This paper highlights provisions of the Act affecting commercial bankruptcy cases and focuses on the impact on businesses which sell goods on open credit.  Unsecured creditors receive some help under the new law but there are other provisions which have a hidden negative impact on creditors.

Reduced Time to Assume or Reject Nonresidential Real Property Leases

Landlords will benefit from the amendments which place an absolute limit on the amount of time a debtor has to determine whether it wishes to assume or reject a lease of nonresidential real property.  The lease is deemed rejected if not assumed by the earlier of 120 days after the bankruptcy is filed or the entry of an order confirming the debtor’s Plan.  The court may extend this 120 day period for only 90 additional days on motion of the debtor or lessor for good cause shown.  No further extensions may be granted unless the lessor consents in writing.

This limitation on time to assume or reject leases can backfire on unsecured creditors, since debtors may have to make decisions before they have all the necessary information to know which sites should be retained and which should be rejected.  In the event the debtor guesses wrong and ultimately breaches one of the assumed leases, the damages for this breach are an administrative claim against the estate which is paid ahead of and reduces funds available to unsecured creditors.  There is some protection in the form of a cap on the amount of administrative expense damages.  While the cap limits the amount of administrative claim to two years’ worth of rental fees, this still could have a significant impact on unsecured creditors, since these damages are paid 100% before any distributions to unsecured creditors. 

Goods Returned on Consent of the Seller

The Code previously allowed the debtor, with court approval, to return pre-petition goods to the seller pursuant to Section 546 (as a result of a motion made within 120 days after the filing of the bankruptcy).  This provision is unchanged but there is a clarification that any such return of goods is subject to the prior rights of secured creditors.  Return of goods has rarely been used since it was originally adopted. 

Protection of Utilities

Section 366(e) was originally enacted to assure post-petition payment to utilities in Chapter 11 cases.  A utility is permitted to terminate service to a Chapter 11 debtor if it does not receive adequate assurance of payment for its post-petition services within 30 days following the petition.  The term “adequate assurance” is defined in the amended Code to mean a cash deposit, letter of credit, certificate of deposit, surety bond, prepayment, or other form of security to which the utility agrees.  This amendment clarifies that adequate assurance does not include the administrative expense priority that a utility automatically receives for unpaid post-petition delivery of utilities.  Such an administrative claim is of little value when the Chapter 11 debtor converts to Chapter 7!  Further, while the court may modify the amount of adequate assurance under Section 366(e), the court cannot take into account the fact that the utility did not have a security deposit prior to the petition, or the fact that the debtor has timely paid its pre-petition bills.  A utility may recover or set off against a pre-petition deposit from a Chapter 11 debtor without notice or order of the court.

While this may be good for utilities, it is detrimental to unsecured trade creditors.  It means that the monies available from post-petition financing will have to be increased (with obvious additional costs to the estate) in order to provide funds to make 30 or 60 day advance utility deposits.  With a retail debtor or other entity with multiple locations, these deposits can pose a significant burden on the estate and therefore ultimately reduce monies available for distribution to the unsecured creditors.

Small Business Case Provisions

A small business case is one in which the debtors engage in commercial or business activities other than the owning or operating of real estate; the debtor has noncontingent liquidated secured and unsecured debts that do not exceed $2,000,000 on the date of petition (excluding debts owed to affiliates or insiders of the debtor); and there has been no committee of unsecured creditors appointed in the case or the court has determined that the existing creditors’ committee is not sufficiently active or representative to provide effective oversight of the debtor.  If a creditors’ committee has been appointed and is active in the case, then the debtor is not considered a small business debtor regardless of the aggregate amount of its debts.

Section 1125 is amended to provide that, in small business cases, the court may determine that the Plan of Reorganization  or Liquidation itself provides adequate information and that a separate Disclosure Statement is not necessary.  Alternatively the court is given the authority to conditionally approve a Disclosure Statement in a small business case, subject to final approval after noticing a hearing.  The hearing on the final approval of the Disclosure Statement may be combined with the confirmation hearing on the Plan provided 25 days notice is given.  Official forms will be developed for Disclosure Statements and Plans for small business cases.

In small business cases, the debtor has the exclusive right to file a Plan within 180 days after the filing of the petition.  Moreover, the total time available for filing a Plan and Disclosure Statement, regardless of who files them, is 300 days after the bankruptcy is filed.  These time periods may be extended for cause only if the debtor demonstrates that it is more likely than not that the court will confirm a Plan within a reasonable amount of time.  If a Plan is timely filed in a small business case, the court must confirm the plan within 45 days after it is filed.  There are some provisions allowing extension of that time period. 

For small businesses with multiple filings, Section 362 is amended to provide that the automatic stay does not apply if the debtor is a debtor in another small business case that was pending when the petition is filed, was a debtor in a small business case that was dismissed for any reason within the prior two years, or was a debtor in a small business case in which a Plan was confirmed within the past two years.  Additionally, if the debtor is an entity that has acquired substantially all of the assets or business of a small business debtor fitting the prior descriptions, the automatic stay will not apply in a bankruptcy case with such entity unless there are certain findings made related to the good faith of the new filing debtor.

Expanded Grounds for Dismissal or Conversion of Chapter 11 Cases

Section 1112 now sets out a list of 16 acts or omissions, including:

·        Substantial or continuing loss to or diminution of the estate and absence of reasonable likelihood of rehabilitation;

·        Gross mismanagement of the estate;

·        Failure to maintain appropriate insurance that poses a risk to the estate or to the public;

·        Unauthorized use of cash collateral substantially harmful to one or more creditors;

·        Failure to comply with an order of the court;

·        Unexcused failure to satisfy timely any filing or reporting requirement established by Title 11 or by rule applicable to the case;

·        Failure to attend a meeting of creditors under Section 341 or an examination ordered under Rule 2004 without good cause;

·        Failure to timely provide information or attend meetings reasonably requested by the U.S. Trustee or Bankruptcy Administrator;

·        Failure to timely pay taxes owed after the date of the order for relief or to file tax returns due after the date of the order for relief;

·        Failure to file a disclosure statement, or to file and confirm a plan within the time fixed by this title or by order of the court;

·        Failure to pay any fees or charges required by Chapter 123 of Title 28;

·        Revocation of an order of confirmation under Section 1144;

·        Inability to effectuate substantial confirmation of a confirmed plan;

·        Material default by the debtor with respect to confirmed plan;

·        Termination of a confirmed plan by reason of the occurrence of a condition specified in the plan; and

·        Failure of the debtor to pay any domestic support obligations that first become payable after the date of the filing of the petition.

Any of these 16 acts or omissions provide a basis for dismissal or conversion of the case.  Section 1112 requires the court to dismiss or convert the case unless there are unusual circumstances identified by the court that establish that such relief is not in the best interest of creditors and the estate, there is a likelihood that a Plan will be confirmed in a timely manner, there is reasonable justification for the debtor’s conduct which gives rise to the grounds for dismissal or conversion, and the grounds for dismissal or conversion will be cured within a reasonable time.  These provisions on dismissal and conversion apply in all Chapter 11 cases, including small business cases. 

Timing for Court Ruling for Dismissal and Conversion Motions in Chapter 11

The court is now required to commence a hearing on a motion to dismiss or convert a Chapter 11 case within 30 days after the motion is filed and to decide the motion within 15 days after the commencement of the hearing, unless the movant consents to a continuance for a specified period of time or compelling circumstances prevent the court from meeting these time limits. 

Appointment of a Trustee or Examiner in Chapter 11

If grounds exist to convert or dismiss the case under Section 1112 as described above, but the court determines that appointment of a trustee or examiner is in the best interest of the creditors and the estate, the court must order the appointment of the trustee or examiner. 

Amendment on Administrative Expenses When Nonresidential Lease is Assumed and Then Rejected

If a nonresidential lease is first assumed and then rejected, a sum equal to all monetary obligations due (excluding those arising from or relating to a failure to operate or to a penalty provision) for a period of two years after the date of rejection or actual turnover of the premises is an administrative expense.  The claim for the remaining sums due for the balance of the lease term is a pre-petition unsecured claim subject to the previously existing landlord’s cap set out in Section 502(b)(6).

Protection of Purchase Money Security Interest

Section 547(c)(3) previously exempted a purchase money security interest from avoidance as a preference if it was perfected within 20 days after the debtor received possession of the property securing the debt.  Under the revisions, that section is amended to expand the 20 day period to 30 days.  This helps trade creditors who sell inventory and equipment subject to a purchase money lien and reflects the fact that a security interest cannot attach until the debtor has rights in the collateral. 

In a related amendment to Section 547(e)(2), the Code makes a second adjustment to increase the grace period for perfection from ten to thirty days in order to make it consistent with Section 547(c)(3).  Secured lenders should keep in mind however that the new thirty-day grace period for filing only applies to preference attacks.  The new bankruptcy law has no effect on the basic UCC rule that a purchase money security interest in equipment must be perfected within twenty days after the debtor gets possession of the equipment in order to trump a prior blanket filing.  (See UCC Section 9-324(a).)

Reclamation

Section 546(c) is amended to substantially alter the reclamation rights of sellers of goods.  The amendment clarifies that any right of reclamation held by the seller is subject to prior rights of a holder of a security interest in the goods and in the proceeds of those goods.  This is simply a clarified statement of what the law already was.  Also, the right of reclamation is expanded to apply to goods received by the debtor within 45 days (rather than the previous 10 days) prior to bankruptcy and the seller has until 45 days after receipt of the goods to make the reclamation demand.  If a bankruptcy is filed before the 45 days expires, the reclaiming Seller has 20 days after commencement of the case to demand reclamation in writing.  Finally, the prior provision in Section 546(c) that gave the courts the discretion to deny a reclamation claim if the Court alternatively granted an administrative priority to the seller, has been deleted from the Code.  It is unclear how this will impact reclaiming creditors but it may signal that return of goods is the only option.

The new law also provides that the reclaiming creditor can seek immediate payment.  The debtor must respond with payment or adequate assurance of payment or else the creditor has grounds to file a motion for conversion of the case.  The amendment also eliminates reference to State UCC law and therefore raises the question of whether reclaiming creditors still have to show that the reclaimed goods were on hand at the time the reclamation demand was received.  Until case law tells us otherwise, reclaiming creditors should still verify that the reclaimed goods are on hand when the reclamation demand is delivered to the debtor.

Administrative Expense Treatment for Goods Sold Within 20 Days Prior to Bankruptcy

Section 503(b) is amended to provide an unexpected and very valuable bonus for unsecured creditors.  The new law only benefits unsecured trade creditors, not lenders.  Sellers will now receive an administrative claim for the “value” of any goods received by the debtor within 20 days before the commencement of the case if the goods were sold to the debtor in the ordinary course of the debtor’s business.  Effectively, this means unsecured trade creditors will receive post-petition payment for unpaid pre-petition shipments which were received by the debtor in the 20 day window prior to filing.  It is unclear whether the inclusion of the word “value” is designed to restrict payment to the Seller’s cost without any profit added.  Of course, this may reduce distributions ultimately available to the class of unsecured creditors.

Involuntary Cases

In involuntary cases, the issue arises of whether debts of the filing creditors are subject to bona fide dispute.  Section 303 is revised to provide that a debt is subject to a bona fide dispute if there is a bona fide dispute as to liability or amount.  This means more money out the door on account of pre-petition unsecured claims.

Employee Wage and Benefit Priorities

Section 507(a) is amended to increase the maximum priority for wages, salaries, and commissions from $4,950 to $10,000 and to extend the applicable pre-petition time period for calculation of this benefit from 90 days to 180 days.

Fraudulent Transfers

Section 548 governing fraudulent transfers is amended so that transfers made within two years (rather than the current one year) prior to the petition date may be avoided.  However, the effective date of this revision is April 2006.  Also, the amendments provide that transfers and obligations that are subject to avoidance include any transfer or obligation to or for the benefit of an insider under an employment contract.    Amendments also specifically point out that transfers or obligations made to or for the benefit of an insider under an employment contract are avoidable if they otherwise satisfy the requirements of Section 548 and are not in the ordinary course of business.  The effective date of this provision was delayed one year to provide adequate notice. 

Even though secured transactions are not often attacked as fraudulent conveyances, this new rule could have an impact on secured parties, including trade creditors who take back a purchase money line on goods sold.  For example, suppose a secured party uses the “strict foreclosure” mechanism allowed under Revised Article 9 to seize collateral without a sale.  The “strict foreclosure” takes place eighteen months before the debtor files bankruptcy.  The trustee could seek to avoid the “strict foreclosure” on the ground that the collateral was worth more than the unpaid balance of the debt, and that retention of the surplus was a fraudulent conveyance under Section 548.  The new two-year reach-back thus increases secured creditor exposure to fraudulent conveyance attack.  The new bankruptcy law does not change the right of a trustee to reach-back even further by using state statutes of limitations governing fraudulent conveyances so long as the trustee can find the shoes of an actual creditor to step into.

Asset Protection Trust

Section 548 on fraudulent conveyances is amended to provide that the trustee may avoid any transfer of the debtor’s property that was made within ten years before the commencement of the case if the transfer was made by the debtor to a self-settled trust or similar device, the debtor is the beneficiary of the trust or device, and the debtor made the transfer with actual intent to hinder, delay, or defraud any entity to which the debtor was or became indebted on or after the date of the transfer.  This amendment may greatly assist the trustee in reaching assets that were not available under the old law.

Notices

Under Section 342(c), if within ninety days before a voluntary petition, a creditor supplies the debtor in at least two communications with an account number and the address at which the creditor requests to receive correspondence, then any notice required by the Bankruptcy Code to be sent by the debtor to the creditor must be sent to that address and include the debtor’s account number.  Creditors which mail statements on a monthly basis can now therefore direct bankruptcy notices and correspondence and avoid having critical notices lost in the lock box, or wherever it is they disappear to.

The creditor in an individual Chapter 7 or Chapter 13 case may file with the court and serve on the debtor a notice of address to be used for all notices to the creditor in that case.  The creditor may also file with the court notice of an address to be used by all bankruptcy courts or by particular bankruptcy courts for all Chapter 7 and Chapter 13 cases in which that entity is a creditor.

Once these actions are taken by the creditor, any notice given by the debtor which is not addressed to the address provided is ineffective until it is actually brought to the attention of the creditor.  Moreover if the creditor designates a person or department to receive notices and has reasonable procedures to deliver notices to that person or department, a notice is not deemed to be brought to the attention of the creditor until the person or department named actually receives it.  No monetary penalties may be imposed on creditors for violations of the stay or for failure to turn over property of the estate unless the creditor’s complained of conduct occurred after the creditor received an “effective notice” under the amendments.

Changes in Preference Law

•             Ordinary Course Defense

The preference provision requiring that sellers return payments or other assets received within 90 days of the bankruptcy remains in place.  However, there is significant help in ‘satisfying’ requirements for the “ordinary course of business” defense.

The requirements for the ordinary course defense at Section 547(c)(2) are amended to require (1) that the debt be incurred by the debtor in the ordinary course of business or financial affairs of the debtor and (2) either that the payment was made in the ordinary course of business or financial affairs of the debtor and the transferee or that the payment was made according to ordinary business terms.  Previously all three prongs of the ordinary course defense were required.  Now creditors can successfully assert the ordinary course of business defense by either showing that the payments were ordinary in terms of the course of dealing between the parties or that they were ordinary in terms of the course of dealing common in the creditor’s industry.  The first prong that the transfer be incurred in the ordinary course of the business or financial affairs of the debtor remains in place in either case. 

•             Small Preferences in Cases With Non-Consumer Debtors

There is new protection from disgorgement of preferences.  If the debtor’s debts are not primarily consumer debts and the transfer is less than $5,000, there can be no preference attack.

This revision not only protects cash payments made to a creditor by a nonconsumer debtor within ninety days of bankruptcy (or one year of the transfer is an insider), but also protects last minute security interests which are obtained on collateral worth less than $5,000.00 or last minute filing of a financing statement to perfect a security interest where the value of the collateral is less than $5,000.00.

•               Venue for Litigation

A trustee or debtor-in-possession is now limited in where it can bring litigation to recover a money judgment or property.  Historically, suit was brought wherever the bankruptcy was filed.  Now, litigation must be brought in the district where the defendant resides if the proceeding is based on nonconsumer debt of less than $10,000.  There is an exception if the litigation is against an insider of the debtor.

The issue of the defendant’s residence is important.  A corporate entity’s residence is controlled by state law but generally a corporation “resides” in any judicial district where it does business and is subject to personal jurisdiction.  The actual language of the venue provisions did not change.

Limitation on Extensions of the Exclusive Period

The debtor in bankruptcy generally had 120 days during which it had the exclusive right to file a Plan of Reorganization or Liquidation.  In large cases, this time period was often extended multiple times.  The amendments provide that, under Section 1129(d), the exclusive period may not be extended beyond a date that is 18 months after the bankruptcy filing.  Further, the period of time that the debtor has to obtain acceptances of the plan may not be extended beyond a date that is 20 months after the bankruptcy filing.

This new protection is essentially meaningless for many of the bankruptcy cases filed.  Only the mega-cases need the extra long period of time in order to reorganize.  Most companies are able to file their Plan of Reorganization or Liquidation within the initial exclusive period or shortly thereafter.  This limitation gives a debtor up to (with extensions) eighteen months instead of four months to file its Plan and twenty months instead of six months to confirm its Plan.  These are substantial periods of time which will have little impact on the average case.