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File (Chapter 11) Now or Risk
Being Broken into Pieces
By John D. Penn
Haynes and Boone, LLP
The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 ("BAPCPA") will dramatically change Chapter 11 reorganizations and could result in companies being liquidated because they cannot reorganize under BAPCPA's new strictures. If a company is undergoing financial problems, is short on unencumbered assets, will need its key executives to lead a reorganization that might take some time to deal with its creditors and landlords, or does not want its confidential business information distributed among all of its creditors (including its competitors), the company should seriously consider filing for reorganization before October 17 when most of BAPCPA takes effect. Waiting for better times could prove fatal.
In each of these key areas, BAPCPA will make reorganizing companies much more difficult for cases filed after October 16 than if the companies had filed on or before that date. As will be more fully discussed below, BAPCPA will increase administrative expenses, make it almost impossible to incentivize key executives to remain through the reorganization, place a definitive end date on when real estate leases must be dealt with, make previously confidential information generally available and limit the company's exclusive period to file a plan of reorganization and the time it has to determine what to do with its real estate leases.
New (and Potentially Very Large) Administrative Expenses
BAPCPA added another layer of administrative expense burden on reorganizing companies when it amended § 503 of the Bankruptcy Code /Footnote 1/ to create an entirely new administrative expense for the value of goods delivered to a debtor within the twenty (20) days before a bankruptcy filing. This is significant because administrative expenses must be paid in full for plan of reorganization to be confirmed. Consequently, instead of pre-bankruptcy trade creditors receiving miniscule distributions in a plan (or trying to improve their position by proving that they were entitled to reclaim the goods under § 2-702 of the Uniform Commercial Code), the goods delivered shortly before the filing will require cash payments under a plan.
The funds to pay these new administrative expenses must either come from a new capital infusion or from monetizing unencumbered (or under-encumbered) assets by either borrowing against them or selling them. Companies that do not have the ability to pay these added "cash costs" will, in all likelihood, be liquidated. Twenty days of deliveries can be an enormous expense for certain retailers and manufacturers - depending upon when the twenty days falls in their business cycle. If these goods are either subject to a lender's lien or are consumed before the bankruptcy is filed, the debtor nevertheless remains liable for the administrative expense.
The twenty day administrative expense exists without regard to whether reclamation of the goods is permitted. This is important because reclamation claims are no longer limited to just goods that were delivered within ten (10) days before a bankruptcy filing. BAPCPA changed § 546 extended the maximum "look back" for reclamation claims to forty-five (45) days before the bankruptcy filing. However, reclamation claims are expressly subject to the claims of secured lenders. A lender with an undersecured lien on "reclamation goods" will eliminate a reclamation claim but will not eliminate the administrative expense for those goods.
If the value of a debtor's unencumbered or under-encumbered assets do not exceed the administrative expense obligations, the debtor is described as being "administratively insolvent." At that point, its most likely next stop for the debtor is being liquidated since the reorganization has become untenable. Depending upon the situation, a company could be administratively insolvent when it files its reorganization petition.
Time Is of the Essence
BAPCPA imposed two critical time limits where no limits previously existed. For cases filed on and after October 17, 2005, the amount of time allowed for a debtor-in-possession to have the exclusive right to file a plan is limited to eighteen (18) months from the bankruptcy filing (§ 1121) and the time to assume or have its real property leases deemed rejected is two hundred ten (210) days after the bankruptcy filing unless each affected landlord agrees to further extensions in writing.
Under existing law, unless the Bankruptcy Court extends these time periods "for cause," debtors' plan exclusivity is limited to one hundred twenty (120) days and real estate leases are deemed rejected after sixty (60) days. There were no limitations on the length of time by which these deadlines could be extended with that decision being left within the Bankruptcy Court's sound discretion. That discretion ends with BAPCPA imposing limits on the maximum amount of time for each.
By placing hard and fast limitations on these periods, Congress effectively shifts the power over those issues away from debtors as each respective deadline approaches. In cases involving multiple real estate leases, debtors will be compelled to move swiftly to evaluate the leases that they want to keep so they can begin the lease extension negotiations as early as possible. This will empower landlords to either coerce debtors to prematurely assume leases or to extract "extension fees" that debtors must pay to obtain the requisite written consent for a further extension. (The extension fees would be even more "administrative expenses" to be paid.) The exclusivity deadline shifts the power over the plan from the debtor to creditors by allowing someone other than the debtor to file a plan. Neither change will make the job of reorganizing a debtor any easier.
Key Employee Retention Plans
In the post-Sarbanes, post-Enron world we live in, few were shocked that Congress took steps to limit the scope and breadth of key employee retention plans. However, the changes that were enacted will make it almost impossible to encourage a company's leaders to stay with the reorganization and to take the risk that their careers will be injured by working for a company that is being restructured.
BAPCPA changed § 503 to essentially make a Key Employee Retention Plan ("KERP") for executives a thing of the past. The change includes requirements to "balance" any retention plan for management with a comparable plan for non-management employees using a moderately complicated formula. For "insiders" to be included in the KERP, BAPCPA includes a requirement for evidence that the insider has received "a bona fide employment offer from another business at the same or greater rate of compensation. While balancing a KERP for management with a non-management KERP is no simple task, requiring key executives to prove that they have in hand the very thing that the company would use a KERP to prevent - a good job offer from another company (that is presumably not in bankruptcy) - makes it impossible to give leaders incentives to stay aboard a ship in distress instead of searching for job stability elsewhere.
While many may think of a pre-bankruptcy agreement as a way to eliminate the strictures of § 503 for KERPs, that avenue was protected as well. BAPCPA changed § 548 to specifically allow for the avoidance of transfers to or for the benefit of insiders under employment contracts during the two years before bankruptcy (including obligations incurred during that time). Admittedly, employment agreements might still be amended pre-bankruptcy in the hope that the avoidance will never be an issue. It is not a secret that many possible avoidance actions are released, overlooked or simply not pursued after a plan of reorganization is confirmed and the debtor resumes "normal" operations. Whether this is enough to provide an added incentive for insiders to stay through plan confirmation in hopes of controlling the decisions regarding which avoidance actions to pursue remains to be seen.
BAPCPA revised § 1102 to require that creditors committees appointed in Chapter 11 cases share information with and solicit information from the committee's constituents. In a vacuum, this sounds reasonable and logical and it might work reasonably well in smaller cases. However, in cases involving bond debt or public shareholders, the potential for serious mischief cannot be ignored.
Aggressive claim trading by hedge funds and others in both public bond debt and trade claims is a relatively recent phenomenon. Claim trading occurs when individuals or entities purchase the claims of creditors in hopes of making a profit on the trade or for other purposes. In claim trading situations, the quality and quantity of information about a debtor often determines the price that a buyer will pay for a claim. Claim traders always want the best information they can obtain.
For committees to function appropriately, their professionals need to have access to information that is not available generally (also known as "material, non-public information). This allows the professionals to help the committee assess the debtor's financial condition, viability and prospects for reorganization to (hopefully) reach a consensus about how the debtor can reorganize. Because of the nature of the information and access they agreed to receive, most committee advisors in large creditors agree to some limitations on how they can use non-public information from a debtor by either having a protective order entered or through an appropriate confidentiality agreement.
That dynamic will change for cases filed after October 16, 2005 when BAPCPA imposes a statutory obligation to share information with the committee's constituents. In cases with a creditors committee, it is virtually impossible to get the committee to support a plan without providing the committee's professionals with very detailed financial information. This level of information, in the hands of competitors who might be able to "reverse engineer" the data to identify very material competitive information, could doom a company's restructuring efforts.
Companies interested in controlling a debtor's business (by either buying the business or by blocking plan confirmation by purchasing at least 33.5% of any class of claims), will undoubtedly try to obtain detailed information when the revised § 1102 takes effect.
Reorganizing companies under the Bankruptcy Code, as it exists today, is not easy and can be very difficult. Requiring that companies accomplish more in a shorter period of time while hoping that senior management remains on the job while they try to reduce administrative expenses may be too much to offer. For companies that cannot achieve this Herculean feat, they will be liquidated either in Chapter 7 or Chapter 11 as operating units or individual assets. The actual manner of sale is not nearly as significant as the fact that they will be sold one way or the other.
Companies that have financial problems now should consider their options carefully because waiting until October 17 to decide could mean that they have waived their ability to reorganize and will end up in pieces.
Footnote 1: All references to Sections (or a "§") refer to the Bankruptcy Code (Title 11, United States Code)
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