FEATURED ARTICLE. Introduction. If You Represent Employees, You May Want to Read This

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1 FEATURED ARTICLE What California Business Lawyers Need to Know About the New Bankruptcy Legislation (Part 2) By Lawrence Peitzman and David B. Shemano Introduction In Part I of this article, published in the last issue of the Reporter (27 CEB CBLR 6 (July 2005)), the authors discussed a number of changes to business bankruptcy practice wrought by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 that was signed into law on April 20, As noted in Part 1, most of the attention focused on the Act both by its proponents and its critics involves the provisions of the law that affect consumer bankruptcies, but many provisions that affect business bankruptcies also found their way into the Act. These changes are too numerous to explain in a survey article. Accordingly, rather than attempting to catalogue all the changes that affect business bankruptcies, this article attempts to highlight the amendments that seem most likely to affect the day-to-day practice of non-bankruptcy lawyers. In an attempt to make the article even more user-friendly, the authors have attempted to organize the discussion by focusing on the nature of the nonbankruptcy lawyer's practice. Part 1 focused on amendments that seem most likely to be of interest to lawyers who represent trade creditors, secured creditors, landlords, and tenants. Part 2 addresses issues that might have special interest for lawyers who represent employees and for those who become involved in the Chapter 11 process. Again, as in Part 1, a note on the effective dates of the provisions added to the Bankruptcy Code by the Act: The Act is generally effective 180 days after its enactment; since it was signed into law on April 20, 2005, the general effective date of its provisions will be October 17, With limited exceptions, the Act will apply in all bankruptcy cases filed on or after October 17, For purposes of this article, therefore, unless otherwise stated, the amendments apply to cases commenced on or after October 17, 2005, and the pre-amendment version of the Bankruptcy Code will continue to apply to cases commenced before October 17, 2005, so do not automatically throw away those "old" copies of the Bankruptcy Code. If You Represent Employees, You May Want to Read This Although equality of treatment of creditors is a fundamental bankruptcy principle, some creditors receive more favorable treatment than others under the Bankruptcy Code, for various policy reasons. An important example is employees. Courts and other interested parties are usually very solicitous of the interests of employees and try to ensure that employees are affected as little as possible by the bankruptcy process. However, apparently as a result of the management scandals at Enron, Worldcom, and other similar recent cases, the Act makes clear that there are two categories of employees in the view of Congress: (1) average employees; and (2) upper management and insiders. Although the average employee continues to be favored, the Act adds to the Bankruptcy Code new provisions that make clear that upper management and insiders are not a beloved bankruptcy constituency. Priority Wage Claims One of the most significant protections for employees in the pre-amendment Code was 11 USC 507(a)(3), which provided that, up to a cap of $4,925, unpaid wages, salaries, or commissions, including severance, sick pay, and vacation pay, earned within 90 days of the bankruptcy, are entitled to priority over all other unsecured claims. In recognition that employees are usually dependent on their wages for living expenses, courts routinely authorize at the very beginning of cases the payment of unpaid wages up to the cap, notwithstanding that prepetition debts are normally not paid until confirmation of a plan. See, e.g., In re Colad Group, Inc. (Bankr WD NY 2005) 324 BR 208, 214. Although the wage cap has marginally increased over the years, 11 USC 507(a)(4), as amended by the Act, dramatically increases the cap to $10,000, and extends the priority period from 90 days to 180 days. Further, unlike most other provisions of the Act that are effective only in new cases filed after October 17, 2005, the

2 increase in the cap is effective in new cases filed on or after April 20, Back Pay Awards Under the Bankruptcy Code, several courts held that if back pay is awarded to an employee based on the employer's wrongful prepetition conduct, the claim for back pay is a prepetition claim. See, e.g., In re Palau Corp. (9th Cir 1994) 18 F3d 746. Under 11 USC 503(b)(1)(A)(ii), as amended by the Act, any portion of an award for back pay that is attributable to the postpetition period is an administrative expense even if the claim is based on prepetition wrongful conduct, as long as the court determines that the award of an administrative expense will not substantially increase the probability of layoffs or termination of current employees.[page 34] Employee Benefits As exemplified by the recent efforts of United Airlines to terminate its pension plan, the treatment of retirement and other employee benefit plans in Chapter 11 is a rapidly developing area. Several changes in the Bankruptcy Code, as amended, are intended to protect the rights of plan beneficiaries. In addition to a priority for wages, the pre-amendment Code included a priority for contributions to an employee benefit plan (such as pension plans, health insurance plans, and life insurance plans), up to $4,925 per employee (subject to reduction to the extent employees are paid priority wage claims), arising from services rendered within 180 days of the bankruptcy. As amended, 11 USC 507(a)(5) increases the cap to $10,000. The priority for contributions to an employee benefit plan is of special significance to the Pension Benefit Guaranty Corporation, which is entitled to assert the priority claim when it takes over financially distressed plans and makes payments. In most ERISA plans, the company is the plan administrator or appoints the plan administrator. Under certain circumstances, some Chapter 11 debtors have taken the position that they are a different entity than the prepetition company and, therefore, are not the plan administrators and do not have to comply with all of the obligations of a plan administrator, including winding up the plan in the event of a liquidation. Amended 11 USC 521(a)(7) attempts to resolve this problem by providing that, unless a trustee has been appointed, the debtor shall continue to perform the obligations of the plan administrator if the debtor was the plan administrator at the commencement of the case. Amended 11 USC 704(a)(11) provides that it is a duty of the trustee to perform the obligations of the plan administrator if the debtor, or any entity designated by the debtor, served as the administrator. Finally, amended 11 USC 541(a)(7) provides that any amounts withheld or collected by an employer for payment as contributions to certain employee benefits plans are not property of the estate, and that such amounts do not constitute "disposable income" in Chapter 13 cases. This change is intended to encourage employees to make maximum contributions to retirement and health plans. Employee Retention Programs and Other Insider Payments In many recent Chapter 11 cases, employee retention programs were approved. Under such programs, various select employees, usually at the upper management level, are promised bonuses if they remain with the debtor for a period of time during the bankruptcy process. The programs are justified on the theory that these employees are critical to the success of the reorganization, but have alternatives preferable to the Chapter 11 debtor and will likely leave the debtor's employ unless there are incentives to remain. Although courts have usually deferred to the debtor's business judgment when such programs have been proposed, retention programs have been criticized as unnecessary and an example of how upper management enriches itself at the expense of the bankruptcy estate. In response to such criticisms, the Act severely circumscribes employee retention programs when the proposed recipient is an insider of the debtor. (For purposes of bankruptcy, the definition of "insider" includes officers, directors, and other persons closely related to the debtor.) Under amended 11 USC 503(c)(1), a transfer to an insider for the purpose of inducing the insider to remain with the business may only be approved if the payment meets the following requirements: The insider has a bona fide job offer from another business at the same or greater rate of compensation; The services provided by the insider are essential to the survival of the business; and The amount of the transfer is either: Not greater than an amount equal to 10 times the amount of the mean transfer of a similar kind given to nonmanagement employees during the calendar year in which the transfer is made; or If no such similar transfers were made to nonmanagement employees during the calendar year, not

3 greater than an amount equal to 25 percent of any similar transfer made to the insider for any purpose during the calendar year. The evidentiary requirements set forth in 11 USC 503(c)(1) are almost impossible to meet. Not only must the insider have a bona fide job offer at a greater salary, but the insider must testify under oath that the insider will leave the debtor unless the retention bonus is paid. Further, there must be evidence that the insider is not simply valuable, but "essential to the survival of the business," which will be difficult to demonstrate under almost any set of circumstances. In addition to the limitation on retention programs for insiders, amended 11 USC 503(c)(2) provides that the debtor may not make a severance payment to an insider unless: The payment is part of a program that is generally applicable to all full-time employees; and The amount of the payment is not greater than 10 times the amount of the mean severance pay given to nonmanagement employees during the calendar year. Finally, under 11 USC 503(c)(3), the debtor may not make any other transfer outside of the ordinary course of business, unless justified by the facts and circumstances [PAGE 35]of the case, for the benefit of officers, managers, or consultants during the bankruptcy case. While retention bonuses are effectively precluded under 11 USC 503(c)(1), 503(c)(3) appears to leave open the option, under appropriate circumstances, of bonus plans that are based on performance instead of duration of service. In light of the "spirit" of the amendments concerning payments to insiders, it will be interesting to see whether courts will approve performance bonus programs if and when they are presented. If You Represent Parties Involved in Chapter 11 Cases, You May Want to Read This Chapter 11 of the Bankruptcy Code contains provisions that are intended to facilitate the reorganization of a financially troubled business enterprise. Although the new legislation contains provisions (discussed below) that dramatically affect certain kinds of Chapter 11 cases so-called "single asset real estate cases" and "small business" Chapter 11 cases on the whole, the legislation did not make sweeping changes to the Chapter 11 process. What it did do, however, was make a great many discrete, interest-group-driven changes that, when taken together, will make reorganization under Chapter 11 much more difficult. Increased Costs Many of these changes will impose increased costs of operating under Chapter 11. As discussed Part 1 of this article, Chapter 11 debtors whose business depends on inventory will have to bear the expense of expanded rights of reclamation in favor of trade creditors. See 27 CBLR 6, 7 (July 2005). These reclamation rights are likely to impose substantial new expenses that a debtor will have to deal with at the outset of a Chapter 11 case. As discussed above, the new legislation more than doubles the amount of pre-bankruptcy wage claims that are entitled to priority under the Bankruptcy Code's distribution scheme and also extends the period during which priority wage claims can be earned from 90 days to 180 days before bankruptcy. These priority claims are not entitled to be paid at the outset of a Chapter 11 case, but courts have frequently authorized such payments at the outset of a case, at least up to the statutory maximum amount entitled to "priority" treatment in the bankruptcy case. See, e.g., In re Colad Group, Inc. (Bankr WD NY 2005) 324 BR 208, 214. Not without good reason, there is tremendous pressure from employees for Chapter 11 debtors to make these payments early in a Chapter 11 case, and the increase in the priority amount could certainly result in increased pressure on the Chapter 11 debtor. The legislation makes significant amendments to 11 USC 366, which deals with utilities. The new legislation permits utilities to put increased pressure on a debtor at the outset of a Chapter 11 case. Under the Bankruptcy Code, utilities have long had the right to demand "assurance of payment" from a trustee or debtor in possession, but the new legislation contains a new definition of "assurance of payment." This definition includes cash deposits, letters of credit, certificates of deposit, surety bonds, prepayment, and any other form of security that is acceptable to the utility involved, but the definition does not include giving the utility administrative expense priority as a form of assurance of payment. Further, as amended, 11 USC 366 will give utilities the right to terminate service without court approval or relief from the Bankruptcy Code's automatic stay, if the trustee or debtor in possession does not, within 30 days after the filing of the bankruptcy petition, provide "assurance" of payment in an amount acceptable to the utility. It appears that amended 366 gives the bankruptcy court power to modify the amount of the assurance, but in

4 making its ruling, the court is directed by the statute not to take into account a number of factors, including the timeliness of the debtor's pre-bankruptcy payments to the utility. Taken together with the new reclamation requirements and wage priorities, these changes cannot help but make the first weeks of Chapter 11 case more expensive for a Chapter 11 debtor. Stricter Time Limits In addition to imposing increased costs on Chapter 11 debtors, the new legislation decreases the statutory time periods for taking certain critical actions in a Chapter 11 case. As discussed in Part 1 of this article, under the pre-amendment version of 11 USC 365(d)(4), when the debtor was a tenant under a commercial real property lease, a trustee or debtor in possession was supposed to assume or reject the lease within 60 days after the order for relief in the bankruptcy case. (For voluntary bankruptcies under 11 USC 301, the mere filing of the petition constitutes an order for relief.) Under pre-amendment 365(d)(4), this 60-day deadline could be extended as many times as the court could be convinced that there was cause to extend it. The new legislation, however, changes the rules. It extends the [PAGE 36]60-day deadline to 120 days, but the bankruptcy court can only extend it for another 90 days. See 27 CBLR 6, 10 (July 2005). In many cases, assuming or rejecting a lease obligation can be a make-or-break decision for a Chapter 11 case, which is why the extensions of deadline were so commonly granted. Under the new legislation, the debtor or trustee can never have more than 210 days to make what could be a fateful, sometimes outcome-determinative decision. Another deadline commonly extended in prior practice was the statutory period under which a Chapter 11 debtor has the exclusive right to propose a Chapter 11 plan. Under the pre-amendment version of 11 USC 1121, unless a Chapter 11 trustee was appointed, during the first 120 days after the order for relief, only the debtor could propose a plan during that period and only the debtor could solicit acceptances of a plan during the first 180 days after the order for relief. Under the pre-amendment version of 1121, the "exclusivity" periods could be extended indefinitely for cause. The amended version of 1121, however, puts outside limits on these extensions: the debtor's exclusivity to propose a plan can never be extended beyond 18 months, and its exclusivity to solicit acceptances can never be extended beyond 20 months. It is not entirely clear what the practical effect of these changes will be. In many cases, as a practical matter, no one but the debtor is in a position to propose a plan, and the lapsing of "exclusivity" can be a non-event. In practice, the changes to 11 USC 365(d)(4) with respect to the deadline for assumption of leases may have greater significance. Still, limiting the debtor's exclusivity periods is likely to increase pressure on the debtor to get out of Chapter 11 quickly, even if that means making some bad decisions or uninformed decisions along the way. Cumulative Impact of Small Changes Numerous other changes made by the new legislation will, in all probability, make it more difficult for companies to emerge successfully from Chapter 11. Some of these were discussed in Part 1 of this article: creditors committees will have greater responsibilities, which may well increase the fees of committee professionals (see 27 CBLR 6, 7 (July 2005)); it will be more difficult to recover preferences from trade creditors (see 27 CBLR 6, 7 (July 2005)) and more difficult to avoid the liens of secured creditors (see 27 CBLR 8 (July 2005)), probably reducing the amounts that would otherwise have been available from avoidance actions for distribution to creditors; landlords are more likely to end up with substantial administrative claims as a result of the changes to the provisions involving commercial real property leases (see 27 CBLR 10, 11 (July 2005)); and it may be more difficult for the debtor to retain competent management because of the limitation on insider employee retention programs discussed above. On top of all this, in all cases commenced on or after the date of the Act's enactment (April 20, 2005), under new 11 USC 1104(e), the United States Trustee is now statutorily required to seek appointment of a Chapter 11 trustee when there are reasonable grounds to suspect fraud, dishonesty, or criminal conduct. These are only some of the many changes made by the new legalization that will affect Chapter 11 reorganizations. The changes are far too numerous to cover them all in a survey article. Each one of the changes might have been adopted for perfectly justifiable reasons, and individually the changes might not have had a substantial impact on Chapter 11 practice, but, cumulatively, these changes may have a far more radical impact on Chapter 11 than Congress actually intended. Small Business Cases

5 For two types of Chapter 11 cases, Congress does appear to have intended to make sweeping changes. One of these types, "single asset real estate cases," was discussed in Part 1 of this article. See 27 CBLR 6, 9 (July 2005). The other type of Chapter 11 case that got what amounts to an extreme makeover is the "small business" Chapter 11 case. The pre-amendment version of the Bankruptcy Code defined a "small business" as one whose aggregate noncontingent debts were not greater than $2 million. The pre-amendment version of Chapter 11 contained certain provisions that pertained to a "small business." Ostensibly, these provisions streamlined the Chapter 11 process for a small business, but they also imposed deadlines and other constraints that were not generally applicable to larger Chapter 11 cases. However, under the pre-amendment version, a small business had to elect to be treated as a "small business" in order for these provisions to apply to its Chapter 11 case. If a debtor did not want to be treated as a small business, it did not have to be. As a result, in some parts of the country, small business Chapter 11 cases became quite common, but in California they were rare. After the new legislation takes effect, that may change. The new legislation deletes the definition of "small business" and substitutes, in its place, two new definitions: "small business case" and "small business debtor." See 11 USC 101(51C), (51D), as amended. A "small business case" is, not surprisingly, a Chapter 11 case involving a "small business debtor." A "small business debtor" is a person (i.e., an entity other than a governmental unit) who: Is engaged in commercial or business activities; Is not primarily in the business of owning or operating real estate; Had aggregate noncontingent liquidated debts, secured and unsecured, of not more than $2 million; [PAGE 37]Is not part of a group of affiliated debtors whose noncontingent liquidated debts collectively exceed $2 million; and Is not a debtor in a case in which the United States Trustee has appointed a creditors' committee. In short, a "small business case" is a Chapter 11 case involving a small non-real estate business in which there is no creditors' committee. It is not clear how many businesses will actually fit these criteria, but for those that do, the consequences will be significant, and the debtor will not be able to opt out of them. (The only way out would be to get creditors to agree to serve on a creditors' committee.) One of the primary consequences of a case qualifying as a small business case is that the debtor will have reporting requirements that are not imposed on debtors in other Chapter 11 cases. See 11 USC 308, (Both of those provisions are added by the new legislation; however, although the provisions of new 1116 will take effect, along with most of the other provisions of the Act, on October 17, 2005, the reporting requirements added by 308 will not take effect until 60 days after the forms required by this section are promulgated by the Advisory Committee on Bankruptcy Rules of the Judicial Conference.) A small business debtor will be required to file reports on, among other things, its profitability. The reporting requirements are presumably imposed because there is no creditors' committee. One might, however, question the logic of imposing greater reporting requirements on "small" businesses than on large ones, and of imposing the expense of such reporting requirements on a small business that is already struggling. Compliance with the new substantial reporting requirements is not likely to make a small business debtor's mandatory "profitability" reports look any better. One advantage of a small business case is that, under 11 USC 1125, as amended, the court can excuse the debtor from complying with the requirements for preparing and circulating a disclosure statement, by determining that the debtor's Chapter 11 plan, by itself, contains adequate information. However, the apparent price for this streamlining is that the debtor's exclusive right to propose a plan cannot be extended, absent exceptional circumstances, beyond 300 days after the order for relief. Further, once a plan is filed by a small business debtor, under new 11 USC 1129(e), the debtor has to obtain confirmation of the plan within 45 days or get the court to enter an order extending that deadline before it expires. All in all, the requirements of the new small business Chapter 11 case appear to be fairly arduous, demanding a lot of work by the debtor and its counsel in a fairly short period of time, which can pretty much be said for debtors and their counsel in larger Chapter 11 cases, as well.