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LEGISLATIVE UPDATE S. 1914 - Analysis of Title IV Small Business Bankruptcy

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Editor's Note: This month’s Update focuses on S. 1914, the "Business Bankruptcy Reform Act," introduced by Sen. Charles E. Grassley (R-IA) on April 2. Analysis of Title IV, Small Business Bankruptcy, was prepared by Joseph B. Collins and Joseph H. Reinhardt of Hendel, Collins & Newton P.C. Analysis of Title VI, Miscellaneous, was prepared by Mark N. Berman of Hutchins, Wheeler & Ditmar. The full text of the bill is available at ABI World at 1914—Analysis of Title IV, Small Business Bankruptcy.

Introduction. The small business bankruptcy provisions set forth in Title IV of the proposed bill include many of the recommendations made by the National Bankruptcy Review Commission (NBRC). The NBRC was concerned that chapter 11 attracted many small business debtors that had no realistic hope of confirming a plan of reorganization. Conversely, the NBRC also recognized that a successful reorganization can save jobs, enhance the return to creditors and preserve the going value of a business.

The proposed bill sets up a class of cases to which special reorganization provisions apply. That class includes all debtors having liquidated debt less than $5 million and all single asset real estate cases. This classification includes the great majority of chapter 11 cases. Certain provisions of the bill seem to relax the difficulty of reorganization for a small business. For example, the provisions that modify disclosure statement requirements should assist debtors in small business cases. The preparation of a disclosure statement sufficient to satisfy the requirements of the existing Code has always been a time-consuming and expensive proposition for debtors.

Other sections of the bill seem to make the reorganization process more complex for small companies. The bill not only restricts the time for filing and confirming a plan of reorganization, but also increases the debtor’s duties during that period by requiring additional reporting requirements and attendance at additional conferences.

Section 401. Small Business Defined. Under the present version of the Code, §§101(51)(B) and (51)(C), small business activity is bifurcated into small business entities with total undisputed debt of $2 million or less (exclusive of owners/operators of real estate) and single asset real est

ate cases with undisputed secured debt of $4 million or less. The bifurcation continues with the distinction that the small business provisions are elective §1121(e), while the single asset real estate provisions are mandatory §101(51)(B). The bifurcation concludes with provisions §§1102(a)(3), 1121(e) and 1125(f), which tend to simplify and expedite the reorganization process in small business cases.

The proposed bill will make designation as a small business case mandatory in single asset real estate cases and when the total debt of other debtors is $5 million or less. The bill will eliminate most of the bifurcation between a small business case and single asset real estate cases. Certain distinctions will, however, exist for the single asset real estate case as discussed in the analysis of §§415 and 416 of the proposed bill.

The mandatory application of the small business provisions of the bill will, therefore, result in a substantial change in small business reorganization efforts throughout the country.

Section 402. Flexible Rules for Disclosure Statements. Under the present Code, small business cases have a simplified disclosure statement procedure. Single asset real estate cases face a full disclosure statement requirement. The proposed bill provides the potential for elimination of a disclosure statement altogether, at the court’s discretion. Even if the court elects to proceed with the disclosure statement process, it can do so in a procedurally simplified manner, due to the proposed use of form disclosure statements and the combination of disclosure statement and plan confirmation hearings.

Section 403. Standard Form Disclosure Statements and Plans. This section is a major departure from the present Code, which has no provision for standard form disclosure statements and plans. The proposed bill provides for a balance in the construction of standard forms between "reasonably complete information" for the courts and creditors, and simplicity for debtors. Standard form disclosure statements and plans have the potential for reducing the time that a debtor spends in bankruptcy and the expense of the case.

Section 404. Uniform National Reporting Requirements. This section represents an entirely new set of provisions for reporting, unparalleled in the present Code. These reports deal with profit and loss, financial projections, historical comparisons of the current financial data with past projections, statutory and rules compliance, and tax compliance.

These reporting requirements are likely to add to the administrative cost of a small business case. Although the desirability of the reports cannot be denied, many small businesses do not have the ability to produce them, and will be obliged to seek professional assistance to comply.

Title IV generally seems to shift the responsibility for monitoring the debtors’ day-to-day activities from the U.S. Trustee to the court. The requirement that statutory reports be filed with the court rather than with the U.S. Trustee is one example. In the days preceding the enactment of the Bankruptcy Reform Act of 1978, much concern was expressed about court involvement in the administrative and business aspects of the case, rather than with the application of the law. By involving the court in financial reporting and status conferences (See §406), Congress should be aware that it is taking a step back in that direction.

Section 406. Duties of a Trustee or Debtor-in-Possession in Small Business Cases. The proposed bill specifies certain additional duties to be performed by a small business debtor. Some of these duties (i.e., filing tax returns and paying post-petition taxes, maintenance of insurance, and filing required post-petition financial reports) codify existing practice. Other requirements go beyond existing practice and should be considered separately.

a. Additional Financial Disclosures to be Filed with Voluntary Petition.

The additional documents that a debtor will be required to file with the voluntary petition are typical of those items produced at the request of the U.S. Trustee or a creditors’ committee in a chapter 11 case. What is significant about the requirement is that these documents must be appended to the voluntary petition, or in a case of an involuntary case, filed within three days after the entry of an order of relief. The Bankruptcy Rules have long recognized the fact that a debtor often enters bankruptcy in response to exigent circumstances. See, generally, Rule 1007. The Bankruptcy Rules have established procedures that allow a debtor to seek extensions of time to file the various lists, schedules and statements required to commence a bankruptcy case. In order to make the requirements for small business cases consistent with the debtor’s other bankruptcy duties, proposed §1115(1) might be amended by deleting the phrase "append to the voluntary petition or, in an involuntary case, file within three days after the order for relief" and inserting the word "file."

b. Attendance at Interviews, Conferences and Meetings. Present law requires a debtor to attend a meeting held pursuant to §341. The U.S. Trustee has also assumed the responsibility for conducting initial meetings with the debtor and its largest creditors at the outset of a case. Typically these meetings will determine whether a creditors’ committee is appointed. Proposed §1115(2) modifies current practice by requiring initial debtor interviews and adds the additional requirement for scheduling conferences to be held before the court.

With respect to initial debtor interviews, the law seems to codify the U.S. Trustee’s existing practice and require attendance by the debtor’s senior management personnel and its counsel.

With respect to scheduling conferences, a new requirement is imposed. These conferences are to be held before the court and are apparently non-evidentiary. Since a debtor’s time is at a premium under the expedited requirements for small business cases, one wonders why senior management personnel of a small business would be required to attend a scheduling conference.

c. Depositing Taxes into Separate Accounts. Proposed §1115(6)(C) requires the establishment of separate deposit accounts into which all taxes collected or withheld must be deposited within one business day after receipt. The requirement for the escrow of taxes within one business day after receipt is a substantial departure from the routine practice of most solvent and insolvent companies. Every business that collects a sales tax, for example, would be required to implement a procedure for the daily accounting and escrow of sales tax receipts in order to comply with the law. The imposition of this new requirement will undoubtedly add additional time pressure on owners of small businesses.

Section 407. Plan Filing and Confirmation Deadlines. Proposed §407 reduces the time within which a small business debtor may file a plan from 100 days to 90 days. The section also reduces the time within which a third party can file a plan from 160 days to 90 days. The section also makes it more difficult for the debtor to obtain an extension of the time within which a plan might be filed. Under existing law, an extension may be given if the debtor can show that the need for an increased time period is the result of circumstances for which it should not be held accountable. Under the proposed law, the debtor must demonstrate by "clear and convincing evidence that it is more likely than not to confirm a plan within a reasonable period of time."

The most obvious effect of the compressed time period for the filing of a plan is to place pressure on a debtor to formulate its reorganization alternatives shortly after the commencement of the case. A more subtle effect of this section is to create circumstances in which it would be difficult for a third party to file a competing plan within the statutory time constraints. A debtor that fears a competing plan is not likely to inform its competitor of its reorganization plans until the last day allowed for the filing of a plan. Since the third party will not know whether it can offer a better plan until the debtor’s is filed, and since the preparation of a competing plan requires a significant expenditure of time and effort, third parties may be less likely to expend the resources necessary to file a competing plan.

Section 408. Plan Confirmation Deadline. Section 408 adds a new paragraph to §1129 that mandates the confirmation of a plan on or before 150 days from the commencement of a case. Since most plans are likely to be filed on the 90th day following the commencement of the case, this basically leaves a 60-day period for plan confirmation. During this 60-day period, the following events would have to occur:

1) The filing of a plan and disclosure statement presumably with a motion seeking the court’s conditional approval of the disclosure statement.

2) A hearing on conditional approval of the disclosure statement, together with any objections that might be filed to the debtor’s motion seeking conditional approval.

3) The modification of the disclosure statement in order to comply with any requirements that the court might make in granting conditional approval.

4) The printing of the plan and disclosure statement and the circulation of the plan and disclosure statement to creditors.

5) The expiration of a 25-day solicitation period; Rule 2002(b), plus a three-day mailing period, Rule 9006(f).

6) The preparation of a report on acceptances and other documents and materials necessary to confirm the plan.

7) The confirmation hearing and funding of the plan.

The events noted above, of course, involve only the bankruptcy requirements. Since many plans contemplate a sale of assets or a financing transaction, the debtor would have to coordinate these events so that they take place within the statutory deadlines. Very few chapter 11 cases have been confirmed on such a fast track. Even with the reduced disclosure statement requirements, the schedule for the debtor will be grueling.

Section 409. Prohibition Against Extension of Time. Section 105 gives the bankruptcy court broad authority to enter orders necessary and appropriate to carry out the bankruptcy process. Under this section, the bankruptcy courts have historically entered a wide variety of orders that have been deemed appropriate to further the bankruptcy process.

Proposed §409 will restrict the court’s discretion to grant extensions of time for the filing or confirmation of a plan under §105.

Section 410. Duties of the U.S. Trustee and Bankruptcy Administrator. The present Code does not contain any statutory duties for the U.S. Trustee or bankruptcy administrators that are aimed at small business cases. The duties promulgated in the proposed bill, however, are similar to those that already have been undertaken by many U.S. Trustees without the statutory mandate. For example, an initial conference is held in many jurisdictions in which many of the issues enumerated in proposed §586(a)(3)(H) are discussed.

The proposed statute departs from existing practice by suggesting that the U.S. Trustee should attempt to develop a scheduling order. The concept of a scheduling order is new to the Code. The proposed statute contains no guidance as to what is to be scheduled, how an order will be presented to the court, or what the U.S. Trustee’s rights are if its attempts to reach agreement with a debtor fail.

Section 411. Scheduling Conferences. Under the present Code, the court had the discretion to hold status conferences. The proposed bill mandates status conferences that are requested by parties in interest. As noted in connection with §404, status conferences tend to deal with administrative, rather than legal, aspects of the case.

Section 413. Expanded Grounds for Dismissal or Conversion and Appointment of Trustee. In the present Code, the court has a significant level of discretion as to whether to convert, dismiss or appoint a trustee. The proposed bill serves to significantly reduce this discretion, making conversion or dismissal mandatory in certain specified circumstances. The proposed bill goes on to force motions to dismiss or convert to the top of the court’s docket by requiring hearings to be held within 30 days from the filing of the motion and decisions within 15 days thereafter.

There are two places in the proposed bill where the language might be changed to clarify the apparent intent of the bill. Specifically, §1112(b)(2)(A)(i) should be changed by deleting the word "an" and inserting the word "the." Also, §1112(b)(2)(A)(ii) might be changed by deleting the phrase "by order of" and inserting the phrase "within the period of time ordered by." Also, §1112(b)(3)(J)(i) and §1112(b)(3)(J)(ii) might be revised to conform more precisely with paragraph (2)(A). Specifically, paragraph (3)(J)(i) could be amended to read "within the applicable period of time specified in this title; or" and paragraph 3(J)(ii) could be amended to read "within the period of time ordered by the court; and."

Section 414. Single Asset Real Estate Defined. Currently, a single asset real estate case is limited to situations where the aggregate secured debt does not exceed $4 million. The proposed bill removes the debt limitation and thus subjects all single asset real estate projects to the requirements of a small business case.

The new bill continues to exclude from the definition of single asset real estate cases, those companies in which substantial business, other than the business of operating the real property, is involved. Given the difficulties that real estate projects will have in meeting the deadlines of the proposed bill, and in consideration of the difficulties that a real estate project will have in confirming a plan under the revisions to §1129, it can be anticipated that litigation over the "substantial business" exclusion will increase.

Section 415. Plan Confirmation. There is considerable debate under the present Code and its interpretive case law as to whether there is a "new value exception" to the absolute priority rule. This conundrum frequently arises in single asset real estate cases in which the plan proposes to cramdown the secured creditors’ claim. The proposed bill gives the secured creditor the right to limit the court’s ability to find that the new value exception has been satisfied to circumstances in which the new value is at least equivalent to 25 percent of the value of the real estate. The 25 percent capital contribution would be payable in cash. This requirement, taken together with the time frame in which the single asset case must proceed to confirmation, will make it very difficult for real estate projects to successfully reorganize.

Section 416. Payment of Interest. This section of the proposed bill requires that a debtor pay a contract rate of interest on the value of the creditors’ interest in collateral in a single asset real estate case. This changes the current law, which requires the payment of a fair market rate of interest.

The proposed bill also provides that such payments may begin as early as 30 days from the date that the court determines that the debtor is a single asset real estate case.

S. 1914—Analysis of Title VI, Miscellaneous Provisions

Section 601. Executory Contracts and Unexpired Leases. This section proposes to amend §365(d)(4) to provide that when a debtor is the lessee under a commercial lease, the lease will be deemed rejected and the debtor forced to vacate the premises unless the lease is assumed within 120 days after the beginning of the case. There is also a provision that allows the commercial lease to be assumed at an earlier point in time, i.e. the date of the order confirming a plan of reorganization, but this would appear of limited utility since plans are seldom confirmed within 120 days after a case is filed. Under this amendment, the only way to extend the 120-day period is for the lessor to file a motion asking the court to grant such an extension. Once a lease is rejected, the amendment repeats the language contained in the current version of §365(d)(4) requiring that the property be surrendered to the lessor.

This amendment proposes a significant change in the law. It is a change that will most likely benefit lessors of commercial property at the expense of successful reorganizations and unsecured creditors. The current version of §364(d)(4) allows the debtor or the trustee a shorter period, 60 days, within which to either assume or reject a commercial lease, but also allows the court to extend that period if a motion seeking such an extension is filed within the 60-day period and the court finds cause for the extension. Cause usually requires that the lessor is being paid all of the rent due under the lease for the period of time subsequent to the filing of the case. In actual practice, it is common for the 60-day period to be extended. It is also common for the extension to exceed an additional 60 days.

The amendment is a potential threat to the dividend available to unsecured creditors. When a lease is assumed, not only are defaults cured and the lessor receives compensation for actual damages, but all future damages that might accrue, should the debtor or trustee later fail, become elevated to the level of expenses of administration, i.e. they must be paid in full before unsecured creditors receive any distribution. As a result, unsecured creditors are usually reluctant to permit a debtor or trustee to assume a commercial lease unless it is done either (1) as part of the plan of reorganization where creditors know what they will receive, (2) as the first step in the ultimate transfer of the lease to a third party who will thereafter be responsible to the landlord for the future rent, or (3) when the debtor’s reorganization is so far along that the prospects for a successful reorganization are real enough to warrant the risk of a large administrative claim by a lessor should the reorganization fail.

Section 602. Allowance of Claims or Interests. This section proposes to amend §502(b)(6) to alter the way in which a lessor of real estate calculates its claim against the bankrupt estate. A lessor’s claim has long been a concern in bankruptcy legislation because that portion of the lessor’s claim related to future rent reserved under a long-term lease could dwarf the claims of other creditors who often do not have a similar opportunity to mitigate damages, i.e. reduce their damages by finding a new tenant for the premises. Historically, the lessor’s claim has been limited or "capped" with the current version of the statute, limiting that claim to the rent reserved under the lease, without acceleration, for the greater of one year, or 15 percent of the remaining term of the lease, not to exceed three years, plus any rent owed as of the earlier of the date of the filing of the case or the date of surrender/repossession of the property. The proposed amendment will re-write the limit of the lessor’s claim

The amendment also requires that the lessor mitigate its claim to the extent mitigation is required by law. The mitigation is applied against the lessor’s total damage calculation before applying the limitations or "cap" imposed on claims for future rent.

The amendment has the benefit of codifying the lessor’s obligation to mitigate its claim for damages, although the reference to "any mitigation required by law" suggests that mitigation requirements may vary from state to state and that some states may not require any mitigation at all. The amendment also resolves a conflict in the case law regarding whether mitigation, i.e. the reduction in the claim, is applied to the lessor’s damage calculation before it is limited by this section, or only after the lessor’s claim has been capped. By using the words "monetary obligations" rather than "rent," the amendment also attempts to prevent a lessor from including in its claim a sum attributable to a non-monetary obligation that is denominated as rent under the lease.

The amendment allows the lessor to include in its claim all rent accrued but unpaid up to the date of the filing of this case. The current version of §502(b)(6) uses the earlier of the date of the filing of the case or the date of surrender/repossession of the premises. As a result, in those situations where the lessor has recovered possession of the premises prior to the filing of the case but has not yet found a new tenant, the lessor will have a larger claim in the case.

The most significant change proposed by the amendment is to allow a lessor to include as part of its claim any cost reasonably incurred or that will be reasonably incurred within the next year after termination of the lease. The determination of what those costs are is made on the date the claim is to be "determined." It is unclear whether the date of determination is the date the lessor files its claim, the date the bankruptcy court rules on any challenge to the claim or the date an appellate court might overturn a bankruptcy court’s previously erroneous determination. This uncertainty could make debtors, trustees and creditors reluctant to object to a lessor’s claim because of fear that additional costs incurred within the year after termination of the lease, but not then part of the claim, might be added to the claim. The lessor can be expected to include in its claim the costs of brokers’ fees or commissions and tenant improvements relating to securing a new tenant, because those costs are specifically included in the amendment as examples. Less obvious costs that a lessor can be expected to include in its claim include advertising, security, utilities, taxes, legal costs related to negotiating and documenting a new tenant’s lease, moving expenses paid by the lessor to the new lessee, and the like. Disputes are likely to flourish over whether these costs are "reasonably incurred." Advocates for other parties in a bankruptcy case also would be expected to argue that these costs should not be included in the lessor’s claim because they are as likely to be incurred by the lessor after the normal, non-bankruptcy related termination of a lease. They are only being accelerated due to the bankruptcy-related termination of the lease.

Section 603. Expedited Appeals of Bankruptcy Cases to Courts of Appeals. This section proposes to amend §158 of Title 28 of the U.S. Code which contains the statutory provisions governing appeals in bankruptcy cases. The proposed amendment maintains the existing structure of bankruptcy appeals, but adds a new feature that applies exclusively in circumstances where an appeal has been taken from a bankruptcy court to the federal district court. In that event, if the district court has not filed its decision within 30 days after the appeal was filed, then the amendment would permit the appeal to be taken to the appropriate court of appeals. In such an instance, the court of appeals is required by the amendment to issue an order directing the clerk of the district court from which the appeal was taken to make the bankruptcy court’s decision the decision of the district court. That decision is then made the subject of the appeal to the court of appeals.

The current bankruptcy appeal system provides for two levels of appeal. First, an appeal may be taken from the bankruptcy court to the district court or, if the circuit has established a bankruptcy appellate panel (BAP), then the appeal may go from the bankruptcy court to the BAP. A further appeal may then be taken from the decision of either the district court or the BAP to the courts of appeal. When the NBRC considered recommendations to Congress, it issued recommendation 3.1.3 to the effect that Congress should eliminate the first layer of review, i.e. all appeals to the district court or the BAP should be eliminated. Instead, all appeals would go directly from the bankruptcy courts to the courts of appeal. The proposed amendment does not implement the Commission’s rec-ommendation.

The amendment appears to address the situation where a decision is needed from the district court within a 30-day time frame but no decision is forthcoming. In such an instance, the amendment will allow a party to the appeal to jump from the district court and pursue the matter in the appropriate court of appeal. However, there is no time requirement for a decision in that higher court. Furthermore, no parallel provision is proposed for matters pending before the BAP. This might motivate appellants to choose to pursue an appeal in the district court rather than the BAP if they view quick access to the court of appeals as advantageous.

The amendment appears to anticipate the elimination of the district courts from appellate review of bankruptcy cases except to the extent emergency consideration requires a resolution within 30 days. It is unlikely that an appeal from a decision of a bankruptcy court will be capable of going through the normal process of designating an appellate record, designating issues on appeal, briefing and oral argument leading to a decision within 30 days after the appeal is filed with the district court. It is possible that adoption of the amendment will result in emergency appeals going to the district court and BAP, while regular, non-emergency appeals will be heard whether by the BAP or the court of appeals.

Section 604. Creditors in Equity Security Holders’ Committees. Section 604 proposes to amend §1102(a)(2) to permit the court to order a change in the membership of a committee appointed in a bankruptcy case. In order to make such an order, the court must first receive a request from a party in interest although it is allowed to act on its own motion. The court also must determine that the change in committee membership is necessary to ensure adequate representation of creditors or equity security holders.

The existing §1102(a)(2) allows the court to order the appointment of additional committees of creditors or of equity security holders. It is silent about the court’s authority to order a change in the membership of an appointed committee. Some bankruptcy courts have found that authority in §105. The amendment would eliminate any confusion in this issue.

Section 605. Repeal of Sunset Provisions. This section proposes to eliminate the sunset provision applicable to chapter 12 of the Bankruptcy Code, which governs the adjustment of debts of a family farmer with regular annual income. If the amendment is adopted, chapter 12 will be become a permanent feature of the Code.

Journal Date: 
Friday, May 1, 1998

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