The most sweeping changes to federal bankruptcy law in over a quarter century went into effect in October 2005. Distressed businesses and their creditors face new challenges, and comprehensive pre-bankruptcy planning will now need to be undertaken by debtors to ensure a successful reorganization.CPAs can play an integral role in this planning process.
The new provisions of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 are far-reaching and affect both businesses and consumers. Some of the most significant provisions favor trade creditors in commercial bankruptcies, including changes to reclamation rights, the avoiding powers of a trustee, and rules for bringing and defending preference actions. These, along with new rules for commercial property leases, will have far-reaching effects on the commercial bankruptcy landscape.
The collective changes brought about by the law will make reorganization more difficult. Proper planning is necessary now to protect a business should a storm of trouble arise.
Expanded reclamation rights
Previously, creditors who shipped goods to a debtor shortly before the filing of a bankruptcy petition had the right to file a reclamation claim within 10 days after receipt of goods by the debtor, or within 20 days if the 10-day period expired after the petition date. Now goods received within 45 days are subject to reclamation. If the 45-day period expires after the petition date, the deadline to make the reclamation demand is 20 days after the petition date.
Further, a trustee's avoidance powers are subject to the rights of a creditor to reclaim goods sold to a debtor within the 45-day period prior to the petition date, provided that the creditor makes a written demand for the return of the goods within 20 days of the filing of the petition date.
Under applicable non-bankruptcy law, a creditor had to make a timely demand, in writing, to preserve its rights. If the creditor failed to make the written demand, all reclamation rights were extinguished. Under the new law, if a creditor fails to make a timely, written demand for reclamation, the creditor is still entitled to an administrative expense claim for goods sold on credit and delivered to the debtor within 20 days of the petition date.
This administrative expense allowance for goods received in the 20-day period prior to filing will have a more significant impact on the Chapter 11 process than almost anything else contained in the new law. Without proper planning, a bankruptcy case may now begin with a new, and potentially large, administrative expense class, and compound the inability of a debtor to compromise these debts. As a result, debtors may find themselves unable to finance successful reorganizations, and many debtors may be administratively insolvent on the petition date, hastening a rushed sale or liquidation.
The return of goods is now subject to the prior rights security interest in the goods or the proceeds of such goods. Previously, the bankruptcy court could approve the return of goods shipped before the petition date, as long as the creditor consented to the relief and offset the purchase price of the returned goods against its pre-petition claims.
Changes to preference rules
Three significant changes benefit recipients of transfers by a debtor in the 90 days prior to a bankruptcy petition filing.
First, a threshold for commencing a preference action was established at $5,000. Second, for preference actions where total transfers at issue are under $10,000, the venue is the district where the defendant resides. Third, the ordinary course defense standard was changed to an either/or test. Previously, a defendant had to prove payments were both in the ordinary course of business between the debtor and the transferee and in accordance with ordinary business terms. Now, either one of the two tests can be met to establish an ordinary course defense.
Additional protection has been extended to trade creditors who held the personal guarantee of an insider of a debtor. Previously, when a debtor made a payment to that creditor to prevent the creditor from pursuing its rights against the personal guarantee during the insider preference period - 91 days to one year - that creditor was placed into the shoes of the insider and exposed to a preference action during the insider preference period.
A trade creditor is no longer subject to this extraordinary exposure, because it took measures to protect its interests by holding a personal guaranty of an insider. Going forward, a trustee or debtor can commence the preference action against such a trade creditor. However, success in the action will enable the trustee or the debtor to reach only the assets of the insider.
Assuming or rejecting leases
Debtors previously had a 60-day period to assume or reject nonresidential real-property leases. Unfortunately for landlords, extensions were routinely granted after cause was shown to the court.
Now, nonresidential real property leases are deemed rejected - and the property must be surrendered - if the trustee does not assume or reject the unexpired lease by the earlier of 120 days after the date of the order for relief, or the date of the entry of an order confirming a plan. The court may extend the 120-day period by an additional 90 days for cause. After the 90-day extension, subsequent extensions can be granted only with the prior written consent of the lessor.
This is a victory for the commercial real estate industry, but it will put pressure on many businesses that need time to assess the viability of numerous locations, further emphasizing the need for sound pre-bankruptcy planning.
For nonresidential real-property leases that were previously assumed and then rejected, the administrative expense cap is limited to all amounts due for a period of two years from the later of the rejection or turnover dates, and allowed as an administrative expense of the estate. The remaining amount due is an unsecured claim subject to existing rules.
Security interests and grace periods
For preference purposes, the new law increased the grace period for the perfection of a security interest from 10 to 30 days. If perfection occurs within 30 days, the transfer is made when it takes effect between the transferor and the transferee. If a security interest is not perfected within 30 days, a transfer occurs when the security is perfected.
The deadline to perfect purchase-money security interests was increased, and the perfection cannot be avoided if the security interest is perfected within 30 days from the time that the debtor receives possession of the property. The prior limit to perfect such interests was 20 days.
Retention bonuses and severance packages
One abuse that the new law addressed was the use of key-employee retention plans and exorbitant severance packages for insiders and senior management. The new rules are strict and will likely constrain management's attempts to reorganize in industries that are highly competitive and where human capital is at a premium. On the other hand, creditors will applaud the new rules for reining in the same individuals responsible for steering the proverbial ship to the bottom of the ocean in the first place.
With regard to retention bonuses, the Bankruptcy Code was amended to narrowly define situations where transfers can be made to, or for the benefit of, an insider of a debtor to induce the insider to remain with the debtor's business.
The court must find the following conditions present to allow a retention bonus:
* The transfer is essential to retention because the individual has a bona fide job offer from another business at the same or greater compensation rate;
* The services provided by the person are essential to the survival of the business; and,
* The transfer is not greater than an amount equal to 10 times the amount of the mean given to non-management employees during the calendar year, or, if no such transfers were made to non-management employees, the amount of the transfer is not greater than 25 percent of any similar obligation made to the insider during the calendar year before the year in which the transfer is made or obligation incurred.
Severance payments to insiders will also be disallowed unless the payment is part of a program that is applicable to all full-time employees, and payment must be limited to not greater than 10 times the amount of mean severance pay given to non-management employees during the year.
Utilities gain leverage
A utility is permitted to terminate service to a debtor 30 days after the petition date if it does not receive adequate assurance of payment within 20 days of the petition date.
Previously, this usually meant that a debtor asked the court to deem a utility or utilities adequately assured based on prior history, existence of deposits, or the availability of an administrative expense priority for unpaid post-petition amounts. A court is no longer allowed to consider any of these in determining adequate assurance for utilities. The change is very explicit. It defines adequate assurance as a cash deposit, letter of credit, certificate of deposit, surety bond, prepayment of utility consumption, or another form of security that is mutually agreed on between the utility and the debtor or the trustee.
The court is now required to dismiss or convert a Chapter 11 case for cause unless the court identifies unusual circumstances that establish that a dismissal is not in the best interests of creditors and the estate, and there is a likelihood that a plan will be confirmed in a timely fashion; or the grounds for granting such relief include an act or omission of the debtor for which there is reasonable justification and will be cured within a reasonable time, as fixed by the court.
There are, however, 16 causes defined by the Bankruptcy Code that cannot be cured:
* Substantial or continuing loss to, or diminution of, the estate and the absence of a reasonable likelihood of rehabilitation;
* Gross mismanagement of the estate;
* Failure to maintain appropriate insurance that poses a risk to the estate or the public;
* Unauthorized use of cash collateral substantially harmful to one or more creditors;
* Failure to comply with an order of the court;
* Unexcused failure to satisfy any filing or reporting requirement established by the Bankruptcy Code or applicable rules in a timely fashion;
* Failure to attend the meeting of creditors - the 341 meeting - or a court-ordered Rule 2004 examination without showing good cause;
* Failure to provide information in a timely fashion or attend meetings reasonably requested by the Office of the United States Trustee;
* Failure to pay taxes owed after the commencement of the bankruptcy, or failure to file tax returns due thereafter in a timely fashion;
* Failure to file a disclosure statement, or to file or confirm a plan, within the time fixed by the Bankruptcy Code or by order of the court;
* Failure to pay any filing fees or quarterly trustee fees;
* Revocation of a confirmation order procured by fraud;
* Inability to meet all conditions required for a confirmed plan to become effective;
* Material default by the debtor with respect to a confirmed plan;
* Termination of a confirmed plan by reason of the occurrence of a condition specified in the plan; or,
* Failure of the debtor to pay any domestic support obligation that first becomes payable after the date of the filing of the bankruptcy case.
If grounds exist to convert or dismiss a case, but the court finds that the appointment of an examiner or trustee is in the best interests of creditors and the estate, it must order such an appointment.
Additionally, the new law now requires that the United States Trustee make a motion for the appointment of a trustee in a Chapter 11 case if there are reasonable grounds to suspect that current members of the debtor's governing body, the debtor's chief executive or chief financial officer, or the members of the governing body who selected the debtor's CEO or CFO participated in fraud, dishonesty or criminal conduct in the management of the debtor or the debtor's public financial reporting.
* New limit on exclusivity period. Under the old law, a debtor had the exclusive right to file a plan of reorganization for the first 120 days of a bankruptcy case. Upon showing good cause, exclusivity could have been extended for months or even years, hindering the ability of other interested parties to submit alternative plans. The new bankruptcy law makes 18 months the maximum time period that a debtor may maintain exclusivity.
* Fraudulent transfer look-back period increased. Fraudulent transfers occurring within two years of the petition date can now be avoided. The Bankruptcy Code was amended to include any transfer or obligation for the benefit of an insider under an employment agreement that was not in the ordinary course of business.
* Employee wage claim limits increased. Employee wage and benefit priorities for unpaid wages, salaries and commissions have been increased from $4,950 to $10,000. The applicable time period for the accrual of these amounts has been increased from 90 to 180 days.
* Retiree benefit plan protection. If an insolvent debtor modifies its retiree benefits plan in the 180-day period prior to the filing of a petition, an interested party may bring a motion to have the benefits reinstated. The bankruptcy court can order that the benefits be reinstated as of the date of the modification, unless the court should find that the balance of the equities favored such modification.
* Duty to continue as an ERISA administrator. A debtor is required to continue to perform all obligations as an administrator of an ERISA plan if it was performing those duties prior to the petition date. In cases where a trustee is appointed, the trustee inherits these same obligations if a plan was in place at the commencement of the case.
* Health care issues. A health care business is broadly defined under the new law. These entities, as debtors, and any trustees appointed are subject to new and explicit rules governing the disposal of patient records to protect privacy. Additionally, the costs incurred to close a health care business, including the transfer of patients to another health care business and the destruction of patient records, are given administrative expense status. A trustee has a duty to use its best efforts to transfer patients from a closing health care business to a health care business in the same vicinity that offers substantially the same services and that maintains a reasonable quality of care.
The court is now required to order the United States trustee a patient care ombudsman to monitor patient care and act as an advocate for patient interests, unless the court finds that such an appointment is not necessary to protect the interests of patients.
* Serial filing. For new cases filed within one year after the dismissal of a pending case filed earlier, the automatic stay terminates 30 days after a new case is filed, unless the court extends the stay after finding that the new case was filed in good faith.
Planning is critical
All these new provisions of the new law dramatically alter the commercial bankruptcy landscape for those in need of protection from creditors to revitalize their businesses. These are just some of the considerations that must be contemplated by businesses filing for bankruptcy.
The unwary can run afoul of the new provisions, and exacerbate the pain of an already difficult situation. Proper planning is essential.
In the quest for a viable survival plan, you, the debtor's CPA, can help to navigate these difficulties and facilitate the most positive outcome possible in a business reorganization.
Edward A. Phillips, CPA, CIRA, CFE, is managing director in the corporate recovery practice of Amper Investment Banking LLC. Reach him at firstname.lastname@example.org. Reprinted with permission from the Pennsylvania CPA Journal, a publication of the Pennsylvania Institute of CPAs.
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