United States: The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005

Article by Adam C. Rogoff, Edward A. Smith, Anya Kyong, Jean Louie, Ian McKim, Timothy Mooney and Denise Penn.

(Preferential Treatment - Special Alert)

After wrestling with bankruptcy reform for eight years, the Congress recently passed the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (the "Act"), by far the most sweeping overhaul of the U.S. bankruptcy laws since the enactment of the Bankruptcy Code (the "Bankruptcy Code" or "Code") in 1978. President Bush is expected to sign the Act into law shortly. While the proposed amendments to the Code relating to consumer bankruptcy cases¹ have received extensive press attention, numerous less-publicized provisions of the legislation significantly affect both debtors and creditors in corporate bankruptcies. Set forth below is an executive summary of the material business changes to the Bankruptcy Code. (Following this summary is a more detailed, section-by-section discussion of the amendments). Among other material changes, the Act implements the following changes to the Code:

CROSS BORDER INSOLVENCY CASES – Currently, the Code permits the commencement of "ancillary cases" in aid of a foreign insolvency proceeding. Notably, § 304 currently provides that a voluntary case ancillary to a "foreign proceeding" may be commenced by a "foreign representative" to seek injunctive relief, turnover of estate property or other appropriate relief (like discovery). After many years of delayed efforts, the Act finally adds a new chapter 15 to the Code which incorporates the provisions of the UNCITRAL Model Law on Cross-Border Insolvency, which, in turn, harmonizes the procedural recognitions rules for foreign insolvency proceedings with the Model Law being implemented outside of the United States. Under new chapter 15, representatives of foreign bankruptcy proceedings may seek recognition in United States courts. Upon recognition, certain Code provisions (including the automatic stay) are triggered and apply to the foreign debtor’s assets in the United States. The provisions of new chapter 15 are extensive but (i) generally coincide with the Model Law and (ii) are in furtherance of the broad cross-border relief recognized in the United States. Section 304 is being replaced by new chapter 15.

EXECUTORY CONTRACTS AND UNEXPIRED LEASES – The Act provides for significant revisions to § 365 of the Code, which will limit the rights of debtor-tenants under the current law.

1. Under current law, there are no express time limitations in § 365 on the court’s ability to extend the debtors’ time to assume or reject a lease of nonresidential real property upon a showing of due cause. § 365(d)(4) of the Act now limits the period of time for the debtor to assume or reject a lease of nonresidential real property. As such, debtors will have a maximum of 210 days in which to assume or reject such a lease, absent lessor consent for a longer extension.
2. The Act also amends § 365(f) of the Code, which currently invalidates restrictions on assignments of executory contracts or unexpired leases to a third party. The amended provision makes clear that § 365(f) does not override the other provisions of § 365, which would include the specific limitations of assignment of shopping center leases in § 365(b)(3). Under current law, courts have modified the strict conditions relating to shopping center leases where enforcement of such strict use and other conditions would limit assignment. The new law would eliminate such flexibility, reducing the debtor’s ability to monetize leasehold interests.
3. Under current § 365(b) of the Code, a debtor is obligated to cure any defaults before assuming an executory contract or unexpired lease. Under the Act, amended § 365(b)(1)(A) provides that debtors do not have to cure nonmonetary defaults under an unexpired lease of nonresidential property if the default is noncurable. The only exception is that defaults resulting from a failure to operate in accordance with a lease must be cured by performance. This new section also defines the circumstances under which a lessor is entitled to be treated as impaired and is entitled to pecuniary damages from non-compliance with the lease.

FINANCIAL CONTRACTS – The Act extensively amends both the Federal Deposit Insurance Act and the Code provisions governing the treatment of financial contracts. Among other things, the Act:

1. Expands the safe harbor provisions found in sections 555, 556, 559 and 560 of the code so that they generally will be equivalent to those that have been applicable to banks under the FDIC Act. Among other things, the safe harbor for repurchase agreements will now include transactions involving mortgage loans or certain mortgage backed securities and the swap safe harbor now clearly encompasses credit derivatives, such as credit default swaps and total return swaps. In addition to expanding and clarifying the existing safe harbors for security contracts, forward contracts, swap agreements and repurchase agreements, Congress added to the Code a new safe harbor provision for master netting agreements.
2. The Act also revises the financial contract provisions of the FDIC Act so that they match the Code safeharbors.

RETENTION BONUSES – Under current law, there are no express limitations on the use of "retention bonuses" for key employees (commonly referred to as "KERP plans"). Such KERP plans are subject to court approval under the debtor’s "business judgment" standard under § 363(b). The Act severely restricts a debtor’s ability to pay retention bonuses and make severance payments to insiders. Under the Act provisions, debtors will be allowed to pay retention bonuses to an insider only if, among other things, the insider has a bona fide job offer from another company at the same or greater rate of compensation, and the insider’s services are essential to the debtor’s business. The Act also limits the amount that may be awarded under a KERP program.

PLAN EXCLUSIVITY – The Act provides for a strict eighteen-month limit on the time period during which a debtor has the exclusive right to file a chapter 11 plan. Currently, § 1121 contains a 120-day exclusivity which may be extended for "cause" (including the complexity of the case), and courts routinely extend the debtor’s exclusivity period, sometimes for years. The Act also limits the period to solicit acceptances of a filed plan to twenty months. As such, a debtor cannot circumvent the strict limitations on exclusivity merely by filing a draft plan and waiting for additional time (beyond the additional two-month solicitation period) to seek to obtain acceptances.

TAXES – The Act provides for various changes and new rules relating to tax issues arising in connection with bankruptcy cases, including the treatment of tax claims under a chapter 11 plan.

1. Confirmation Issues - Under an amendment to § 1129(a)(9)(C) of the Code, a debtor will be required to make regular installment payments of unpaid tax claims over less than five years in a manner no less favorable than the most favored non-priority unsecured claim provided for in the plan. The Act also provides, under § 511, that the interest rate for mandatory interest payments on tax claims will be conformed for all tax claims by determining such rate under applicable nonbankruptcy law, and in the case of a confirmed plan, such rate will be determined at the end of the calendar month in which the plan is confirmed.
2. Provisions Facilitating Tax Collection – Under § 724(f), the Act limits the types of claims that may be paid with or from the proceeds of property securing a tax claim to claims for unpaid wages, salaries, and commissions, and claims for contributions to an employee benefit plan. The Act also requires, under § 1308, that chapter 13 debtors file all pre-petition tax returns prior to the first meeting of creditors. Certain pre and post-petition taxes secured by property of the estate and post-petition taxes not secured by property of the estate, including ad valorem property taxes, incurred by the bankruptcy estate will be entitled to administrative expense priority payment under § 503(b)(1). Finally, under § 362(b)(26), taxing authorities will be permitted to set-off income tax refunds against income tax liabilities, when each relates to a taxable period prior to the petition date.
3. Discharge - Pursuant to § 1141(d) of the Code, the confirmation of a plan discharges a debtor from debts arising pre-confirmation. The Act excepts from a corporate debtor’s discharge any debt owed to the government due to fraud and arising from a fraudulent tax return or willful tax evasion. Also, under § 1328(a)(2), chapter 13 debtors will not be discharged of any obligations with respect to fraudulent tax returns. Finally, the Act clarifies that under § 523(a), a debtor will not be discharged of liability relating to tax returns which the taxing authorities were required to prepare based on information gathered without the taxpayer’s assistance.

RETIREE BENEFITS – The Act amends § 1114 of the Code to confer on the court the power to undo certain pre-petition modifications to "retiree benefits" (which include (i) medical, surgical or health care benefits, and (ii) benefits relating to disability, sickness, accident or death). As amended, the section provides that if a debtor modifies "retiree benefits" within 180 days preceding commencement of the case, the court, upon request of a party in interest, will negate the modifications and reinstate the benefits as they existed immediately prior to the modification. However, the court will allow the modification to remain unaffected if it finds that the balance of the equities clearly favors such modification.

DISINTERESTEDNESS AND INVESTMENT BANKERS – Currently, § 101(14) of the Code provides that certain persons performing work for the debtors as investment bankers are not "disinterested" and therefore do not qualify to represent the debtor in a bankruptcy case. The Act provision removes any mention of investment bankers and attorneys from the definition of "disinterested person," meaning that the debtor’s pre-petition investment bankers and its attorneys will be permitted to work for the debtors after the bankruptcy filing.

AVOIDANCE PROVISIONS – The Act provides for significant changes to the Code’s various avoidance power provisions. Currently, § 547(c)(2) of the Code provides for a defense to a preference action if the transfer was (i) in payment of a debt incurred by the debtor in the ordinary course of business of the debtor and the transferee; (ii) made in the ordinary course of business of the debtor and the transferee, and (iii) made according to ordinary business terms. All three elements are required for this key preference defense. Under the Act, the defense is available if the creditor establishes the first element and either that the transfer was made (i) in the ordinary course of the business of the debtor and creditor, or (ii) according to ordinary business terms. The Act also provides for an increase in the § 548 reach back period during which transfers may be considered fraudulent from one to two years and includes a provision that any transfer made in exchange for less than a reasonably equivalent value, and made to an insider under an employment contract and not in the ordinary course of business would be avoidable as a fraudulent transfer. This latter provision could include extraordinary bonuses or payments made to management or directors.

UTILITIES AND ADEQUATE ASSURANCE – The Act provides that a debtor must provide adequate assurance, in the form of a cash deposit, surety bond, or other instrument, to utilities within 30 days of commencement of a chapter 11 case. This will end the current practice under § 366 of the Code of deeming utilities adequately assured of payment by way of their administrative expense claims for post-petition service. If the debtor fails to provide adequate assurance within 30 days, utilities may discontinue service.

DISMISSAL AND CONVERSION OF CHAPTER 11 CASE – § 1112(b) of the Code currently provides that the court "may" convert a chapter 11 case to one under chapter 7 upon a showing of cause. Under the Act’s amended § 1112(b), dismissal or conversion upon a showing of cause is mandatory absent unusual circumstances establishing that conversion or dismissal is not in the best interests of creditors and the estate. The Act also lists additional specific grounds that constitute cause warranting dismissal or conversion. The additional grounds include gross mismanagement of the estate, failure to maintain appropriate insurance, unauthorized use of cash collateral, failure to timely pay taxes and file tax returns, failure to file a disclosure statement, and revocation of an order of confirmation.

PRIORITY WAGE CLAIMS – The Act increases the amount of priority wages claims allowed under § 507(a) of the Code from $4,925 to $10,000. It also expands the pre-petition protected period for earned wages and benefits from 90-days to 180-days before the petition date.

APPOINTMENT OF CHAPTER 11 TRUSTEE – Under current § 1104(a) of the Code, a court may appoint a chapter 11 trustee upon a showing of cause or if such appointment is in the best interests of the creditors, equity holders and other interests of the estate. The Act amends § 1104(a) to provide that the court may appoint a trustee where cause exists to dismiss or convert the chapter 11 case if the court concludes that to do so is in the best interests of the creditors and the estate. The Act also adds § 1104(e), which obligates the United States trustee to move for the appointment of a trustee if reasonable grounds exist to suspect fraud by debtor’s board of directors or high level management.

RECLAMATION - § 546(c) of the Code allows a seller of goods to assert a claim for reclamation within 10 days after the debtor’s receipt of the goods. If the 10 days expires after the debtor’s bankruptcy filing, the seller is permitted to assert its reclamation claim up to 20 days after the debtor’s receipt of the goods. The Act amends § 546(c) to provide that if the debtor was insolvent within 45 days of the petition date, the seller has 45 days after receipt of the goods or 20 days after the petition date, whichever is later, to assert its reclamation claim. If the seller fails to timely give notice of its reclamation claim, it may assert an administrative claim for the value of any goods received by the debtor within 20 days prior to the petition date under amended § 503(b)(9).

EFFECTIVE DATE OF THE ACT CHANGES – Most of the Act’s provisions take effect 180 days following its enactment. However, certain amendments relating to (i) priority of pre-petition wages, (ii) payments to insiders under employment contracts as fraudulent transfers, (iii) debtor’s prepetition modification of retiree benefits, (iv) jurisdiction of district court over employment of professionals, and (v) appointment of trustees in cases of suspected fraud are immediately effective upon enactment by the President.