United States: An Overview of The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005

The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) became effective October 17, 2005. BAPCPA enacted far-reaching changes in the administration and implementation of consumer and commercial bankruptcy cases. The following outline focuses on those BAPCPA provisions that will have a material impact on commercial bankruptcies. Given the nature of the amendment, it would not be unfair to draw the following inferences:

• Creditors, in particular some trade creditors, sophisticated financial creditors, and landlords will have considerably more leverage in dealing with debtors than they had prior to the enactment of BAPCPA

• As with each major amendment to federal bankruptcy law, litigation likely to result from the BAPCPA amendments will diminish bankruptcy assets that could otherwise aid reorganization efforts

• The critical importance of early planning to successfully reorganize will tend to encourage:

1. More "prearranged" or "prepackaged" bankruptcies in which prepetition debt is converted to equity and shareholder interests are eliminated

2. An increase in the use of Section 363 sales to dispose of all or substantially all of a debtor’s assets at the outset of a case

I. Limits on Plan Exclusivity — Hard Deadlines to File Plan and Solicit Acceptances The Bankruptcy Code now limits a debtor’s ability to obtain extensions of exclusivity. The initial exclusivity period remains at 120 days for filing a plan and 180 days to solicit acceptances and confirm a plan. The new code limits extensions of those periods to dates that are 18 and 20 months, respectively, after the petition date. In large cases, such deadlines may be very difficult to meet. Creditors and parties seeking to use bankruptcy as a framework for mergers and acquisitions will have greater influence.

BAPCPA gives courts more authority in the composition of creditors’ committees. Section 1102 now expressly (a) provides that the court may order the U.S. Trustee to change the members of the committee if the court determines the change is necessary to ensure adequate representation of creditors and equity holders, and (b) allows a party in interest to seek such relief.

BAPCPA provides that a court may require the U.S. Trustee to increase the number of committee members to include a creditor that is a small business concern if the court finds that the creditor holds claims against the debtor that are disproportionately large in comparison to the respective creditor’s annual gross revenue.

BAPCPA adds a provision that requires the committee to provide access to information to creditors who hold claims of a kind represented by the committee. This provision leaves open issues regarding preservation of confidentiality, particularly in the public company context. This provision will likely facilitate participation of ad hoc committees in Chapter 11.

Prior to BAPCPA, vendors were required to make reclamation demands for goods no later than 10 days after delivery of the goods, or, if the 10-day period expired after the bankruptcy filing, no later than 20 days after delivery of the goods. The bankruptcy court had the discretion to deny the vendor’s request to reclaim the goods by giving the vendor an administrative priority or secured claim.

Under the amended Section 546(c), vendors are now permitted to reclaim goods delivered to a debtor during the 45-day period prior to the filing of the bankruptcy petition; however, this right is subject to any superior rights of a creditor in the goods or proceeds thereof. In order to reclaim goods, the vendor must make a written reclamation demand no later than 45 days after the delivery of the goods or, if the 45-day period expires after the filing of the bankruptcy petition, no later than 20 days after the petition date.

The amended Section 546(c) strengthens the position of vendors by expanding the time during which the vendors may reclaim their goods. Moreover, the bankruptcy court no longer has the discretion to satisfy the reclamation claim by granting the vendor an administrative priority or secured claim.

Under Section 365(b)(1)(A) of the current Bankruptcy Code, both prior to and after BAPCPA, a debtor must cure, or provide adequate assurance that it will cure, any default in an unexpired lease of real property in order to assume such a lease.

i. Monetary Defaults

To the extent that there has been a monetary default under a lease, a debtor, prior to assuming such lease, must pay, or provide adequate assurance that it will pay, such arrearage.

A more difficult question, which is addressed by BAPCPA, is whether a debtor must cure a nonmonetary default under a lease such as a failure to maintain appropriate insurance or a failure to maintain the premises in a condition required by the lease, prior to assumption, even when it is impossible to do so. For example, it would be impossible for a debtor to cure its prior failure to continuously maintain appropriate insurance with respect to a leased property, since the debtor cannot retroactively remedy such default. Post-BAPCPA Section 365(b)(1)(A) now provides that nonmonetary defaults under a real property lease need not be cured before assumption if such cure is impossible.

However, if the nonmonetary default relates to a debtor’s failure to operate in accordance with the terms of a nonresidential real property lease, the debtor will be required to cure the default by (i) complying with the lease operating requirements from and after the time of the assumption, and (ii) curing monetary losses, if any, incurred by the lessor due to the debtor’s nonmonetary default under the lease.

Under Section 365(d)(4) of the pre-BAPCPA Bankruptcy Code, any unexpired lease of nonresidential real property that is not assumed or rejected within 60 days after the petition date is deemed rejected unless the court, for cause, extends the time within which the debtor may assume or reject the lease. The deadline could, however, be extended for periods of time without concrete limits. After BAPCPA, the limits for the assumption deadline to be extended is earlier of (a) 120 days from the date of the order for relief or (b) the date of the entry of an order confirming a plan. However, the court, for cause, can extend the 120-day period for up to a maximum of 90 days, and any further extensions can be granted by the court only with the prior written consent of the lessor. This latter provision poses a significant problem for debtors who operate numerous retail sales locations.

BAPCPA creates Section 503(b)(7), which provides that if a debtor/lessee first assumes, then later rejects, a lease for real property, the lessor is entitled to an administrative claim equal to all monetary obligations (except for penalties) for a two-year period following the later of the date of rejection or of the actual turnover of the property. The balance of any claim will be an unsecured claim subject to the caps set forth in Section 502(b)(6) of the Bankruptcy Code.

Under Section 365(f) of the Bankruptcy Code, a debtor may assign a lease to a third party without regard to any transfer restrictions contained in the lease. BAPCPA creates an exception to this rule with respect to the assignment of a shopping center lease. To assign a shopping center lease, the debtor/lessee must comply with existing contractual transfer restrictions such as radius and use provisions contained in the lease.

Under the pre-BAPCPA Bankruptcy Code, single asset real estate bankruptcy cases were limited to cases involving debtors who own real property secured by no more than $4 million. BAPCPA amends the definition of "single asset real estate" debtor to mean a debtor with (a) real property constituting a single property or project, other than residential real property with fewer than four residential units, (b) which generates substantially all of the gross income of a debtor who is not a family farmer, and (c) on which no substantial business is being conducted by a debtor other than the business of operating the real property and activities incidental. Significantly, this amendment removes the $4 million cap on the amount of debt secured by the real property that previously limited the number of debtors that could be classified as "single asset real estate" debtors.

The modification of the definition of "single asset real estate" debtor will affect a secured creditor’s ability to obtain relief from the automatic stay. That is, since the definition of "single asset real estate" debtor has been expanded, more secured creditors will have the ability to obtain relief from the automatic stay. This advantage to secured creditors derives from significant new burdens imposed upon single-asset debtors by BAPCPA. Among these burdens are the following: 3

Section 362(d)(3) of the current Bankruptcy Code provides that a secured creditor of a "single asset real estate" debtor may be granted relief from the automatic stay if such debtor, within 90 days of the petition date, fails to file a plan of reorganization that has a reasonable possibility of being confirmed or fails to commence making interest payments on the underlying debt. BAPCPA also creates Section 362(d)(4) of the Bankruptcy Code that provides that a creditor with a claim secured by real property can obtain relief from the automatic stay if the court determines that a debtor’s bankruptcy filing was part of a scheme to "delay, hinder, and defraud creditors" by either (i) transferring all or part of an ownership interest in the real property without the consent of the secured party or the bankruptcy court or (ii) filing multiple bankruptcies affecting such real property.

Additionally, BAPCPA provides that in a situation where the debtor’s status as a "single asset real estate" debtor is disputed, the debtor must either file a plan of reorganization that has a reasonable possibility of being confirmed or commence paying interest to the secured creditor on the underlying obligation within 90 days from the petition date or 30 days after a court determines that the debtor is a "single asset real estate" debtor

BAPCPA provides that the monthly interest payments that must be made by a "single asset real estate" debtor to a secured creditor are to be made at the nondefault contract interest rate, rather than a current fair market rate, which is the applicable interest rate under the current Bankruptcy Code. BAPCPA also provides that such payments can be made from rents or other income from the property, notwithstanding Section 363(c)(2) of the Bankruptcy Code, which prohibits the use of cash collateral without the consent of the secured creditor or the bankruptcy court

BAPCPA permits a court to appoint a trustee or examiner if grounds exist for dismissal or conversion and the court determines that the appointment of the trustee is in the best interest of creditors and the estate. The appointment of a trustee also terminates the exclusivity period and, accordingly, gives more leverage to creditors.

BAPCPA also provides that a U.S. Trustee must move for the appointment of a Chapter 11 trustee if reasonable grounds exist to suspect that the debtor’s board of directors, dominant shareholders, or management participated in actual fraud, dishonesty, or criminal conduct in the management of the debtor or the debtor’s public financial reporting. The statute does not indicate whether such activity must have occurred pre-bankruptcy or post-bankruptcy. Thus, it is fair to assume that the U.S. Trustee’s office will exercise fairly wide latitude in construing its role in such situations.

Importantly, BAPCPA requires that the court must dismiss or convert the case: …absent unusual circumstances specifically identified by the court that establish that such relief is not in the best interests of creditors and the estate, if the debtor or another party in interest objects and establishes that:

1. There is a reasonable likelihood that a plan will be confirmed … within a reasonable time

2. The grounds for granting such relief include an act or omission of the debtor other than [continued diminution of the value of the estate] (i) for which there exists a reasonable justification for the act or omission and (ii) that will be cured within a reasonable period of time fixed by the court

The post-BAPCPA Code expands the grounds for conversion or dismissal of the Chapter 11 case, including, among others, gross mismanagement, failure to maintain insurance where such failure poses a risk to the estate, unauthorized use of cash collateral substantially harmful to a creditor, failure to comply with court orders, failure to attend a Section 341 meeting of creditors, or failure to pay post-petition taxes.

Section 1114(d) requires that the court order the appointment of an official committee of retired employees if the debtor seeks to modify or eliminate retiree benefits. The U.S. Trustee must appoint the members of a retiree committee if such committee is appointed.

BAPCPA also provides that if the debtor modified retiree benefits and was insolvent on the date such benefits were modified the court, on motion of a party in interest, must restore the benefits to their prior level as of the date of the modification. The burden is on the debtor to demonstrate that the balance of the equities in the case necessitates the modification to lower levels.

BAPCPA adds disclosure requirements, including the requirement that the disclosure statement contain a discussion of the potential material federal tax consequences of the plan to the debtor and to potential investors typical of the holders of claims or interest in the case.

BAPCPA amends various provisions to facilitate the filing and confirmation of pre-packaged plans. A debtor may solicit pre-packaged plans and move the court to waive Section 341 meetings in certain instances where the debtor has solicited acceptances of a plan prior to commencement of the bankruptcy case and in compliance with applicable nonbankruptcy law.

United Nations Commission on International Trade Law (UNCITRAL) has been adopted as Chapter 15 of the U.S. Bankruptcy Code and replaces former Section 304.

The purpose of UNCITRAL is to facilitate multi-jurisdictional restructurings.

Chapter 15 allows a "foreign representative," appointed by a foreign court adjudicating an insolvency proceeding, to petition a U.S. court for recognition and to commence an ancillary proceeding to address assets of the foreign debtor located in the United States. It also allows the foreign representative to petition for a voluntary (under certain circumstances) and involuntary proceeding under the U.S. Bankruptcy Code; and allows the foreign representative to appear in cases regarding the subject debtor as a party in interest.

Upon the filing of a petition by the foreign representative for recognition, a U.S. court may, at the request of the foreign representative, impose interim relief regarding the subject debtor, including staying execution against and appointing an administrator of its assets.

Upon recognition of a foreign "main" proceeding by the U.S. court, the debtor’s assets will be subject to the automatic stay of the Bankruptcy Code, the foreign representative will be given authority to operate the debtor’s assets, and the foreign representative will have the power of a trustee under the Bankruptcy Code to use, sell, and lease the assets of the debtor. A foreign "main" proceeding is an insolvency proceeding in the jurisdiction where the debtor has the center of its main interests.

If the foreign proceeding recognized is not a "main" proceeding, the U.S. court may grant "appropriate relief" and the court has the authority to grant much of the same relief available in a "main" proceeding.

BAPCPA amended Section 548 to provide that a benefit paid to an insider under a KERP may be avoided as a fraudulent transfer unless it was made in the ordinary course of business. See 11 U.S.C. Section 548(a)(1)(B)(ii)(iv). However, subsection (a)(1)(B) requires a showing that less than reasonably equivalent value was received in exchange for such transfer or obligation, but the new KERP provision does not require a showing of insolvency. Thus, it appears that even if the debtor was solvent at the time of the payment, payments made to insiders for improper purposes are avoidable. The lack of clarity in the amendment will work to the advantage of aggressive creditors.

1. More Proof of Necessity for KERP Payments Section 503 now sets forth limitations on the payment or allowance of claims for retention bonuses or severance pay to the debtor’s insiders. Specifically, it disallows payment to induce persons who are insiders to remain in the debtor’s employ unless the payment is essential to retain a person who has a bona fide job offer from another business at the same or a greater rate of compensation with the reference rate being the amount to be paid under the KERP.

The amount of the payment under the KERP may not exceed 10 times the amount of a similar transfer to a nonmanagement employee during the calendar year of the proposed transfer. If no such transfer has been made to nonmanagement personnel during the calendar year, then it may not exceed 25 percent of the amount of any similar transfer to an insider in the calendar year prior to commencement of the case.

The "disinterestedness" definition in 11 U.S.C. Section 101(14) has been made more permissive in a narrow but important manner by deleting language that automatically rendered investment bankers for a security of the debtor (without regard to the timing of the issuance of the security) and their attorneys not disinterested. Now, the only circumstance that would render investment banks not disinterested is found in the general provision that they may not have an interest materially adverse to the estate or to any class of creditors or equity security holders.

BAPCPA amended Section 541 to exclude from the definition of property of the estate any amount withheld by an employer from the wages of employees for payment as contributions to an employee benefit plan that is a governmental plan under Section 414(d) of the Internal Revenue Code of 1986, including deferred compensation plans under Section 457 of the Internal Revenue Code or a tax-deferred annuity under Section 403(b) of the Internal Revenue Code of 1986. The exclusions include Employee Retirement Income Security Act (ERISA) employee benefit plans and other types of benefit plans or tax-sheltered trusts or plans.

Section 1106(a)(1) incorporates Section 704(a)(12) and requires debtors in the health care business to use "all reasonable care and best efforts" to transfer any patients of such a business being closed to another such business in the physical vicinity that provides substantially similar services with reasonable quality of care. The U.S. Trustee is given a duty of investigating the availability and quality of similar health care businesses and seeing that patients are properly transferred.

Section 503(b)(8) was added by BAPCPA to permit administrative expenses for the actual and necessary costs related to closing a health care business.

If the debtor in a Chapter 7, 9, or 11 case is a health care business, the court shall order, not later than 30 days after the commencement of the case, the appointment of an ombudsmen to monitor the quality of patient care and to represent the interests of the patients of the health care business unless the court finds that the appointment of such ombudsmen is not necessary for the protection of patients under the specific facts of the case.

If the debtor is a health care business in a Chapter 7, 9, or 11 case, and the trustee does not have a sufficient amount of funds to pay for the storage of patient records in the manner required under applicable federal or state law, the trustee is required to promptly publish notice in a newspaper that if patient records are not claimed by the patient or insurance provider within a year of the published notice the records will be destroyed. However, the trustee is required within that year period to attempt to contact the patients, insurance carriers, and federal agencies prior to the destruction of the records.

Prior to BAPCPA, a transfer could not be avoided as a preference to the extent the transfer was in payment of a debt incurred by the debtor in the ordinary course of the business or financial affairs of the debtor and transferee, and such transfer was:

i. Made in the ordinary course of business of the debtor and the transferee and

ii. Made according to ordinary business terms

Under BAPCPA, Section 547(c)(2) was amended to provide that a transfer may not be avoided as a preference to the extent that the transfer was 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 such transfer was:

i. Made in the ordinary course of business or financial affairs of the debtor and the transferee or

ii. Made according to ordinary business terms

The effect of this amendment is to make the "ordinary course" defense easier to assert since the transferee now needs only to prove either that the transfer was made in the ordinary course or financial affairs of the debtor and the transferee or that the transfer was made according to ordinary business terms. This reduces the evidentiary burden of asserting the "ordinary course" defense since the transferee need not always prove that the transfer was made according to ordinary business terms. This proof usually required expert testimony regarding industry standards.

Prior to BAPCPA, Section 547(c)(3)(B) allowed a holder of a purchase money security interest 20 days to perfect its security interest as a defense to a preference action. Perfection was considered contemporaneous for purposes of the "contemporaneous exchange for value" defense under Section 547(e)(2) if the perfection occurred within 10 days of the transfer.

Section 547(c)(3)(B) was amended to give a secured creditor 30 days after the transfer to perfect its purchase money security interest. Moreover a lien, including a purchase money security interest, is deemed to have been perfected contemporaneous with the underlying transfer for purposes of the "contemporaneous exchange for value" defense under Section 547(e)(2) if the perfection occurs within 30 days of the transfer.

These amendments limit the ability of a trustee to avoid the perfection of liens as preferential transfers by increasing the time permitted for a creditor to perfect its liens without the perfection resulting in a preferential transfer.

BAPCPA added Section 547(c)(9), which provides that in nonconsumer (i.e., business) cases, the recovery of a preferential transfer is precluded unless the aggregate property at issue is equal to or greater than $5,000.

This new provision may have the most dramatic impact in liquidation trust cases where contingency fee counsel is typically retained to prosecute even de minimis avoidance actions, where the threat of legal action and its attendant expenses is often times enough to induce a quick settlement.

In Levit v. Ingersoll Rand Fin. Corp. (In re Deprizio Constr. Co.), 874 F.2d 1186 (7th Cir. 1989), the Seventh Circuit held that transfers taking place more than 90 days but prior to one year before a bankruptcy filing, which preferentially benefited insider guarantors, were voidable, and that the transfers could be recovered from the noninsider transferee. This decision was a shock to the lending community, since a bank, with no insider relationship to its borrower, might be exposed to preference actions for up to a year after payment to the bank simply because it had a guaranty from an insider who was indirectly benefited by the payment. As a result of Deprizio, Congress amended Section 550(b) to preclude recovery from a noninsider outside the basic 90-day preference period.

BAPCPA added Section 547(i), which provides that in the event that the trustee successfully avoids a transfer made by the debtor between 90 days and one year prior to bankruptcy to a creditor who is not an insider, but the transfer is for the benefit of a creditor who is an insider, the transfer is avoided only as to the creditor that is an insider. This change became effective immediately upon the enactment of BAPCPA.

28 U.S.C. Section 1409(b) limited venue to the defendant’s district only in cases to recover property worth less than $1,000 or to collect a consumer debt of less than $5,000.

Under BAPCPA, Section 1409(b) was amended to provide:

i. The proper venue where a trustee may commence litigation to recover a money judgment or property based upon a consumer debt of less than $15,000 is the district where the defendant resides

ii. The proper venue where the trustee may commence litigation to recover a money judgment or property against a noninsider based upon a nonconsumer debt of less than $10,000 is the district where the defendant resides

These caps will limit the ability of a trustee to commence adversary proceedings in the district where the debtor’s bankruptcy case is pending when adversary proceedings seek the recovery of amounts less than $15,000 (for consumer debt) and $10,000 (for noninsider, nonconsumer debt). Instead, the trustee will be required to commence such adversary actions in the district where the defendant resides. This will increase litigation costs for the trustee and will likely deter such adversary proceedings.

Prior to BAPCPA, Section 548(a)(1) only allowed the trustee to avoid fraudulent transfers made within one year of the bankruptcy filing.

Under BAPCPA, Section 548(a)(1) was amended to allow the trustee to avoid fraudulent transfers made within two years of the bankruptcy filing. The amended Section 548 also expressly identifies fraudulent transfers to or for the benefit of insiders under an employment contract as being subject to this provision.

This change is not effective until April 20, 2006. By lengthening the reach-back period of Section 548, BAPCPA increases the transfers possibly subject to recovery under Section 548. However, given the U.S. Trustee’s ability, in many cases, to use the longer reach-back period available under state fraudulent transfer law, this change may not have a material impact.

BAPCPA added Section 548(e), which provides that transfers by a debtor to a self-settled trust within 10 years of the bankruptcy filing may, in certain circumstances, be set aside as a fraudulent transfer.

New Section 548(e) of BAPCPA implements a major change in the way the credit default swaps and derivatives contracts between large debtors and sophisticated financial intermediaries are treated. Prior to BAPCPA, financial institutions that owed money to debtors under swaps and derivatives could not acquire obligations owed by the debtor to third parties in order to obtain setoff rights assertable against the debtor in bankruptcy. Such activity was the subject of massive litigation in the ENRON bankruptcy. Under new Section 548(e), financial institutions are able to engage in elaborate "netting agreements" resulting in significant setoffs. The end result may be the material diminution of assets of the estate to the detriment of creditors who are not parties to such agreements.

This article includes contributions from Paul J. Astolfi, Laura J. Eisele, James S. Harrington III, Nicole Y. Lamb-Hale and Kevin A. Reck.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.