurance of payment, including by providing: (1) a cash deposit, (2) a letter of credit, (3) a certificate of deposit, (4) a surety bond, (5) a prepayment of utility consumption, or (6) another form of security that is mutually agreed on between the utility and the debtor or the trustee. More importantly for utilities, the amendment expressly provides that the creation of an administrative expense priority claim for the utility is not to be considered adequate assurance of payment. In addition, the assurance of payment must be "satisfactory" to the utility, though the debtor can seek judicial redress if the utility is not satisfied.

Investment Bankers; Definition of "Disinterested Person"

Under current law, an investment banker who advised the debtor on a pre-petition basis in connection with its issuance of securities cannot do post-petition work for the debtor because, by definition, it is not viewed as a "disinterested" person. The 2005 Act will make it significantly easier for an investment banker to be employed post-petition by a debtor, regardless of the type of services it may have provided prepetition. As amended, the investment banker need only demonstrate that it does not hold an interest adverse to the debtor on the matter for which it is to be retained. This amendment puts investment bankers on equal footing with other professionals, such as lawyers and accountants, who have been able to provide post-petition services to a debtor by meeting the "adverse interest" standard, even though they could not otherwise establish that they were disinterested persons. This change in the law could lead to a change in the competitive environment for the provision of investment banking services in bankruptcy cases, as large banks and investment houses previously considered unqualified under the disinterestedness rules will now be in a position to compete with boutique and niche firms that have in recent years dominated investment banking in bankruptcy cases.

Official Committees

The 2005 Act authorizes the court, upon the request of a party in interest and after notice and a hearing, to order the U.S. Trustee to change the membership of a committee of creditors or interest holders, if the court determines that the change is necessary to ensure adequate representation of creditors or equity security holders. This section limits the U.S. Trustee’s discretion and grants creditors the right to petition for inclusion on the committee notwithstanding the U.S. Trustee’s refusal to appoint them. The amendments also require the committee to provide information access to creditors that are not committee members and that hold claims of the kind represented by that committee. The committee will further be required to solicit and receive comments from such non-committee creditors. These amendments are a victory for creditors who felt that their inability to petition the court for inclusion on the committee, compounded with the committee’s ability to deny other creditors access to information, effectively denied them a seat at the bargaining table. However, these new provisions may also create difficulties and added (expensive) hurdles for committee counsel who must balance the right to access information with the important responsibilities of protecting confidentiality and the attorney-client privilege with the client committee.

The reform legislation also authorizes the court to order the U.S. Trustee to increase the membership of a court-appointed committee to include a creditor that is a small business concern following the court’s determination that such creditor holds claims of the kind represented by the committee. This is an exception to the general rule that the largest creditors of the debtor serve on the creditors’ committee, and it permits smaller creditors to play an active role in negotiations while keeping their legal costs down (i.e., because the debtor’s estate bears the costs of the committee’s representation).

Appointment of New Bankruptcy Judges

The 2005 Act provides under 28 U.S.C. § 152(a) for several new temporary2 bankruptcy judgeships in different states, including four for Delaware and one for the Southern District of New York. These particular amendments are to take effect on the date of the enactment of the legislation rather than six months from the Enactment Date, as is the standard for most of the revisions to the Bankruptcy Code. This section is intended to clear congested bankruptcy court dockets, especially in jurisdictions like Delaware where so many business bankruptcy cases are filed. The amendment is expected to result in more efficiently-run courts and greater availability of judges and hearing dates in large chapter 11 cases.

Claim Administration

Claims of Sellers of Goods

Currently, Section 546(c) of the Bankruptcy Code permits a seller of goods to assert a reclamation claim within ten days after a debtor’s receipt of goods, unless the ten-day period expires after the commencement of the debtor’s case, in which case the seller has 20 days after the debtor’s receipt to assert a reclamation claim. The 2005 Act greatly expands the rights of sellers of goods by increasing the reclamation period to goods received up to 45 days prior to the filing date, with an additional 20 days after the filing date if the 45-day period expires after the commencement of a debtor’s case. If the seller fails to provide notice of its reclamation claim, the seller still may assert an administrative expense claim for the value of the goods received by the debtor within 20 days before the commencement of the case. Thus, either by obtaining return of the goods or an administrative claim, sellers who qualify in the time limits provided will be able to be paid in value 100% of such claims, putting them in a far better position than other unsecured creditors.

Employee-Related Claims

The amendment to the employee wage administrative expense provisions, which reflects Congress’ concern for the employees of debtors in bankruptcy, increases the amount of wages given priority status from $4,925 to $10,000, and increases the time period during which such wages, commissions, vacation pay, severance, etc. must have been earned from 90 days to 180 days prior to commencement of the case. This amendment will increase administrative payments to employee-creditors of business debtors, whose plight has received much attention in the wake of the Enron and WorldCom bankruptcy filings. However, by increasing the administrative expense burden on the estate (assuming that the estate in question is not solvent), this amendment will have the effect of diminishing the funds available for distribution to unsecured, non-priority creditors such as lessors of property subject to rejected leases. It also may increase the pressure on creditors with blanket security interests to allow greater use of their cash collateral to pay employees’ priority claims in the preliminary stages of the case for the sake of morale. While this section appears to be a "win" for employees in corporate bankruptcy cases, like some of the other "pro-employee" amendments, it is not without costs, given that, by making bankruptcy more expensive for debtors, and by doubling the amount of priority wage claims that must be paid in order for a plan to be confirmed, this amendment could make the success of the bankrupt company—and the retention of the employees’ jobs—less likely.

Tax Claims

Section VII of the 2005 Act contains Bankruptcy Tax Provisions, which are designed to increase recoveries by taxing authorities. Although these provisions generally have escaped commentary, they appear to contain some surprises that may impact negatively on the ability to reorganize successfully.

For example, before amendment, Bankruptcy Code Section 724 allowed all administrative expense claimants in a chapter 7 case to be paid from the proceeds of assets encumbered by tax liens before the trustee paid the claims secured by such liens. Now, as a result of Section 701 of the Act, if a case is converted to chapter 7, payment of secured tax claims will not be subordinated to administrative claims incurred during the pre-conversion chapter 11 case, other than claims for wages, salaries and commissions. This change increases the risk of nonpayment for all professionals in a chapter 11 case, as well as for creditors who supply goods or services to the debtor-in-possession or make a substantial contribution to the chapter 11 case.

Additional provisions designed to maximize and expedite collections on tax claims are found in Sections 718, 712, and 710 of the Act. Each of these provisions also may impair the likely success of a chapter 11 case. Section 718 amends Bankruptcy Code Section 362(b) to permit tax authorities to offset pre-petition income tax refunds they owe the debtor against the debtor’s pre-petition income tax obligations to the tax authority or, if the amount of the obligation is being disputed, to hold the refund pending resolution of the dispute. This freeze or offset may squeeze a debtor-inpossession’s cash flow and hamper its business efforts. Additionally, bankruptcy courts generally assert discretion to deny relief from stay, and may bar the exercise of setoff rights for equitable reasons, such as the debtor’s need to use cash and ability to provide adequate protection for the cash use. Exclusion of income tax offsets from the automatic stay removes judicial discretion on this point.

Section 712 of the reform bill amends both Bankruptcy Code Section 503(b)(1) and 28 U.S.C. § 960 so that post-petition tax obligations, other than real property taxes on abandoned property, incurred by a debtor-in-possession or trustee automatically are allowed as administrative expenses and are required to be paid on or before the applicable nonbankruptcy law due date. This amendment certainly will increase the cash flow burden on entities operating in chapter 11.

Section 710 is designed to enhance tax authorities’ collections under chapter 11 plans by improving the treatment of tax claims under Bankruptcy Code Section 1129(a)(9)(c). The new provisions require allowed priority tax claims, and tax claims that would be priority tax claims but for the fact that they are secured, to be paid in full within five years after the order for relief (usually the petition date), instead of within six years after the assessment date. Moreover, whereas it has been common to structure plans to defer tax payments to the latter part of the six-year period, debtors and other plan proponents will now have to provide for priority taxes to be paid in "regular installment payments," and with treatment no worse than that provided for "the most favored nonpriority unsecured claim," other than convenience class claims, under the plan. This may increase pressure on cash flow early in the post-confirmation period, and may cause other creditors to share more of the longer-term feasibility risks posed by a confirmed plan.

Two tax-related amendments in particular are likely to spawn litigation and delay plan confirmation. Section 708 amends Bankruptcy Code Section 1141(d) to prohibit the discharge of any tax with respect to which the debtor made a fraudulent return or engaged in fraudulent or evasive acts. Fraud claims of this type often result in costly and protracted litigation, and potentially involve sums that must be resolved before a plan may be found to be feasible. Section 717 invites litigation and delay by specifically requiring disclosure statements to discuss "potential material Federal tax consequences" of the proposed plan to the debtor, the debtor’s proposed successors, and the impact of the tax consequences on a "hypothetical investor typical of the holders of claims or interests in the case." Tax discussions in disclosure statements have tended to be pro forma, and parties may use this amendment to justify new challenges to disclosure statement approval.

Avoidance Actions

Ordinary Course Defense Made Easier To Establish

The 2005 Act contains a number of creditor-friendly amendments to the avoidance powers provided under the Bankruptcy Code. Principal among these is the change to the way in which a creditor may establish an "ordinary course defense" to a preference action asserted against it under Section 547 of the Bankruptcy Code. Under current law, Section 547(c)(2) enables a creditor to establish that a transfer is not an avoidable preference if, among other things, it (1) is made in the ordinary course of business or financial affairs of the debtor and the transferee, and (2) is made according to terms that are ordinary in the debtor’s and creditor’s industries. The 2005 Act changes the "and" to an "or," and accordingly would protect any transfer that met either one of the two current requirements. Thus, creditors will face less of a burden when trying to prove the ordinary course defense.

Minimum Thresholds for Preference Claims

In addition, in cases in which a debtor primarily owes nonconsumer debts, transfers with an aggregate value of less than $5,000 are not avoidable preferences. The change will protect creditors who have received de minimis payments from having to incur the cost of defending against preference attacks. Similarly, the 2005 Act amends federal venue regulations to provide that preference recovery actions (among other actions to collect money or property) against non-insiders must be brought in the defendant’s home district if the action seeks to collect less than $10,000. This should reduce the costs and inconvenience for creditors defending against preference claimsattacks.

Extension of "Safe Harbor" Period for Perfection of Liens

Subparagraphs (A), (B) and (C) of Section 547(e)(2) of the Bankruptcy Code are each amended by increasing the period from ten days to 30 days for a secured party to perfect its lien and thereby avoid preference attack by the debtor. This change is consistent with the amendment to Section 547(c)(3)(B) which extended from 20 to 30 days the period in which the holder of a purchase money security interest could perfect its lien and become immune from preference attack.

Resolves Issue Raised after 1994 Amendments over Deprizio Fix

The 2005 Act contains a technical amendment to Bankruptcy Code Section 547 that appears finally to fix the "Deprizio problem" for non-insider transferees. Under the Deprizio line of cases, where a lender held a guaranty from an insider of the debtor, a trustee or debtor would be able to recover from the lender any payments the lender received from the debtor between 90 days and one year (i.e., the insider’s extended avoidance period) before the petition date, to the extent the payments reduced the insider-guarantor’s potential liability on the guaranty. The 1994 amendments to the Bankruptcy Code clarified that non-insider transferees would not be required to return "payments" received outside the 90-day non-insider preference window, leaving open the risk that such a transferee would remain vulnerable to the avoidance of non-cash transfers, such as the grant of a lien in the context of a workout or loan amendment, beyond the 90-day period. This ambiguity in the 1994 amendments has required the continued negotiation of "Deprizio waivers" in guaranties, and impacted lenders’ willingness to permit an insider-guarantor to ever be a creditor of the debtor. The 2005 Act appears to lay this issue to rest by providing that any avoidance of a transfer (whether in the form of a payment or otherwise) made to a non-insider more than 90 days but less than one year before the petition date is to be considered effective only with respect to any insider creditor who benefited from the transfer. As a practical matter, this means that affected insiders will be liable to the estate for the monetary value of the avoided lien. It also means that lenders can now permit insiders to become creditors under the terms of their guaranties without risking avoidance of liens granted to the lenders. Unlike most of the 2005 Act (which only apply to cases filed on or after the Effective Date), this amendment will be effective in any case that is pending as of the date of enactment of the 2005 Act.

Extension of Fraudulent Conveyance Period from One to Two Years

Under current law, a trustee or debtor-in-possession may avoid fraudulent transfers made at least within one year prior to the bankruptcy filing (longer periods are available, however, under state laws, to the extent applicable, under other provisions of the Code.) The 2005 Act amends Section 548 by expanding the "look-back" period to two years. (Unlike other amendments which generally take effect 180 days after enactment, this provision will only apply to cases filed more than one year after the date of enactment.) Furthermore, under current law, unless actual fraud was involved, Section 548 of the Bankruptcy Code requires a showing that the debtor was insolvent when the transfer was made or was rendered insolvent as a result of such transfer. The 2005 Act eliminates this insolvency test for fraudulent transfer claims relating to employment agreements that are "outside the ordinary course" of the debtor. In addition, in all cases filed on or after the date of enactment, the 2005 Act expands to ten years the look-back period for fraudulent transfer claims arising from self-settled trusts entered into by the debtor under circumstances that evidence an intent to hinder, delay or defraud creditors.

These amendments are intended to deter corporate fraud and to facilitate the recovery of fraudulent transfers, particularly with respect to "golden parachutes" and other compensation arrangements common among senior management. As with other aspects of the 2005 Act that may appear well-intentioned on the surface, however, there may be unintended consequences to the fraudulent transfer amendments. In particular, as executive compensation packages come under greater scrutiny and are put at greater risk of being avoided, it is possible that a financially distressed corporation will find it much more difficult to recruit or retain the very people necessary to steer the company during turbulent financial times.

Financial Contracts

Title IX of the 2005 Act clarifies the ability of counterparties to financial contracts to exercise contractual self-help rights upon the insolvency of their counterparties. This section of the law was originally titled the "Financial Contract Netting Improvement Act." These changes amend several important laws, including the Bankruptcy Code, the Federal Deposit Insurance Act ("FDIA"), the Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") and the Federal Credit Union Act ("FCUA") (for the most part, changes to FCUA closely track changes to the FDIA). The primary purpose of these self-help rights is to reduce systemic risk to the financial markets and banking systems that could be caused by the ripple effect emanating from the insolvency of a significant marketplace participant.

While these changes are important, they are best described as evolutionary rather than completely new legal rights. The changes (i) clarify areas of uncertainty since the provisions were adopted, (ii) harmonize similar provisions in the Bankruptcy Code, FDIA and FDICIA, and (iii) update the provisions to encompass developments in the financial markets since their adoption.

The provisions apply to numerous financial contracts, including swaps, options, repurchase agreements, commodity contracts (including futures contracts) and forward contracts. The contractual rights referred to as "self-help" rights against an insolvent counterparty include the right to terminate or close-out all outstanding financial contracts, to net all payment obligations and to foreclose on all pledged collateral. Exercise of some or all of these rights is generally permitted under each of the Bankruptcy Code, FDIA, FDICIA and FCUA, notwithstanding the insolvency of a counterparty.

However, the provisions in the current Bankruptcy Code raised uncertainty regarding the scope of some of the provisions, as well as the interplay between the provisions of the Bankruptcy Code and FDIA, on the one hand, and the provisions of FDICIA, on the other. The new law makes numerous important changes to these provisions, including: (i) expanding and clarifying the definitions of the covered financial contracts and offering sufficient flexibility to cover future developments in those markets, (ii) extending the protections for financial contracts to related security documents, (iii) expanding the scope of protected counterparties by conforming these categories to certain Federal Reserve and SEC definitions and creating a new definition of "financial participant," (iv) clarifying the ability of counterparties to net payments across different categories of financial products by defining "Master Netting Agreement" in the Bankruptcy Code for the first time, (v) making unenforceable "walkaway clauses" under FDIA, (vi) limiting the ability of a conservator or receiver under FDIA to "cherry-pick" among an insolvent financial institution’s qualified financial contract obligations to the same circumstances under which such conservator or receiver can transfer a qualified financial contract, (vii) strengthening the liquidation and acceleration rights for qualified financial contracts under the Bankruptcy Code, (viii) clarifying under FDIA that a counterparty cannot immediately exercise an ipso facto clause, (ix) clarifying that the Bankruptcy Code’s protective provisions apply to ancillary proceedings and municipal bankruptcies, (x) clarifying the effect of an order under the Securities Investor Protection Act, or a judicial or regulatory order under the Bankruptcy Code, on the exercise of self-help contractual rights, (xi) clarifying the date from which damages from termination, acceleration or liquidation of a qualified financial contract are measured, and (xii) expanding the list of institutions to which the Federal Deposit Insurance Corporation ("FDIC") can transfer qualified financial contracts from depository institutions to brokers, dealers, foreign financial institutions and bridge banks.

The new bill, though, does not address certain related issues that participants in the financial markets had hoped would be addressed. For example, a proposed new "safe harbor" for asset-backed securitizations was not included. This provision would have provided that assets transferred as part of a securitization conclusively would not be part of the debtor’s estate so long as the transfer met the specified criteria.

Ancillary and Cross-Border Cases: New Chapter 15

Section 801 of the new law deletes the former Section 304 and substitutes a new chapter 15 entitled "Ancillary and Other Cross-Border Cases." The new chapter 15 incorporates into federal bankruptcy law the Model Law on Cross- Border Insolvency drafted by the United Nations Commission on International Trade Law ("UNCITRAL"). This change will bring federal ancillary proceedings in line with those of numerous other industrialized countries.

Section 304 permitted a foreign representative to originate an ancillary proceeding in the United States courts if there existed outside the United States a foreign proceeding involving the debtor. Among the powers granted by Section 304 to U.S. judges were the powers to turn over the assets of a debtor located in the United States for adjudication as part of a foreign proceeding. Section 304 specified certain factors for a judge to review in deciding whether to grant a petition from a foreign representative; comity with respect to the laws and proceedings of a foreign state was perhaps the most important of those factors. United States creditors also were given the ability to show that they would be disadvantaged by the approval of a foreign representative’s petition.

The procedural and substantive application of chapter 15 should not differ significantly from the application of the former Section 304 in that chapter 15 is based to a significant degree on the principles underlying Section 304. Section 1515 permits a foreign representative to file a petition for recognition. Once a petition is filed, a United States court can stay execution on the assets of a debtor, entrust administration of the debtor’s U.S. assets to the foreign representative, or grant other specified relief. Once a foreign proceeding is recognized, Section 1521 provides greater relief to the foreign representative, including by imposing a stay similar to the automatic stay under § 362 and by providing for the examination of witnesses and taking of evidence. However, Section 1522 does not permit the U.S. court to grant relief under Section 1521 unless "the interests of the creditors…are sufficiently protected."

Separately, chapter 15 appears conclusively to answer the open question of whether the U.S. branches and agencies of foreign banks may be subject to petitions under Section 304. This issue is the subject of a current case that is about to be heard by the Second Circuit on appeal from an order entered on June 11, 2004 by Judge Rakoff of the Southern District of New York. Under the pre-revision Bankruptcy Code, it was unclear whether claims by foreign representatives to the U.S. assets of such entities could be entertained by U.S. courts. Section 109 of the pre-revision Bankruptcy Code made clear that such entities could not be debtors under the Bankruptcy Code. However, Section 304 was silent on this issue. Chapter 15 appears to settle the point. Section 1501(c) states that "[t]his chapter does not apply to (1) a proceeding concerning an entity…identified by exclusion in section 109(b)." The newly revised Section 109(b) now excludes from the Bankruptcy Code "a foreign bank…that has a branch or agency (as defined in section 1(b) of the International Banking Act of 1978) in the United States."

Footnotes

1 Under the revised Bankruptcy Code, "single asset real estate" is defined as "real property constituting a single property or project, other than residential real property with fewer than four residential units, 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 the property and activities incidental [thereto.]" 2005 Act § 1201. As is the case under the current Bankruptcy Code, this definition would exclude debtors that are hotels, hospitals, casinos, etc., where the debtors’ income derives from the operations taking place on the debtors’ premises.

2 "Temporary" in this context means that when any judge filling a "temporary" position leaves the bench (due to death, removal, resignation or retirement) in the jurisdictions in which the new judges are appointed after the first five years after the appointment dates, such vacancies will not be filled. 

Copyright © 2007, Mayer, Brown, Rowe & Maw LLP. and/or Mayer Brown International LLP. This Mayer Brown article provides information and comments on legal issues and developments of interest. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended to provide legal advice. Readers should seek specific legal advice before taking any action with respect to the matters discussed herein.

Mayer Brown is a combination of two limited liability partnerships: one named Mayer Brown LLP, established in Illinois, USA; and one named Mayer Brown International LLP, incorporated in England.

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