Statutory Schizophrenia and the New Chapter 11

Statutory Schizophrenia and the New Chapter 11

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The text of chapter 11, as well as the decision-making process that shapes the outcome of reorganization cases, has been changed substantially by the Bankruptcy Abuse Prevention and Consumer Protection Act of 20051 (BAPCPA).2 This article focuses on the stresses being placed on the bankruptcy system as it attempts to give effect to two competing and often conflicting policy imperatives voiced by BAPCPA. First, BAPCPA addresses actual or perceived management misuse of the chapter 11 remedy, including use of the courts to "bless" payments to managers perceived as being excessive.3 Under BAPCPA, the U.S. Trustee (UST) has been directed to file a motion seeking the appointment of a chapter 11 trustee when (1) confronted with a reasonable suspicion of certain pre-bankruptcy bad management conduct,4 (2) strict limitations are being imposed on the ability of debtors to pay highly compensated executives,5 (3) implementing key retention bonus6 and severance programs,7 and (4) compensation paid to certain individuals prior to the commencement of a bankruptcy case will be subject to disgorgement under appropriate circumstances.8 The remedies embodied in these new chapter 11 provisions, much like strong medicine, may have a salutary effect, but almost certainly will have unwanted side effects on case administration, much as aspirin relieves pain but can cause stomach upset. The uncertainty, delay and added expense that may be engendered by these BAPCPA provisions could be particularly nettlesome if the courts are to move reorganization cases more quickly through the bankruptcy system to give effect to the second policy imperative embedded in BAPCPA chapter 11 provisions: "the need for speed."9 This second policy imperative is given effect by several provisions of BAPCPA, including those imposing fixed deadlines on (1) the exclusive right of a debtor in chapter 11 to file a reorganization plan and solicit acceptances of such plan,10 and (2) the period during which a debtor must determine whether or not to assume or reject each of its leases for each of its nonresidential real property leaseholds.11 As will be discussed below, these changes to the Bankruptcy Code also come to us with their own set of potentially unwanted side effects.

BAPCPA Restrictions on Management Prerogatives

BAPCPA contains a number of provisions designed to protect specific constituencies and the general public from actual or perceived management misuse of the chapter 11 process. First, under prior law, the UST had the discretion to move for the appointment of a chapter 11 trustee. After BAPCPA, the UST is directed by new §1104(e) to move for the appointment of a chapter 11 trustee where facts give rise to a reasonable suspicion of certain pre-bankruptcy misconduct.12

The United States Trustee shall move for the appointment of a trustee...if there are reasonable grounds to suspect that current members of the governing body of the debtor, the debtor's chief executive or chief financial officer or members of the governing body who selected the debtor's chief executive or chief financial officer, participated in actual fraud, dishonesty, or criminal conduct in the management of the debtor or the debtor's public financial reporting.13

The office of Sen. Edward M. Kennedy, author of §1104(e), advises that this new Code section was crafted to spur the UST to spring into action and redress malfeasance where in the past the UST did not assume an aggressive posture.14 Notwithstanding the remedial purpose of the statute, i.e., a mechanism designed to oust bad actors from the executive suite, the text of §1104(e) lacks clarity and, as a result, is likely to give rise to unintended results.15 Attorneys and consultants providing counsel to a potential chapter 11 filer must be concerned that §1104(e) could be read to mandate a financially distressed employer to "clean house" prior to a chapter 11 filing to avoid even the possibility of motion practice under §1104(e).16 Such an outcome may result in the innocent being forced out with the guilty or the innocent seeking alternate employment to avoid being caught up in a "house cleaning" exercise. Almost certainly, neither such result was intended by Congress. Also, the loss of senior executives and experienced board members who are guilty of no wrongdoing can only serve to harm a reorganization effort by depriving a financially distressed entity of the expertise, experience and institutional knowledge possessed by such individuals. Ironically, despite the intent of BAPCPA to foster corporate good conduct by removing bad players from the executive suite, §1104(e) may harm the interests of creditors, rank-and-file employees and the other constituencies BAPCPA has been drafted to protect by potentially increasing costs and potentially depriving a financially distressed entity of the abilities and institutional knowledge possessed by experienced executives and board members at a critical juncture: the eve of a chapter 11 filing.

A little more than a year after the effective date of BAPCPA, new §1104(e) has not been subjected to substantial judicial scrutiny, as the Office of the U.S. Trustee has filed only a handful of motions seeking relief under §1104(e).17 Moreover, to date, there appear to be no reported decisions addressing a request for relief made pursuant to §1104(e).

Anecdotal evidence provided by professionals involved in chapter 11 cases indicates that to date, there has not been an appreciable change in response to the inclusion of §1104(e) in BAPCPA. However, the apparent toothlessness of §1104(e) may last only until a motion prosecuted or decided under §1104(e), for the first time, disrupts or complicates a reorganization case, causes the unwanted departure of senior executives, or results in the appointment of a chapter 11 trustee.

A second provision of BAPCPA designed to control management conduct limits the ability of a chapter 11 entity to pay key employee retention bonuses (KERPs), severance payments and other compensation.18 Although the legislative history is scant, it is readily apparent that §503(c) has been crafted to prevent court approval of certain types of payments to highly compensated insiders, at the expense of other constituencies, including rank-and-file employees, general creditors and noninsider shareholders. However, not all types of payments are limited, as new §503(c) neither addresses nor apparently restricts performance-based incentive plans, and principally appears to leave such performance-based incentive plans subject to the business judgment rule, as it applied to insider compensation prior to the effective date of BAPCPA.19

Under new §503(c)(1),20 the payment of a KERP to any employee designated by the Code as an insider is prohibited unless (1) the payment is necessary because the insider has a bona fide job offer from another business at the same or greater rate of compensation, and (2) the insider is essential to the survival of the debtor's business. Additionally, even if a debtor could satisfy the two aforesaid requirements, the amount of the KERP is restricted.21 Second, severance payments are restricted under the new §503(c)(2),22 as the amount of a severance payment offered to an insider cannot exceed 10 times the amount of the mean severance payment given to non-executive employees.23 Finally, new §503(c)(3) of BAPCPA prohibits the allowance or payment of compensation "outside the ordinary course of business and not justified by the facts and circumstances of the case...."24 At first blush, this formulation does not seem to change prior law and would seem to substantially restate the business judgment rule, at least until the clause is interpreted differently by the courts.

Several chapter 11 debtors have tried to avoid the effect of new §§503(c)(1) and 503(c)(2) since the effective date of BAPCPA by presenting a proposed benefit plan as being performance-based.25 The courts have reacted in several such cases by approving the proposed compensation program in the absence of significant objection being interposed to the relief requested.26 However, in the face of multiple objections to a management compensation plan proposed by Dana Corp., Bankruptcy Judge Burton R. Lifland (S.D.N.Y.) denied approval of a proposed compensation scheme.27

In Dana, Judge Lifland found that the proposed compensation plan violated the insider compensation restrictions imposed by new §§503(c)(1) and 503(c)(2), as key provisions of the proposed compensation plan fit within the statutory definition of a KERP (§503(c)(1)) and of a severance plan (§503(c)(2)).28 Judge Lifland reached his conclusion in Dana, although Dana labeled the proposal as something other than a KERP or a severance plan so that the proposal would not be governed by §§503(c)(1) and (c)(2).29 Judge Lifland, however, left the door open for the approval of an appropriately crafted compensation plan that would not be subject to the restrictions imposed by §§503(c)(1) and 503(c)(2), limiting his holding to the facts of the case.30

While the intent of new §503(c) clearly is salutary (i.e., to prevent management from acting in its self interest at the expense of others), the new statutory scheme has had the negative effect of increasing uncertainty and adding cost, as the courts have struggled to give effect to the statute. However, a somewhat more subtle, yet fundamentally more harmful, negative side effect of new §503(c) may be that distressed businesses will suffer the inattention of experienced managers, as such individuals focus their efforts on securing a bona fide job offer and changing jobs, rather than attending to the preservation of the going-concern value of their existing, but troubled, employer. Although some managers may be sophisticated enough to pursue a bona fide job offer to qualify for a retention bonus under the new statutory condition precedent of §503(c), the more likely scenario is that managers simply will decide they have insufficient economic incentive to remain employed by an economically challenged employer, and as a result, seek and accept alternative employment.

In sum, although §503(c) has been designed to restrict the ability of a financially distressed entity to enrich entrenched management, on several occasions debtors and courts have attempted to avoid the effect of the statute with some success. Moreover, to the extent courts rely on §503(c) to limit compensation plans, such an outcome could have the side effect of depriving reorganizing debtors of the ability to provide the economic incentives to highly compensated individuals required to allow such employees to retain the services of those individuals. However well intentioned, the effect of §503(c) on targeted individuals may end up hurting the very constituencies Congress has attempted to help. This may occur in several ways. First, it may be more difficult for a debtor to survive as a going concern without retaining certain highly compensated employees, with the resultant potential loss of rank-and-file jobs. Second, reorganization cases may be more difficult, and therefore more costly, to administer in the absence of certain employees of a debtor entity, resulting in smaller distributions to creditors and less being available for rank-and-file employees.

BAPCPA also targets compensation paid to certain insiders31 prior to the commencement of a case.32 New §548(a) of the Code,33 in relevant part, provides that a trustee (or debtor-in-possession) may avoid a transfer to an insider under an employment contract, made within two years before a filing, if the transfer was not in the ordinary course of business and the debtor did not receive reasonably equivalent value in exchange for the transfer.34

While the remedial purpose of the amendment requires no explanation, new §548(a), much like BAPCPA provisions targeting corporate good citizenship discussed above, could have negative side effects on the reorganization process, including making it more difficult for financially distressed entities to hire and retain managers and restructure quickly. Able individuals, including outside consultants and restructuring experts, may simply pass on an employment offer tendered by a financially distressed entity after deciding it is not worth bearing the risk of working for a distressed business and then two years later being subjected to an investigation into the propriety of the compensation received, and potentially being forced to disgorge.

Several other provisions of BAPCPA appear to have been designed to restrict management's prerogatives for the purpose of preventing harm to various constituencies, including rank-and-file employees. First, under new §541(b)(7),35 payments withheld or received by an employer from the wages of its employees made as contributions to employee retirement plans are excluded from the definition of "property of the estate" to assure that such payments are not subject to avoidance and recovery. Second, under new §1114(l),36 a debtor is prevented from terminating retiree benefit plans on the eve of a bankruptcy filing, and any modification to an employee plan made within 180 days before a filing is to be reinstated, unless a court determines that the balance of the equities favors the modification. Third, new §507(a)37 provides greater protection for the rank-and-file employees by increasing the cap on wage and employee benefit claims entitled to priority from $4,650 to $10,000. Also, this priority will now apply to wages or benefits earned up to 180 days prior to a bankruptcy filing, whereas previously only wages and benefits earned 90 days prior to a filing were elevated to priority status. Fourth, and finally, new §362(b)(25)38 attempts to provide greater protection for noninsider investors by making it clear that investigatory actions of the SEC undertaken pursuant to its regulatory powers are not subject to the automatic stay otherwise afforded by §362. These changes to §§541, 1141(1), 507 and 362, by their very nature, will serve to saddle reorganizing debtors with a level of administrative expense that did not exist prior to the effective date of BAPCPA. The open question at this time is, will these provisions help or hurt the constituencies Congress intended to protect?

BAPCPA Provisions Designed to Accelerate the Reorganization Process

Congress intends reorganization cases to proceed more quickly under BAPCPA than they did under prior law. For all chapter 11 cases filed on and after Oct. 17, 2005, the exclusive period for a debtor to file a reorganization plan may not be extended beyond a date that is 18 months after the entry of an order for relief, and a debtor's exclusive period to obtain acceptance of such plan cannot be extended beyond 20 months after the order for relief.39 Prior to the effective date of BAPCPA, bankruptcy judges had the discretion to grant multiple extensions of the exclusive periods, and there were no deadlines after which further extensions could not be granted. Congress crafted the new absolute deadlines of amended §1104(e) to take the authority away from bankruptcy judges to extend the exclusivity periods indefinitely. The new fixed deadlines of §1104(e) will compel debtors to work more quickly to reorganize or risk losing control of the reorganization process due to the ability of third parties to propose and confirm competing reorganization plans.

Additionally, BAPCPA adds a fixed deadline for the assumption or rejection of unexpired nonresidential real property leases that cannot be extended, with regard to each lease, without the written consent of the appropriate landlord.40 Pursuant to new §365(a), the initial period for assumption or rejection has been extended from 60 to 120 days.41 However, a debtor will be permitted to seek only a single 90-day extension of such initial period upon a showing of "cause." Any further extensions of the period to assume or reject, beyond a total of 210 days, may be allowed by a bankruptcy court only upon the written consent of the landlord.42

New §365(d) will require every chapter 11 debtor to make the decision to assume or reject with greater speed than under prior law—an excellent result for the relevant landlord. However, the "need for speed" may force a debtor to decide prematurely to assume or reject, with several possibly negative consequences. First, a failure to timely assume could result in the loss of a needed lease or a valuable and saleable leasehold interest. Second, interested parties may be faced with the need to allow a debtor to assume at a time when it may be unclear whether or not a successful reorganization is in the offing, thereby giving rise to potential additional administrative expense claims by a landlord resulting from an assumption and subsequent breach or rejection.43

In sum, while the period for assumption or rejection ostensibly has been extended by BAPCPA, judges no longer have the unfettered discretion to grant temporal extensions "for cause" without landlord consent, as they could under the prior law.44 Practically speaking, a debtor will have less time under the new law to decide whether to assume or reject its unexpired leases than it had under prior law. The effect of the new §365(d)(4) deadline surely will be to force debtors to move more quickly to assume or reject, thereby accelerating the pace of the reorganization case, at the cost of the potential negative outcomes described above.


Whether increasing the speed with which entities are moved through the bankruptcy court system is a sound policy choice or not is well beyond the scope of this article.45 However, the "need for speed" policy now underlies the law of the land in chapter 11 cases. On the other hand, assuring good corporate conduct undoubtedly is a desirable policy goal. However, the changes to chapter 11 designed to govern such conduct appear to impose requirements on chapter 11 debtors likely to make it more difficult for them to reorganize quickly and move with alacrity through the bankruptcy system from filer to reorganized debtor.

The courts are only beginning to be called upon to interpret and give effect to many provisions of chapter 11 amended by BAPCPA relating to corporate conduct and "the need for speed." Perhaps in several years, when the volume of cases construing these provisions of BAPCPA has increased substantially, the cases collectively will reveal just how BAPCPA will have changed the decision-making process employed by courts and other interested parties in reaction to the schizophrenia now deeply embedded in the psyche of the new chapter 11.


1 Pub. L. No. 109-8, §331, 119 Stat. 23 (2005). The opinions set forth herein are those of the author and not necessarily those of Thompson & Knight LLP.

2 Unless otherwise noted, all references to BAPCPA will be to the codified provision. Unless otherwise noted, BAPCPA amendments are applicable to cases filed 180 days after the enactment of BAPCPA: Oct. 17, 2005.

3 This is symptomatic of a general perception of excessive compensation. In 1982, the average CEO made 42 times the average pay of a production (non-management) worker. By 2004, the ratio of average CEO pay to the average pay of a production worker was 431 to 1. (Sahadi, J., "CEO Pay: Sky-high Gets Even Higher,: CNN, Aug. 30, 2005).

4 11 U.S.C. §1104(e) (2005).

5 11 U.S.C. §503(c)(3) (2005).

6 11 U.S.C. §503(c)(2) (2005).

7 11 U.S.C. §503(c)(1) (2005).

8 11 U.S.C. §548(a)(1) (2005).

9 Top Gun (Paramount Pictures, 1986).

10 11 U.S.C. §1121(d) (2005).

11 11 U.S.C. §365(d)(4) (2005).

12 11 U.S.C. §1104(e) (2005).

13 11 U.S.C. §1104(e) (2005) (emphasis added).

14 Based on correspondence with the Chambers of Sen. Edward M. Kennedy, the author of the amendment. There is scant legislative history for §1104(e).

15 Herman, Ira L., "Sarbanes Oxley Meets Bankruptcy Reform: The New Guardians of Truth, Justice and Corporate America," in Bankruptcy Reform 2005: Expert Analyses Examining and Predicting the Impact on the Commercial Practitioner, 15-21 (Kate Colangelo & F. Joseph Faracci eds., 2005).

16 Id.

17 Based on inquiry made to the Administrative Office of the U.S. Trustee regarding the number of §1104(e) motions filed to date throughout the country.

18 11 U.S.C. §503(c) (2005).

19 See Klee, Kenneth N. and Butler, Brendt C., "The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005—Business Bankruptcy Amendments," ALI-ABA Course of Study Materials, SL051 ALI-ABA 305 (2005) (noting that §503(c) of the Code does not prohibit incentive plans and speculating that debtors will increasingly design compensation programs to include performance metrics and incentives).

20 11 U.S.C. §503(c)(1) (2005).

21 Id.

22 11 U.S.C. §503(c)(2) (2005).

23 Id.

24 11 U.S.C. §503(c)(3) (2005).

25 Id.

26 See, e.g., In re Calpine Corp., Case No. 05-60200 (BRL) (Bankr. S.D.N.Y. May 15, 2006) (the debtors' entry into employment agreements with chief executive officer (CEO) and chief financial officer/chief restructuring officer (CFO/CRO) does not violate §503(c)(3) of the Code); In re Pliant Corp., Case No. 06-10001 (MFW) (Bankr. D. Del. Mar. 14, 2006) (the debtor's payment incentive compensation to eligible employees pursuant to incentive compensation plan does not implicate §503(c) of the Code); In re Musicland Holding Corp., Case No. 06-10064 (SMB) (Bankr. S.D.N.Y. Feb. 1, 2006) (the debtor's continuing to provide incentive bonuses under management incentive plan does not violate §503(c) of the Code); In re Nobex Corp., Case No. 05-20050 (MFW) (Bankr. D. Del. Jan. 20, 2006) (program that ties executive compensation to the amount of proceeds from sale of the debtor's assets is not subject to §§503(c)(1), (c)(2) or (c)(3) analysis and is justified by the facts and circumstances of the chapter 11 cases).

27 In re Dana Corp., 2006 WL 2563458 (Bankr. S.D.N.Y. Sept. 5, 2006).

28 Id.

29 Id.

30 Id.

31 11 U.S.C. §101(31) (2005).

32 11 U.S.C. §548(a) (2005).

33 Id.

34 Id.

35 11 U.S.C. §541(b)(7) (2005).

36 11 U.S.C. §1114(1) (2005).

37 11 U.S.C. §507(a) (2005).

38 11 U.S.C. §362(b) (2005).

39 11 U.S.C. §1121(d) (2005).

40 11 U.S.C. §365(d)(4)(2005).

41 Id.

42 Id.

43 BAPCPA implicitly recognizes that bad decisions might be made and limits administrative claims for nonresidential leases assumed and subsequently rejected to a sum equal to all monetary obligations for the period of two years following the later of (1) the rejection date or (2) turnover of the premises.

44 11 U.S.C. §365(d)(4)(2005).

45 See Covitz, Daniel M., et al., "Are Longer Bankruptcies Really More Costly?" Fed. Reserve Bd., Divs. of Research & Statistics and Monetary Affairs, Finance and Economics Discussion Series, Working Paper No. 2006-27, 2006).

Bankruptcy Code: 
Journal Date: 
Friday, December 1, 2006