S. 2798 ANALYSIS BY ABI RESIDENT SCHOLAR
Employee Abuse Prevent Bill Would Change Venue Rules And Elevate Employee Claims
By: Prof. G. Ray Warner
Robert M. Zinman American Bankruptcy Institute Scholar in Residence
On August 1, 2002, Senator Dick Durbin (D-IL) and Rep. William Delahunt (D-MA) introduced a package of amendments to the Bankruptcy Code that are designed to protect employees and retirees when businesses file bankruptcy. The proposed Employee Abuse Prevention Act of 2002 (S. 2798 & H.R. 5221) expands the estate’s power to challenge pre-bankruptcy transactions and provides greater protection to the claims of employees and retirees. In addition, the bill would eliminate Delaware as a proper venue for most corporate cases by removing the state of incorporation as a venue option. Finally, the bill would reverse some of the bankruptcy-related changes made by the recent revision of Article 9 of the Uniform Commercial Code by enhancing the estate’s ability to attack asset securitization transactions and to avoid security interests. All but one of the changes made by the bill would be effective immediately upon enactment and would apply to cases pending on that date.
Venue At Corporation’s Center of Gravity
On the venue front, the bill would amend 28 U.S.C. 1408 to provide that the domicile and residence of a corporation are conclusively presumed to be the debtor’s principal place of business in the United States. This change would eliminate the debtor’s state of incorporation as a venue option and would have a major impact on the Delaware bankruptcy practice. Under the change, venue would be appropriate in the districts where the debtor’s principal place of business or principal assets in the United States were located.
In addition, the bill would change the "affiliate venue" rules that currently permit the filing of a case in any district where a case involving an affiliate of the debtor is pending. Instead, the new affiliate rule would limit the debtor to filing in a jurisdiction where its parent (an entity that owns, controls, or has the power to vote 20 percent or more of the debtor’s outstanding voting securities) has a pending case. If the parent corporation is not in bankruptcy, then the subsidiary could file in the district where the debtor’s affiliate that has the greatest assets in the United States has its principal place of business, whether or not that affiliate has filed bankruptcy. This provision could not be used by the parent to expand its venue options. Under the proposed revision, an entire corporate group could file only in the districts where the parent could file. A sub-group that included only subsidiaries could file only where the affiliate with the greatest U.S. assets has its principal office. The changes in the affiliate rules would affect New York, since cases like Enron could not be filed there. However, since many major corporations have their headquarters in New York, the net effect of shifting those filings from Delaware to New York might offset the loss of cases resulting from the affiliate rule changes.
Finally, the venue rules would be amended to require that cases filed in an improper venue either be dismissed or transferred to a district in which venue properly lies if a timely objection to venue is made. Although the venue provisions would apply to cases pending on the enactment date, the "timely objection" requirement might prevent the transfer of cases already pending in districts where venue would be improper under the amendment.
Pension and Retiree Protections
Several provisions of the bill address employee and retiree issues. First, current section 1114 prevents a Chapter 11 debtor from unilaterally modifying certain retiree benefits, such as retiree health insurance, during the case unless an authorized retiree representative is appointed and agrees to the modification, or the court authorizes the modification as necessary to the reorganization. The bill would amend section 1114 to prevent debtors from evading its requirements by terminating retiree benefit plans on the eve of bankruptcy. The bill would require retroactive reinstatement of retiree benefits that were modified "in contemplation of bankruptcy" within 180 days before filing unless the pre-petition modification was essential to the continuation of the debtor’s business. Modifications made within the 180-day period would be subject to a rebuttable presumption that they were made in contemplation of bankruptcy.
Several provisions are designed to enhance the recovery on pension and wage claims. The bill would increase the current section 507(a)(3) priority for unpaid wage claims from $4,650 to $13,500. More importantly, in certain instances the bill would convert employee equity security interests held in pension plans from "interests" to "claims." The bill would amend the section 101(5) definition of "claim" to include equity securities held in an ERISA pension plan if the employee was forced to invest the pension assets in equity securities of the debtor or an affiliate of the debtor. The "claims" thus created would be entitled to priority under the section 507(a)(4) "employee benefit plan contribution" provision. The amount of the section 507(a)(4) priority claim would be set at the market value of the stock at the time it was contributed to, or purchased by, the pension plan. Note that the section 507(a)(4) benefit plan priority is limited to the unused portion of the 507(a)(3) priority times the number of employees. This would remain the case for benefit plan contributions. No dollar limit would apply, however, to the new pension plan stock claim. The effect of these changes would be to elevate covered employee pension plan stock interests from the lowest priority common stock level to a fourth level priority ahead of general unsecured claims. In a case like Enron, where the contributed stock had a high value at the time of the contribution, this provision could divert all of the residual value of the estate from the unsecured creditors to the employees.
Certain pension claims would be elevated even higher. An almost incomprehensible provision appears to prime both secured lenders and administrative expenses (including professional fees) where a claim is based on the breach of an ERISA or state law fiduciary duty respecting a pension plan. The bill initially would amend section 503(b) to grant such breach of fiduciary duty claims an administrative expense priority. This would place such claims on parity with other administrative expenses, but ahead of other types of priority claims and general unsecured claims. However, the bill would then amend section 507(b) to provide that these claims would have priority over every other administrative expense claim. Finally, the bill would amend section 506 to provide that any pension plan, any plan participant, or any plan beneficiary could recover any unpaid amount of such claim from property securing allowed secured claims. This provision is designed to encourage secured creditors to monitor the debtor and ensure that it complies with its fiduciary obligations under its pension plans. The net effect of these provisions would be to give such claims a superpriority on any unencumbered assets and, if that was not sufficient to satisfy them in full, a surcharge against secured claims. As a practical matter, these changes might increase the costs and reduce the availability of credit and might deprive the estate of the funds necessary to administer cases with large pension plan fiduciary breach claims. The provision priming secured claims is the only provision of the bill that would not become effective immediately or apply to pending cases. It would apply only to liens created after the bill becomes law.
Avoidance of Security Interests and Asset Securitization Transactions
Although only tangentially related to pension security and employee protection, several provisions of the bill would make it easier for the estate to avoid pre-petition security interests and asset securitization transactions. These proposed changes would have a significant impact in all cases and would only incidentally aid employees by enlarging the estate and providing a greater dividend to unsecured creditors.
Asset securitization is a financing method that attempts to insulate the financing transaction from a bankruptcy of the debtor. This is done by creating a new bankruptcy remote special purpose entity ("SPE") and transferring income-producing assets of the debtor to the SPE in a "true sale" transaction. The financing transaction then occurs at the SPE’s level. By the time the debtor files bankruptcy, the assets belong to the SPE and are not property of the estate. Thus, the lender is not subject to the automatic stay, use of cash collateral, or any other bankruptcy-based alteration of its rights. While bankruptcy courts currently can review the transaction to determine whether the formalities of a true sale were complied with, the amendment would expand the court’s power to recharacterize such sales as secured loans. The bill would expressly override non-bankruptcy law, such as laws in some states that purport to make the parties’ characterization of the transaction as a "true sale" binding on the courts. See, e.g., Del. Code Ann. Tit. 6, § 2701A, et seq. In addition, the bill appears to create a new federal standard that allows the court to recharacterize a transaction if the "material characteristics" of the transaction are "substantially similar" to the characteristics of a secured loan. The section-by-section analysis accompanying the bill indicates that the provision is designed to allow the court to "look through the formalities of a ‘sale’.…"
In addition, the bill would undo much of the additional protection from bankruptcy attack that secured creditors obtained from last year’s revision of Article 9 of the Uniform Commercial Code. Under current law, the trustee’s "strong arm" power under section 544 of the Code gives the trustee the powers of a "lien creditor" with respect to personal property assets. The recent revision of Article 9 significantly reduced the trustee’s avoiding powers by reducing the powers of lien creditors under state law. See C. Scott Pryor, How Revised Article 9 Will Turn the Trustee’s Strong-Arm Into a Weak Finger, 9 Am. Bankr. Inst. L. Rev. 229 (2001); see also G. Ray Warner, The Anti-Bankruptcy Act: Revised Article 9 and Bankruptcy, 9 Am. Bankr. Inst. L. Rev. 3 (2001). The bill purports to restore the trustee’s power by upgrading the trustee’s status to that of a hypothetical "good faith reliance purchaser for value." The new status would allow the trustee to avoid an Article 9 security interest based on any error in the financing statement. Current law only allows avoidance based on a name error or an error in the collateral designation. In addition, the trustee could avoid security interests in instruments and investment property if the secured creditor had relied on the filing of a financing statement as its method of perfection. The wording of the section may go even further. In addition to treating the trustee as a good faith purchaser for value, it also treats the trustee as though he/she had taken possession of the property. In the case of negotiable instruments, this change may give the trustee priority over even a holder in due course of the instrument, a result presumably not intended by the drafters. The good faith purchaser status could create other inconsistencies and possibly unintended consequences.
Enhanced Avoidance of Fraudulent Transfers and Excessive Compensation
The bill would also enhance the recovery of voidable transfers and impose limits on executive compensation. Two changes would make it easier for the estate to avoid pre-petition transfers. First, the one-year look-back period for fraudulent transfers under section 548 would be extended to four years. Thus, both actual fraudulent transfers and constructive fraudulent transfers (transfers for less than reasonably equivalent value when the debtor is insolvent) could be avoided by the estate if they occurred within four years before bankruptcy. This change would have relatively little impact in most cases since most such transfers already could be avoided using very similar state fraudulent transfer laws. The provision would enhance the estate’s recovery in those cases where the state law statute of limitations was less than four years or where the state law was less expansive than section 548. A more important provision would amend the section 546(e) safe harbor for securities settlement payments to limit the safe harbor protection to brokers, clearing agents, and other financial intermediaries. The safe harbor would no longer protect the actual shareholders who are the beneficiaries of an avoidable transfer involving securities. Compare Lowenschuss v. Resorts Int’l, Inc. (In re Resorts Int’l, Inc.), 181 F.3d 505 (3d Cir. 1999) (safe harbor protects shareholders), with Munford v. Valuation Research Corp. (In re Munford), 98 F.3d 604 (11th Cir. 1996) (shareholders not protected).
The bill would also expand section 548 to allow the recovery of excessive benefit transfers and obligations made to insiders (including officers and directors), general partners, and affiliated persons during the four years prior to bankruptcy if the debtor was insolvent or was rendered insolvent by the transaction. This provision would apply even though the transaction was not otherwise fraudulent. A two-part test would be used to determine whether the benefit was excessive, and thus avoidable. If similar benefits were provided to nonmanagement employees during the same calendar year, then the benefit would be excessive if it was equal to or greater than 10 times the average similar benefits provided to nonmanagement employees during the same calendar year. If no such benefits were provided to nonmanagement employees, then the benefit would be excessive if it was equal to or greater than 125% of the amount of any similar benefit provided in the calendar year prior to the year of the benefit transaction. The bill appears to avoid the entire transaction, and not merely the portion deemed excessive. This appears to be intended as a disincentive to engage in such transactions. The bill does not indicate whether the section 548(c) "good faith transferee for value" defense could be used to limit avoidance in appropriate cases. Although the provision appears to be designed to apply to management compensation, nothing in the language of the provision limits it to compensation. Arguably it could be used to avoid non-fraudulent transfers between corporate affiliates if they met or exceeded the 125% threshold.
The bill also would substantially limit the bankruptcy court’s authority to approve retention and severance programs for officers and directors. Retention payments to insiders (including officers and directors) would not be allowed unless the court finds "based on evidence in the record" that the retention benefit is essential because the individual has a bona fide job offer at the same or greater rate of compensation and that the services of the individual are essential to the survival of the business. Further, even after those elements were shown, the retention benefit could not be greater than 10 times the average similar benefit provided to nonmanagement employees during the same calendar year or, if no similar benefits were provided to nonmanagement employees, the retention benefit could not exceed 125% of any similar benefit provided to the same insider during the prior calendar year. It is not clear which benefits would be considered in computing these caps since the bill refers to "similar" transactions "for any purpose". While use of the term "similar" suggests that the comparison is to other retention benefits, the "any purpose" language suggests that the cap is computed on the basis of total compensation. The bill would not limit retention programs for nonmanagement employees. The bill would also limit severance benefits for insiders (including officers and directors). The severance payment would have to be part of a program that is generally applicable to all full-time employees and could not be greater than 10 times the average severance given to nonmanagement employees during the same calendar year.
Finally, the bill contains broad language barring post-petition transfers and obligations that are outside the ordinary course of business, unless they are justified by the facts and circumstances of the case. Compensation of officers, managers, or consultants hired post-petition would be deemed to be outside the ordinary course of business. The effect of this provision would be to subject the compensation arrangements for management personnel and consultants hired post-petition to greater scrutiny by the court.