Curbing Gap Period Abuses Under 303

Curbing Gap Period Abuses Under 303

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The Bankruptcy Code's "gap period" provisions found at 11 U.S.C. §303(f) permit debtors during the period between the filing of an involuntary petition and entry of the order for relief to operate their businesses without complying with most of the Bankruptcy Code's restrictions or disclosure requirements, while simultaneously enjoying the benefits of the automatic stay. Gap debtors can exploit these provisions, especially with respect to secured creditors who, absent bankruptcy, could protect their interests in their collateral, but due to the automatic stay, have few means by which to protect their collateral during the gap period. Although §303(e) authorizes courts to restrict debtors' operations during the gap period, courts generally have interpreted the statute narrowly and have imposed substantial evidentiary burdens on creditors seeking restrictions. Due to the reluctance of courts to impose restrictions on gap debtors, Congress should modify §303(f) to enable secured creditors to protect their interests in collateral during the critical gap period.

The Gap Period and the Automatic Stay

The gap period is commenced upon the filing of an involuntary petition and terminates only once the court either enters an order for relief or dismisses the petition. The purpose of the gap period is to enable a debtor against which an involuntary petition has been filed to carry on its business in the ordinary course, pending a determination by the court whether to enter an order for relief. Section 303(f) provides as follows:

Notwithstanding §363 of this title, except to the extent the court orders otherwise, and until an order for relief in the case, any business of the debtor may continue to operate, and the debtor may continue to use, acquire or dispose of property as if an involuntary case concerning the debtor had not been commenced. (Emphasis added.)

Section 303(f) thereby protects gap debtors where no order for relief is ever entered.

Although §303(f) enables a gap debtor to continue to use, acquire and dispose of property pending a ruling on the involuntary petition, it poses significant risks to secured creditors, due to the automatic stay of 11 U.S.C. §362. Section 362 imposes the stay upon the filing of the petition under §303, not when the order for relief is entered.

Hence, a gap debtor can use a secured creditor's collateral or dispose of proceeds such as rents (1) without making any payments on the obligation, (2) without affording the secured creditor adequate protection for the use of the collateral and (3) without disclosing the use to the secured creditor. Meanwhile, the secured creditor is barred by the automatic stay from taking action to protect its interest in collateral to which it would be entitled under non-bankruptcy law had no petition been filed. Although §303(f) permits a secured creditor to seek entry of an order protecting its interest, as discussed below, courts have been reluctant to restrict the operations of gap debtors. As a result, §303(f) can be used by a debtor to frustrate the legitimate rights of secured creditors by disposing of collateral proceeds such as rents in violation of the secured creditor's rights.

The risk of abuse is greatest in cases such as single asset real estate cases in which the secured creditor has an interest in the debtor's rental income. In single asset real estate cases, during the gap period, the debtor can dispose of cash collateral, such as rents, without restriction, and the gap debtor is under no requirement to afford the secured creditor adequate protection for the use of the cash collateral or even to disclose the disposition of the rents. Before the involuntary petition is filed, the secured creditor can exercise its assignment of rents to collect rental income. After the order for relief is entered, the debtor is barred from using any cash collateral without either court approval or consent of the secured creditor. However, during the gap period, the gap debtor can dispose of the cash collateral without either restriction or disclosure.

For example, upon the filing of an involuntary petition, the gap debtor has no obligation to continue to pay debt service, insurance escrows or tax escrows. Instead, the debtor can continue to collect rents (since the secured creditor is barred from exercising its assignment of rents) and to use the rents to pay any obligations it chooses to pay, including debts to insiders and affiliates for loans or management fees. Not only can the gap debtor make the payments, but it is under no obligation to report the payments. The potential for abuse is tremendous.

The Threshold to Limit Rights

Section 303(f) authorizes courts during the gap period, on the request of a secured creditor, to prohibit or condition the use, sale or lease of collateral. However, not only is the burden inappropriately placed on the lender to seek affirmative relief, but courts that have construed the section have set an unreasonably high threshold for creditors to meet. Moreover, because the Bankruptcy Code imposes no disclosure requirements on gap debtors, and the automatic stay enjoins creditors from exercising their rights under non-bankruptcy law, the secured creditor may not know of the wrongful disposition of its collateral until long after the act.

In re DiLorenzo, 161 B.R. 752 (Bankr. S.D.N.Y. 1993), is a prime example of a decision which placed an unreasonable burden on creditors seeking to limit a gap debtor's rights. In DiLorenzo, the court stated:

Pursuant to §303(f), unless the court orders otherwise, the alleged debtor is free to continue to operate his business and use, acquire and dispose of his property free from the constraints imposed by §363, as if the involuntary petition was not filed [footnote quoting §303(f) omitted]. That right has been described as "[t]he most important protection given [an alleged debtor] by the Code..." The statute does not specify either the cause sufficient to give rise to relief thereunder, or the nature of the relief available to an aggrieved party. However, the legislative history instructs that an alleged debtor should remain in control of his assets unless it is shown that he "may attempt to abscond with assets, dispose of them at less than their fair market value, or dismantle his business, all to the detriment of [his] creditors." (emphasis added)

DiLorenzo, 161 B.R. at 754 (citations omitted). In DiLorenzo, the court refused to require the gap debtor to give the petitioning creditors minimal notice before encumbering or transferring assets other than as necessary to meet reasonable living expenses.

In In re ROPT Limited Partnership, Case No. 96-15114 (Bankr. D. Mass. July 22, 1996), the court ruled that the authority granted in §303(f) to limit debtors' actions is extremely limited. The court denied a motion by a secured creditor in this single asset real estate case to require the gap debtor to account for and segregate the creditor's cash collateral and to prohibit the debtor from using the cash collateral for any purposes other than paying essential post-petition expenses of operating, maintaining, repairing and insuring the real property. The court in that case subsequently dismissed the involuntary petition after the debtor used the lender's cash collateral to pay off debts owed to petitioning creditors.

Gap Debtor Abuse Through Delay

Rule 1013(a) of the Federal Rules of Bankruptcy Procedure requires courts to act quickly on involuntary petitions in order to protect both the gap debtor and the creditors. Rule 1013(a) provides that "[t]he court shall determine the issues of a contested petition at the earliest practicable time and forthwith enter an order for relief, dismiss the petition or enter other appropriate orders." Unfortunately, this rule does not guarantee a speedy adjudication of the gap debtor's status. Indeed, a study of 515 involuntary petitions filed in 1988 and 1989 found gap periods ranging from a low of one month to a high of 48 months with a mean gap period of 12.7 months. Joseph Mullin, "Bridging the Gap: Defining the Debtor's Status During the Involuntary Gap Period," 61 U. Chi. L. Rev. 1091, 1094 n.17 (1994).

The length of the gap period depends not only upon the court's calendar, but also upon the actions by the petitioning creditors and the gap debtor. A gap debtor interested in exploiting the benefits of the gap period can work with the petitioners to extend the period. For example, friendly petitioning creditors (or petitioning general partners in partnership cases) can extend the time within which the gap debtor has to file an answer to an involuntary petition by failing to serve the summons timely, by consensually extending the time to file a response, or after a response to the involuntary petition has been filed, by delaying the hearing on the petition.

Working in concert, the debtor with the cooperation of the petitioning creditors or general partners can continue to operate during the gap period without court supervision, and can effectively extend other deadlines provided for in the Bankruptcy Code that commence only upon the entry of the order for relief. Meanwhile, during the gap period, the gap debtor can utilize proceeds or rents that are generated from the secured creditor's collateral almost without restriction.

Even gap debtors with adverse petitioning creditors can extend the gap period through obstructionist efforts that delay entry of the order for relief. See In re Wynn, 889 F.2d 644, 645 (5th Cir. 1989), in which the gap debtor was able to extend the gap period for two years through discovery delays.

As a result, the secured creditor has no certain avenue to protect its security interest. It cannot foreclose its lien and cannot prevent the debtor from dissipating its cash. The result is particularly burdensome to a lender in a single asset real estate case in which it has a perfected security interest in the property's rental income. As the primary mortgagor is likely to be undersecured in these cases, the cash flow from the rents is a critical part of the mortgagor's security and the rents, once dissipated, are impossible to recover. If a subsequently appointed trustee has a claim under §549 to recover the spent rents, then it must undertake the administrative burden and expense to file and prosecute an adversary proceeding to recover the transfers. Typically, the debtor has no other assets in which to grant the creditor a replacement lien. The result is inconsistent with the protections that Congress granted to real property lenders in 1994, when it amended §552(b) to clarify the continuation of security interests in rents post-petition.

Corrective Legislation

The National Bankruptcy Review Commission did not address these problems in the report it issued last month. In addition to considering the Commission's report, Congress should consider modifying §303(f) to limit increasing abuse. Two limited modification would suffice. First, Congress should except §§363(c)(2), (3) and (4) from the operation of §303(f). Sections 363(c) (2), (3) and (4) govern a debtor's use of cash collateral, require the debtor to segregate cash collateral in its possession, custody or control, and prohibit a debtor from using, selling or leasing cash collateral without the secured creditor's consent or court order. Excepting §§363(c)(2), (3) and (4) from the operation of §303(f) would protect secured creditors' rights in cash collateral while enabling a debtor to operate its business in the ordinary course with only minor restrictions.

Second, Congress should modify §303(f) to provide that, although a gap debtor may operate its business in the ordinary course until an order for relief is granted, the court may prohibit the gap debtor from disposing of assets for less than their fair market value, or from using cash collateral to pay pre-petition debt or non-essential post-petition expenses or services.

The Exclusive Period

A second problem created by involuntary petitions involves the exclusive period during which a chapter 11 debtor may file a plan of reorganization. Section 1121(b) of the Bankruptcy Code provides that "except as otherwise provided in this section, only the debtor may file a plan until after the 120 days after the date of the order for relief under this chapter." Where an involuntary debtor opposes the entry of an order for relief it will have ample time prior to the entry of an order for relief to prepare a plan, and it should not need a full 120-day exclusive period.

Congress can remedy this problem in one of several ways. First, Congress can amend §1121(b) to provide that the exclusive period terminates on the date the order for relief is entered or 120 days after the date of the filing of the involuntary petition, whichever is earlier. As a result, the 120-day period would commence immediately, though the debtor would not be required to file a plan any earlier than the date of the order for relief if the order for relief were entered more than 120 days after the petition date. Alternatively, Congress could reduce the length of the exclusive period that follows an involuntary petition. In any event, the result should be to limit the exclusive time period for the debtor to file its plan in an involuntary case to comport with the spirit and underlying intent of the Code.


[1] The authors acknowledge Mary Theresa Moran and Daniel Carragher of Day, Berry &Howard for their assistance in preparing this article.[RETURN TO TEXT]

Journal Date: 
Saturday, November 1, 1997