THE BUSINESS SIDE OF THE NEW BANKRUPTCY ACT

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1 APRIL 2005 APRIL 2005 THE BUSINESS SIDE OF THE NEW BANKRUPTCY ACT CONTENTS Effective Date... 1 Preferences... 1 Fraudulent Transfers... 2 Reclamation Rights... 3 Executory Contracts and Unexpired Leases... 4 Notice to Creditors... 5 Disclosure of Information to Creditors... 5 Warehouseman s Lien... 6 Limiting Retention Bonuses, Severance Pay, etc... 6 Committees... 6 Small Business Cases... 7 Single Asset Real Estate Cases... 8 Health Care Business Cases... 8 Chapter 11 Cases by Individual Debtors... 9 Involuntary Bankruptcy Cases Prepackaged Plans Limits on Extending Exclusivity Curbing Abusive Filings Dismissing, Converting, and Appointing a Trustee in Chapter 11 Cases Miscellaneous Amendments The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 ( BAPCPA ) was signed into law by President Bush on April 20, Due to extensive media coverage and political debate, it is generally known that BAPCPA substantially changes consumer bankruptcy law. However, the 500-page plus legislation also makes important changes to business bankruptcy law of which our clients should be aware. This Client Alert, prepared by Womble Carlyle s Bankruptcy and Creditors Rights Practice Group, summarizes the key business bankruptcy law changes by BAPCPA and offers advice on how some of the changes are likely to affect our clients. (Not covered are various provisions of BAPCPA dealing with municipal cases, tax issues, bankruptcy statistics and data, ancillary and cross-border insolvency cases, financial contract provisions, family farmer and fishermen cases, consumer cases, and consumer credit disclosure.) For ease of presentation, we use debtor to include debtor in possession and trustee as those terms are used in the Bankruptcy Code. Effective Date Generally, BAPCPA will take not take effect until 180 days after enactment October 17, 2005 and will not apply to bankruptcy cases commenced before the effective date. Relevant exceptions are noted below. Preferences One of the defenses to an avoidable preference is commonly called the ordinary course of business defense. Under existing law, the defense requires the transferee (i.e., the creditor who receives the alleged preferential payment from the debtor) to prove three things: (1) that the payment was incurred in the ordinary course of business or financial affairs of the debtor and transferee, (2) that the payment was made in the ordinary course of business or financial affairs of the debtor and transferee, and (3) that the payment was made according to ordinary business terms. It requires not only proof of the ordinary course of business between the debtor and transferee and the alleged preference s being consistent with that course of business, but also proof of the ordinary business terms in the relevant industry and the transfer s being consistent with the industry norm. Expert testimony is typically required to prove the

2 industry s ordinary business terms. Because the transferee carries the burden of proof, if any one of the elements is not established, the defense will fail. For all these reasons, unless an alleged preference was received within stated invoice terms, the defense has generally been hard and expensive to prove. BAPCPA makes the ordinary course of business defense much easier to prove. It requires proof only that the transfer was made either in ordinary course of business or financial affairs of the debtor and transferee or according to ordinary business terms. This means greater leverage for our clients in negotiations to settle preference claims and could lead to more preference claims being litigated to judgment. BAPCPA also adds a new preference defense in cases not involving primarily consumer debts. In such cases, a transfer will not be an avoidable preference if the aggregate value of all property that constitutes or is affected by such transfer is less than $5,000. The defense applies to each transfer. Thus, if a creditor in a business case receives an alleged preferential payment for less than $5,000, it should be defensible even if the creditor receives other payments and collectively receives more than $5,000. We also believe this new defense is likely to spawn litigation over what is meant by the aggregate value of property affected by a transfer. BAPCPA provides that if the trustee avoids a transfer made between 90 days and 1 year prior to the petition date to non-insider creditor for the benefit of an insider creditor, such transfer shall be considered avoided only as to the insider creditor. This amendment will apply to pending cases as well as cases commenced after enactment. The existing preference statute provides that a purchase money security interest is not avoidable so long as it is perfected within 20 days after the debtor receives the property purchased. BAPCPA expands the time to perfect from 20 to 30 days. Finally as to preferences, BAPCPA requires that lawsuits to recover preferences in amounts less than $10,000 will have to be brought in the defendant's home district, rather than in the bankruptcy court where the debtor's case is pending. As a practical matter, a debtor is not likely to sue for preferences of less than $10,000 if forced to do so outside the state where the bankruptcy case is pending. Fraudulent Transfers Fraudulent transfers are avoidable under existing bankruptcy law if they occur within 1 year immediately preceding the bankruptcy petition. BAPCPA increases the look-back period from 1 to 2 years. (Note that a debtor may also avoid transfers that are fraudulent under applicable state law where the look-back period is typically 3 or 4 years.) BAPCPA targets compensation paid under pre-petition employment contracts with officers and other insiders for possible avoidance as fraudulent transfers. First, any transfer to or for the benefit of an insider under an employment contract is avoidable as a fraudulent transfer if made within 2 years of the bankruptcy petition date and with actual intent to hinder, delay or defraud creditors. Second, any such transfer is avoidable as a fraudulent transfer if made within 2 years of the bankruptcy petition date, if less than reasonably equivalent value was received, and if made to or for the benefit of an insider, under an employment contract and not in the ordinary course of business. A new provision is added allowing avoidance of transfers made within 10 years of the petition date if made to a self-settled trust or similar device by the debtor, the debtor is a beneficiary, and the debtor made the transfer with actual intent to hinder, delay or defraud creditors. Actual intent may be established by proving that the transfer was made in anticipation of any money judgment, settlement, civil penalty, equitable order or criminal 2

3 fine incurred, or which the debtor believed would be incurred, as a result of violating certain securities laws. Whether anticipation of violating other laws will establish actual intent for this purpose is an open issue. These amendments to the fraudulent transfer law became effective immediately upon enactment, but only apply to bankruptcy cases filed on or after the date of enactment except that the 2-year look-back only applies to cases filed more than 1 year after enactment. Reclamation Rights BAPCPA materially expands the rights of vendors who sell goods on open credit. First, BAPCPA amends existing bankruptcy law on reclamation rights by increasing from 10 days to 45 days the pre-petition period during which goods received by an insolvent debtor may be reclaimed. The seller must demand reclamation of goods in writing not later than 45 days after the debtor s receipt of the goods or not later than 20 days after the date of the commencement of the bankruptcy case if the 45-day period expires after commencement of the bankruptcy case. Another amendment codifies case law recognizing that a vendor s reclamation rights are subject to the prior rights of a holder of security interest in the subject goods and proceeds thereof. Separate and apart from the above-described right to reclaim goods, BAPCPA gives vendors a new administrative expense priority claim for the value of any goods sold to the debtor in the ordinary course of the debtor s business and received by the debtor within 20 days before the date of commencement of the bankruptcy case. To qualify for this priority claim, no proof is required that the subject goods are still in the debtor s inventory or that there are no overriding prior rights of creditors secured by the inventory. Litigation should be anticipated over establishing the value of goods for purposes of the amendment. For clients who do their own proofs of claim, please keep in mind that allowance and payment of administrative expense claims must be requested by a filing with the bankruptcy court that is separate from the proof of claim. These changes raise a number of questions that are not likely to be answered until the courts interpret and apply the amendments. Will a vendor be able to reclaim goods for the full 45-day period and also be allowed an administrative expense priority claim for the overlapping 20-day period, or must the vendor make an election of remedies? The amendment does not expressly prohibit making both claims. At a minimum, a vendor will be able to assert an administrative expense priority claim for goods received by the debtor within the 20 days immediately preceding the commencement of the bankruptcy case and a claim for physical reclamation of goods received by the debtor within the period from 21 to 45 days preceding the case. If a vendor makes demand and then prosecutes a reclamation claim for the full 45-day period, may the debtor compromise and settle the claim by court order approving the debtor s retention of the goods in exchange for granting the vendor an administrative expense priority claim for the value of the retained goods? Would this be a way to expand beyond the 20-day administrative expense priority claim to which all vendors will be entitled without making a reclamation demand? Under current law, vendors make reclamation demands which they hope to convert into priority claims, i.e., vendors don t normally press for physical reclamation of goods and if they did, existing law authorizes the court to deny reclamation in exchange for an administrative expense priority claim. BAPCPA s only remedy for the period from 20 to 45 days prior to commencement of the bankruptcy case will be physical reclamation of goods. This means that vendors who are serious about reclaiming their goods will need to take affirmative action in the bankruptcy court to lift the automatic stay so that goods can be reclaimed, to obtain discovery of the debtor s business records on receipt of goods and of any creditors secured by the debtor s inventory, and to enjoin the debtor from continuing to sell the goods pending a resolution of the reclamation claim. 3

4 The courts will need to sort out how to determine and balance the prior rights of creditors secured by the goods against the rights of reclaiming vendors. Assuming equity in the debtor s inventory beyond the secured debt, there may be competition by reclaiming vendors for that equity. For example, if the inventory equity is determined to be $1,000,000, and the total value of all goods subject to 45-day reclamation demands is $2,000,000, will the court restrict each reclaiming vendor to repossessing 50% of its goods or will a first come, first served approach be used, rewarding the vendors who are first to seek relief? Clients are advised to maintain, in the ordinary course of business, dated delivery receipts signed by customers or other records evidencing when goods were received by customers at least over the prior 45 days. Because physical reclamation of goods is now an important remedy, clients with reclamation claims are advised to take prompt affirmative action (lift stay motion, discovery, injunction, adversary proceeding) early in bankruptcy cases, rather than to continue the customary practice of simply making written reclamation demands and waiting to see how reclamation claims are administered by the debtor. We anticipate that over time the courts and debtors will react to BAPCPA by developing omnibus procedures for administering reclamation claims just as they have for existing reclamation law. Executory Contracts and Unexpired Leases The rights of commercial landlords are strengthened in several ways. Most importantly, business tenants will not be able to obtain unlimited extensions of time within which to assume or reject leases. Under current law, the decision to assume or reject a nonresidential real property lease must be made within 60 days of the petition date unless extended by court order. Many bankruptcy courts have adopted the practice of allowing extensions indefinitely up to confirmation of the debtors chapter 11 plans. BAPCPA puts an end to that practice, enlarging the initial decision period from 60 to 120 days (in recognition that most debtors are too preoccupied with other matters early in their cases to make informed decisions on commercial leases), authorizing the court to grant a single 90-day extension for cause upon motion made during the initial 120-day period, and authorizing further extension only with the landlord s prior written consent. Under existing bankruptcy law, the debtor cannot assume an unexpired lease without curing defaults or providing adequate assurance that defaults will be cured. The courts have split on whether the cure requirement applies to nonmonetary as well as monetary defaults. BAPCPA clarifies the issue in two ways. First, as to all residential and nonresidential real property leases, nonmonetary defaults must be cured, unless it is impossible to do so, by performing nonmonetary acts at and after assumption. Second, as to nonresidential real property leases only, nonmonetary defaults arising from the failure to operate in accordance with the lease must be cured by performance at and after assumption. In addition, any pecuniary losses suffered by a landlord as a result of a debtor s failure to operate in accordance with a nonresidential real property lease must be compensated as a condition of assumption. BAPCPA adds the following exception to classes of claims and interests that are impaired for purposes of voting on chapter 11 plans: A class is not impaired and entitled to vote on a plan if each claim or interest in the class arises from the debtor s failure to perform a nonmonetary obligation (other than a default arising from failure to operate a nonresidential real property lease) and the plan compensates the holder of such claim or interest (other than the debtor or an insider) for any actual pecuniary loss incurred as a result of such failure to perform. The rights of commercial landlords whose leases are first assumed and later rejected in bankruptcy are clarified and strengthened. First, such a landlord is granted an administrative expense priority claim for all monetary obligations due under the lease (excluding only obligations arising from or relating to failure to operate or a penalty provision) for the period of 2 years following the later of the rejection date or the date the premises are 4

5 turned over. The only offsets or reductions to this administrative priority claim are for sums actually received or to be received from an entity other than the debtor. Thus, the claim will generally not be mitigated unless and to the extent the landlord succeeds in reletting the premises and receives, or is contractually entitled to receive, rent from the new tenant within the 2-year period. Finally, the landlord will have a general unsecured claim for any remaining sums due under the rejected lease (i.e., beyond sums due during the 2-year period). This unsecured claim is subject to the existing limitation on lease rejection damages, i.e., the rent reserved under the lease for the greater of 1 year or 15% (not to exceed 3 years) of the remaining term. However, BAPCPA is unclear as to whether the rent reserved is to be calculated from the petition date, from the rejection date, or from the date that is 2 years following rejection. Notice to Creditors Under existing law, notice to creditors of bankruptcy filings and deadlines is sometimes defective (e.g., mailed to lock box address, wrong address, satellite office), leading to inadvertent violation of the automatic stay, violation of the turnover law, failure to file timely proofs of claim, and other consequences harmful to creditors interests. BAPCPA allows creditors to protect against defective notice. If at least twice within the 90 days immediately preceding a bankruptcy petition (or at any time if sending such communication within the 90-day period would violate nonbankruptcy law), a creditor communicates to the debtor its address for receipt of correspondence and its account number for the debtor, then any required bankruptcy notice by the debtor must be sent to such address and specify such account number. Any bankruptcy notice provided to a creditor other than in conformance with the above will not be effective until brought to the attention of the creditor. If a creditor designates a person or subdivision to be responsible for receiving bankruptcy notices and establishes reasonable procedures for such notices to be delivered to such person or subdivision, then notice not in conformance with the above will not be considered to be brought to attention of the creditor until actually received by such person or subdivision. No monetary penalty may be imposed for violation of the automatic stay or failure to turn over property of the estate unless the conduct that forms the basis of the alleged violation occurred after receipt of proper notice of the order for relief. In light of these provisions, clients are advised to designate an individual by name or title for receipt of all bankruptcy notices; to insert this information, together with the individual s mailing address, in the standard terms and conditions of invoices to customers or in the credit applications that customers fill out; and periodically to remind other employees to forward any bankruptcy notices to the designated individual. These steps should be recognized by the courts as establishing the reasonable procedures required to benefit from the law. Disclosure of Information to Creditors Under an existing bankruptcy rule, parties and their counsel may be sanctioned for presenting documents except a list, schedule or statement to the court that are not factually supported and consistent with the law or with a nonfrivolous argument to modify or extend the law. In a sense of Congress provision, BAPCPA urges the Supreme Court to modify the rule so that it covers all documents (including schedules), signed and unsigned, submitted to a court by debtors and requires, before submission, reasonable inquiry to verify that the information in the documents is well grounded in fact and warranted by existing law or a good faith argument for extension, modification or reversal of existing law. This provision should improve the accuracy and reliability of information contained in debtor s bankruptcy filings including chapter 11 schedules and statements of financial affairs. The Judicial Conference of the United States is directed to propose amended bankruptcy rules and to prescribe official bankruptcy forms directing chapter 11 debtors to file and serve periodic reports on the value, operation 5

6 and profitability of any closely held corporation, partnership, or other entity in which the debtor holds a substantial or controlling interest. The stated purpose of this amendment is to assist creditors and other interested parties in ensuring that such interests of the debtor are used to pay allowed claims. As written, the directive to the Judicial Conference covers all entities in which a chapter 11 debtor holds a substantial or controlling interest, whether the entities are debtors in affiliated cases or are operating outside of bankruptcy. What constitutes a substantial or controlling interest is not defined. Warehouseman s Lien Existing bankruptcy law permits avoidance of certain statutory liens, including those not perfected or enforceable at the commencement of the bankruptcy case as well as those for rent. BAPCPA creates an exception by prohibiting avoidance of a warehouseman s lien for storage, transportation, or other costs incidental to the storage and handling of goods. The prohibition is to be applied in a manner consistent with any state statute applicable to such lien that is similar to section of Uniform Commercial Code, as currently enacted or hereafter amended. The full meaning of this last provision is unclear, but it suggests, among other things, that if a warehouseman loses his lien under Section of the UCC, such as by voluntarily delivering the goods or unjustifiably refusing to deliver the goods, he will not be able to enforce the lien in bankruptcy. Limiting Retention Bonuses, Severance Pay, and Other Obligations to Insiders and Consultants BAPCPA places significant limitations on retention bonuses and severance pay to insiders and on other transfers or obligations that are outside the ordinary course of business and not justified by the facts and circumstances of the case, including transfers made to, or obligations incurred for the benefit of, officers, managers, or consultants hired after the date of the filing of the petition. Committees Upon request by a party in interest and after notice and hearing, a bankruptcy court may order the United States Trustee to change the membership of a committee if the court determines change is necessary to ensure adequate representation of creditors or equity interest holders. This should increase requests by trade creditors in larger cases for representation on committees that are dominated by bondholders. Bankruptcy courts are also authorized to change the membership of a creditors committee by ordering the United States Trustee to add a small business (as defined in section 3(a)(1) of Small Business Act) member, provided that the court determines that the small business holds claims that, in comparison with its annual gross income, are disproportionately large. Committees are required to provide access to information by non-member creditors who hold claims of the sort represented by the committee. Further, committees must solicit and receive comments from such non-member creditors and be subject to court order that compels further reports to such creditors. One likely consequence of these changes is increased administrative fees of committee professionals in conducting these communications with non-member creditors. It may also impair confidential communications between the debtor and committee members, because of the risk that the committee will voluntarily or by compulsion of court order disseminate information obtained from debtors broadly to the creditor body. On the other hand, clients who do not serve on a committee but have an unsecured claim in a case should find it easier to obtain relevant information from committee members or professionals. 6

7 Small Business Cases BAPCPA changes the definition of a small business debtor and amends chapter 11 procedures for small business debtors in several respects. Under existing law, a small business debtor is a person engaged in commercial or business activities (other than real estate) whose aggregate non-contingent, liquidated debts, both secured and unsecured, do not exceed $2,000,000 on the petition date. The definition is substantially amended by requiring that the $2,000,000 debt limit not be exceeded on either the petition date or the date the order for relief is entered in an involuntary case, by excluding from the $2,000,000 limit any debt owed to affiliates or insiders, and by excluding cases where a creditors committee has been appointed unless the court has determined that the committee is not sufficiently active and representative to provide effective oversight of the debtor. Finally, the definition is amended to include any affiliate that is also a debtor except for any member of an affiliated group of debtors with debt that exceeds the $2,000,000 limit. How this last amendment will be construed and applied by the courts is unclear. It suggests that the debts owed by affiliated debtors will not be aggregated in determining whether the $2,000,000 debt limit is satisfied, and that some members of an affiliated debtor group will qualify as small business debtors while others will not. Generally, affiliated cases are consolidated for administrative purposes (e.g., first meeting of creditors, debtors filings, deadlines, hearings, etc. all occur at the same time). However, if not all members of an affiliated group qualify as small business debtors, administrative consolidation will be difficult because the procedures in small business cases differ materially from those in other chapter 11 cases. The end result may to discourage such debtors from electing to be considered small businesses. (There is no change in existing law that allows a small business debtor to choose between normal chapter 11 procedures and the more streamlined, less costly chapter 11 procedures afforded small business debtors.) In other amendments regarding small business chapter 11 cases: the $2,000,000 debt limit is subject to adjustment in future years; the Judicial Conference is required to prescribe standard form disclosure statements and plans designed to balance the needs for information against the needs for economy and simplicity; debtors are required to file periodic financial statements and reports containing information on profitability, cash flow projections, actual receipts and disbursements, compliance with tax filings and payments, and other matters; the Judicial Conference is required to prescribe standard form financial statements and reports for debtors; debtors are charged with specific duties, including (i) to file with the petitions (or within 7 days after an order for relief is entered in an involuntary case) their most recent balance sheets, operating statements, cash flow statements and federal income tax returns, (ii) to have senior management attend meetings scheduled by the court and the United States Trustee, (iii) to file timely schedules, statements of financial affairs, and monthly operating reports, (iv) to maintain insurance customary and appropriate to the industry, (v) to file tax returns and pay taxes timely, and (vi) to allow inspection of books and records by the United States Trustee; the initial exclusivity period for a small business debtor to file a plan is extended from 100 days to 180 days, and the period during which any party must file a plan and disclosure statement is extended from 160 days to 300 days; these time periods cannot be extended unless prior to their expiration the debtor (BAPCPA appears to have a drafting error in that Congress must have intended that any plan 7

8 proponent not just the debtor could seek an extension of the 300-day period) has demonstrated the likelihood of plan confirmation within a reasonable time, a new deadline is imposed, and the extension order is signed by the court; in a material departure from current practice, the United States Trustee is required to become actively involved in investigating, monitoring, and assisting the small business debtor and to seek conversion or dismissal of the case if circumstances warrant; and the automatic stay does not protect a small business debtor guilty of serial chapter 11 filings. Single Asset Real Estate Cases Under existing bankruptcy law, the term single asset real estate means property securing no more than $4,000,000 in noncontingent, liquidated debt. BAPCPA eliminates any dollar cap on secured debt. To keep the automatic stay in place, single asset real estate debtors are currently required within 90 days after the order for relief is entered (or such later date as the court may order for cause) either to file a chapter 11 plan that has a reasonable possibility of being confirmed within a reasonable time or to commence monthly payments to secured creditors. BAPCPA codifies the practice of many courts to allow a single asset real estate debtor to use the rents and income generated from the property in making the required monthly payments to secured creditors. BAPCPA also amends the time period for filing a plan or starting payments by making it the later of 90 days or 30 days after the court determines that it is a single asset real estate case. Finally, BAPCPA provides that the monthly payments must be made in an amount equal to interest at the nondefault contract rate (as opposed to the current fair market rate under existing law) on the creditor s interest in the property. Health Care Business Cases Health care business is a newly defined bankruptcy term and broadly includes all public and private profit and non-profit entities primarily engaged in the diagnosis or treatment of injury, deformity, or disease, and surgical, drug treatment, psychiatric or obstetric care. Specific examples of health care businesses are any general or specialized hospital, ancillary ambulatory, emergency, or surgical treatment facility, hospice, home health agency, or similar health care institution. Other examples are any long-term care facility including any skilled nursing facility, intermediate care facility, assisted living facility, home for the aged, domiciliary care facility, and any related health care institution primarily engaged in offering room, board, laundry, or personal assistance with and incidentals to activities of daily living. Patient and patient records are also newly defined terms, and the debtor in a health care business case is prohibited from destroying patient records unless they have not been claimed by patients or insurance carriers after a full year s notice and unless the debtor has requested and been denied the right to deposit the records with appropriate federal agencies. New administrative expense priority claims are created for the costs and expenses incurred by the debtor or governmental agency in disposing of patient records and in transferring patients from a health care business that is closing to another health care business. In liquidation as well as reorganization cases of health care businesses, the court is directed to order the appointment of an ombudsman to protect the interests of patients unless the court finds, under the specific facts of a case, that the appointment is unnecessary. Once ordered, the United States Trustee is charged with making the appointment. The ombudsman is required to file periodic reports with the court concerning the quality of patient care, including whether it is declining significantly or is otherwise being materially compromised. If 8

9 the ombudsman detects a problem with patient care, BAPCPA authorizes him to file and serve a motion or a written report, but is silent on what relief might be requested or granted. Ombudsmen in health care business cases are to be compensated in the same way as other debtor professionals. Where a health care business is being closed, the debtor must use all reasonable and best efforts to transfer patients to another health care business that is in the same vicinity, provides substantially similar services, and maintains a reasonable quality of care. If a debtor fails in this regard, we would expect the court to hold that the ombudsman has standing to seek relief, but it is unclear what the range of the relief might be. BAPCPA does not expressly require the debtor to obtain court approval for the transfer of patients, but as a practical matter we would expect the debtor and its bankruptcy counsel to move for such approval. Finally as to health care business cases, BAPCPA adds another exception to the automatic stay by permitting the Secretary of Health and Human Services to exclude the debtor from participating in medicare or other federal health care programs. Chapter 11 Cases by Individual Debtors BAPCPA makes numerous changes to the law governing chapter 11 cases by individual debtors. Such debtors are often professionals or guarantors of debt owed by corporations and other business entities that they own and that file related chapter 11 cases. If a creditor moves for relief from the automatic stay in an individual chapter 11 case, the stay will automatically terminate unless the motion is decided by the court within 60 days or the 60-day period is extended either by consent of the parties or by court order for a specific period required for good cause as described in findings by the court. Under existing law, property of the estate in an individual chapter 11 case does not include post-petition earnings by the debtor for services rendered. Particularly in cases involving doctors, lawyers, dentists, accountants and other professionals, the courts have differed markedly in how they divide post-petition income of the debtors professional practices into that which is not part of the estate (i.e., earnings for the debtors services) and that which is (i.e., earnings attributable to services performed by staff personnel, sales of related goods such as medical devices, orthodontic appliances, etc., and other assets of the professional practice). BAPCPA amends the law to provide that in every chapter 11 case of an individual debtor, property of the estate includes all of the debtor s earnings for services rendered post-petition until the case is closed, dismissed or converted. BAPCPA requires that the chapter 11 plan in an individual debtor s case must provide that the debtor s postpetition earnings will be used as necessary to execute the plan. In order for an individual debtor to cram down a chapter 11 plan over the objection of an unsecured creditor, the debtor must show that the value of the property to be distributed under the plan is not less than the debtor s projected disposable income for the longer of 5 years or the period of distribution under the plan. An individual chapter 11 debtor cannot obtain a discharge unless either he has completed payments under his confirmed plan or, after notice and hearing, the court grants discharge after finding that payments made under plan are greater than what creditors would have received had there been a liquidation under chapter 7 and plan modification is not practicable. The right to modify an individual debtor s confirmed chapter 11 plan is expanded. At any time prior to completion of all payments under the plan, the debtor, the United States Trustee or an unsecured creditor with 9

10 an allowed claim may request plan modification to alter the amount of payments to a class, the time period for such payments, or the payments to an individual creditor to account for payments received by the creditor from a source other than the plan. A related amendment appears to require that all chapter 11 plan modifications whether made before or after confirmation and whether the debtor is an individual or not do not become effective until after there has been such disclosure as the court may direct, notice and hearing, and approval by the court. Currently, individual debtors can elect the exemptions specified in the bankruptcy law or the exemptions available under applicable state law. In Florida and a few other states, the homestead exemption is either unlimited or so broad as to allow exemption by an individual debtor of millions of dollars invested in a principal residence. BAPCPA curbs this abuse in several ways. First, the homestead exemption will be reduced to the extent of fraud where non-exempt property was disposed of by the debtor within 10 years prior to the bankruptcy petition with intent to hinder, delay, or defraud a creditor. Second, the homestead exemption is limited to $125,000 of the debtor s interest in property acquired within 1215 days (i.e., 3 years) prior to the bankruptcy petition, notwithstanding more liberal state exemption laws. The $125,000 limitation does not include the debtor s interest in a prior principal residence that was acquired more than 3 years prior to the bankruptcy petition and that the debtor transferred into his current principal residence, provided that both are in the same state. Even if the debtor s homestead was acquired more than 3 years prior to the bankruptcy filing, the debtor can only exempt up to $125,000 if the court determines, after notice and hearing, that the debtor has been convicted of a felony reflecting that the bankruptcy filing was an abuse or if the debtor owes a debt arising from (i) securities violations, (ii) fraud, deceit, or manipulation in a fiduciary capacity or in connection with purchase or sale of security, (iii) a civil remedy for violation of the federal Racketeering Influenced and Corrupt Organizations Act, or (iv) any criminal act, tort, willful or reckless misconduct that causes death or physical harm to individual. Finally as to individual chapter 11 debtors, the bankruptcy court shall not confirm a plan unless requested tax documents have been filed with the court. Involuntary Bankruptcy Cases Involuntary bankruptcy cases must be brought by a petitioning creditor or creditors who, among other things, have claims that are not the subject of a bona fide dispute. BAPCPA modifies the law by requiring that there be no bona fide dispute as to liability or amount of the creditor s claim. Presumably this new provision will be satisfied by a claim that is beyond bona fide dispute as to some dollar amount. For example, if a creditor s total claim is $500,000, of which half is subject to bona fide dispute and the other half is indisputably owed, the creditor should not be disqualified as a petitioner on the ground that his claim is subject to bona fide dispute as to amount. This is one of the rare provisions of BAPCPA that became effective upon enactment and applies to all involuntary cases commenced before, on or after enactment. Prepackaged Plans BAPCPA adds a new provision to the bankruptcy law that allows solicitation of acceptance or rejection of a plan from a holder of a claim or interest even though the holder has not received an approved disclosure statement, provided that the solicitation complies with applicable nonbankruptcy law and provided further that the holder was solicited before the commencement of the chapter 11 case in a manner complying with applicable nonbankruptcy law. 10

11 In a related change, the court, upon motion by an interested party and for cause, may order the United States Trustee not to conduct a meeting of creditors or equity holders if the debtor has filed a plan for which it solicited acceptance prior to commencement of the case. Presumably cause would not exist if the debtor failed to solicit acceptance in accordance with applicable nonbankruptcy law. Limits on Extending Exclusivity The debtor in a chapter 11 case (other than a small business case) is the only party permitted to file a plan within 120 days of the order for relief and to gain acceptances of the plan within 180 days of the order for relief. Under existing law, these exclusive periods for the debtor may be increased or reduced for cause, and in practice many courts have granted multiple increases that extend a year or more. BAPCPA limits extension of the 120-day period to 18 months and extension of the 180-day period to 20 months. For our clients that sell to financially distressed retail chains, we expect these new limits on exclusivity to weigh heavily in their decisions on when to file for chapter 11 relief. Some may be pushed to file before this provision of BAPCPA becomes effective in 6 months. Otherwise, we expect retail chains will now be more likely to file in the second half of the year. Curbing Abusive Filings BAPCPA targets individual debtors who file two or more bankruptcy cases (including chapter 11 cases) by defining circumstances in which such repeat filings will be presumptively (but a presumption subject to rebuttal) in bad faith and by making it easier for creditors to obtain relief from the automatic stay. Special relief is accorded creditors secured by real property of an individual debtor making multiple bankruptcy filings. A new ground is added for obtaining relief from the automatic stay, namely, if the court finds that the bankruptcy petition was part of a scheme to delay, hinder or defraud creditors involving either (i) a full or partial transfer of ownership of the real property without consent of the secured creditor or court approval or (ii) multiple bankruptcy filings affecting the real property. If a lift stay order is entered on this ground, the secured creditor can record it with the register of deeds or other recording office for interests in real property, and the recorded order will be binding in any subsequent bankruptcy case filed within 2 years of the order s entry, subject to the right of the debtor to move for relief from the order based upon changed circumstances or other good cause shown. Finally, exceptions to the automatic stay are added for acts to enforce a lien or security interest in real property where a court order of the type described above has been entered in a prior case (again subject to the debtor s right to seek relief from the order for changed circumstances or other good cause), where the debtor is ineligible to file the current case, and where the current case is filed in violation of a court order in a prior case prohibiting the debtor from filing a new case. To qualify for the first of these new exceptions to the automatic stay, the court order in a prior case does not have to be publicly recorded. Dismissing, Converting, and Appointing a Trustee in Chapter 11 Cases Existing bankruptcy law provides for the election of a chapter 11 trustee upon request by a party in interest and pursuant to supervision by the United States Trustee. BPACPA adds provisions requiring the United States Trustee to file a report certifying the election, specifying when the elected trustee assumes office and replaces any interim or other trustee appointed by the United States Trustee, and, finally, providing that the court shall resolve any dispute arising out of a trustee election. BAPCPA encourages dismissal or conversion of a chapter 11 case in appropriate circumstances and expands the grounds for such relief. Under existing law, the court may convert or dismiss a chapter 11 case for cause. As amended, the court shall convert or dismiss for cause absent unusual circumstances specifically 11

12 identified by the court that establish that the requested conversion or dismissal is not in the best interests of creditors and the estate. Such unusual circumstances will be established if there is a reasonable likelihood for a plan to be confirmed in a reasonable timeframe or if the grounds for dismissing or converting include an act or omission by the debtor for which there is a reasonable justification and which will be cured within a reasonable timeframe fixed by the court. In our view, these provisions will encourage more appeals of bankruptcy court decisions denying conversion or dismissal. Under current law and practice, the court is under no compulsion timely to hear or decide a motion to convert or dismiss. BAPCPA requires the court to conduct a hearing within 30 days after the filing of the motion and to decide the motion within 15 days after the commencement of the hearing unless the movant consents to a continuance for a specified time or compelling circumstances prevent the court from meeting these time limits. Lastly, the existing law s laundry list of 10 different examples of grounds for dismissal or conversion is superceded by BPACPA s new list of 16 different examples. The lists overlap somewhat, but new examples include gross mismanagement of the estate, failure to maintain insurance that poses a risk to the estate or public, failure to comply with a court order, unexcused failure to comply timely with bankruptcy filing or reporting requirements, unexcused failure to attend the first meeting of creditors or an examination under the bankruptcy rules, failure timely to provide information to or attend meetings reasonably requested by the United States Trustee, and failure timely to pay taxes or file tax returns due post-petition. BAPCPA also expands the grounds for appointing a chapter 11 trustee or examiner. Specifically, if grounds are established for dismissal or conversion, the court may in lieu thereof appoint a trustee or examiner if the court determines that such relief is in the best interests of the creditors and the estate. In an amendment obviously prompted by the public scandals of Enron et al., BAPCPA requires the United States Trustee to move for the appointment of a chapter 11 trustee in cases where there are reasonable grounds to suspect that current members of the debtor s governing body, the debtor s chief executive officer or chief financial officer, or the members of the debtor s governing body who selected the officers participated in actual fraud, dishonesty, or criminal conduct in the management of the debtor or the debtor s public financial reporting. Miscellaneous Amendments Other BAPCPA amendments affecting business bankruptcies include: The definition of disinterested person is modified to delete the several references to investment banker. The definition of transfer is substantially modified to mean (a) the creation of a lien, (b) the retention of title as security, (c) the foreclosure of a debtor s equity of redemption, or (d) each mode, direct or indirect, absolute or conditional, voluntary or involuntary, of disposing of or parting with (i) property, or (ii) an interest in property. Utilities the rights of utilities are clarified and expanded by describing in detail what constitutes adequate assurance of payment and by authorizing utilities to set off against pre-petition security deposits without notice or court order. Nonprofit charitable corporations and trusts transfers of property by a debtor that is a nonprofit charitable corporation or trust, whether made during the bankruptcy or pursuant to a confirmed chapter 11 plan, must be made in accordance with applicable nonbankruptcy law. 12

13 Additional bankruptcy judges are authorized including, in Womble Carlyle s footprint, four for Delaware, one for Georgia, three for Maryland, one for North Carolina, one for Virginia, and one for South Carolina. Excluded from property of the estate is property no longer subject to the debtor s right of redemption. Direct appeal to the Court of Appeals is authorized where the bankruptcy court, district court or bankruptcy appellate panel decides that a judgment, order or decree involves (i) a question of law for which there is no controlling precedent within the circuit, (ii) a matter of public importance, (iii) a question of law requiring resolution of conflicting decisions, or (iv) circumstances such that an immediate appeal may materially advance the progress of the case. Employee wage and benefit priorities are appreciably enhanced by expanding the priority period from 90 to 180 days and increasing the per employee dollar maximum from $4,000 to $10,000. If you have any questions or would like assistance regarding the matters discussed in this Client Alert, please contact Bill Sullivan at or or your regular Womble Carlyle Contact. This Client Alert is provided by Womble Carlyle Sandridge & Rice, PLLC for educational and informational purposes only and is not intended and should not be construed as legal advice. This Client Alert may be considered advertising under applicable state laws. 13

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