Statement Of The American Bankruptcy Institute

Before The House Judiciary Committee

Subcommittee On Commercial And Administrative Law

On The Business Bankruptcy Provisions of H.R. 3150

 

Mr. Chairman and members of the Subcommittee, my name is Christopher F. Graham. I serve as Chairman of the Real Estate Committee of the American Bankruptcy Institute ("ABI") as well as Director of the ABI's Medal of Excellence Program for our nation's law schools. The ABI's 6,000 members, with backgrounds in law, accounting, academia and lending, form the nation's largest multi-disciplinary organization dedicated to education and research on bankruptcy issues.

The ABI is a non-profit and non-partisan organization. Therefore, even though members of the ABI regularly appear before Congressional Committees, the ABI does not take any advocacy position on pending legislation. To the extent that I take a personal position before you today rather than an official ABI position, it is based on my experience as a bankruptcy and creditors' rights practitioner and as a member of the firm of Thacher Proffitt & Wood in New York.

The ABI commends Representative Gekas for conducting hearings on single asset real estate and small business cases as well as the Subcommittee for its continued interest in addressing

problems, whether real or perceived, with the bankruptcy laws. The ABI is committed to assisting all of you in these endeavors.

BACKGROUND

Small Business Debtor

The Bankruptcy Reform Act of 1994 introduced the concept of a "small business debtor" to Chapter 11 of the Bankruptcy Code. Those amendments were designed to streamline the Chapter 11 proceedings of a qualifying debtor which elects such treatment within 60 days of the order for relief and reduce the administrative expenses incurred during such Chapter 11 proceedings, which expenses are often a true burden on small debtors. The amendments reduced the exclusive period during which only the debtor may file a plan of reorganization, relaxed the stringent requirements for disclosure statements and solicitation of acceptances for a plan of reorganization and did away with the automatic appointment of a creditors' committee.

The amendments proposed by H.R.3150 go even further in streamlining the Chapter 11 case of a small business debtor. More debtors will be eligible for treatment as a small business because the indebtedness cap will be raised from $2,000,000 to $5,000,000. Additionally, the disclosure statement and solicitation process will be further streamlined by, inter alia, not requiring a disclosure statement in all circumstances. The proposed bill also mandates the creation of uniform forms of disclosure statements and plans of reorganization. However, to keep the process balanced and address the needs of creditors, the amendments call for increased reporting requirements, a longer solicitation period and strict rules prohibiting serial filings. The role of the Office of the United States Trustee also becomes more prominent.

Single Asset Real Estate Debtor

The Bankruptcy Reform Act of 1994 also incorporated the concept of "single asset real estate" ("SARE") cases into the Bankruptcy Code. SARE bankruptcy filings increased in the late 1980s and early 1990s as a result of rising interest rates, a surplus of commercial space and the loss of tenants -- often through relocation or bankruptcy. The amendments to the Bankruptcy Code regarding SARE cases were designed to address potential abuses of the Bankruptcy Code by certain debtors. Typically, these debtors had one significant asset composed of improved real estate which was in foreclosure, one or two secured creditors, few unsecured creditors with relatively small claims, few or no employees and conducted no operations other than the maintenance and operation of the real estate asset. Frustrated mortgagees would find their enforcement actions stayed on the eve of foreclosure, usually after protracted and expensive litigation. Thereafter, the mortgagees were required to wait even longer while debtors attempted to sort out their financial difficulties, often at the expense of the mortgagees.

The major change proposed by H.R.3150 is to eliminate the $4,000,000 ceiling on SARE cases and codify the New Value Exception to the Absolute Priority Rule -- a hotly debated issue over the past decade. Additionally, the bill clarifies certain aspects of the Bankruptcy Code's SARE provisions. These clarifications are necessary because certain cases have tested the SARE provisions and found them to be open to differing interpretations.

H.R. 3150 ("Bankruptcy Reform Act of 1998")

Small Business Debtor

 

The small business bankruptcy provisions of the proposed bill -- sections 321-343 -- are designed to create a "faster track" for debtors whose liabilities do not exceed $5,000,000 including SARE debtors with debts of $5,000,000 or less. The provisions of the new bill modify certain sections of Chapter 11 and create additional duties of the debtor and the United States Trustee. Most of the changes shorten various time periods by which debtors are required to perform certain acts. The appointment of a creditors' committee remains optional with the bankruptcy court in order to reduce administrative costs and expedite the Chapter 11 process.

Section 231. ("Definitions.")

Section 101(51C) of the Bankruptcy Code currently defines a "small business" as one in which the aggregate noncontingent liquidated secured and unsecured debts do not exceed $2,000,000. Section 231 of H.R. 3150 would expand the definition of "small business debtor" in three ways. First, section 231 clarifies that a small business debtor includes its affiliates. Second, section 231 increases the amount of debt from $2,000,000 to $5,000,000 that may be carried by a small business debtor. Finally, section 231 expressly includes SARE debtors, except to the extent that such a SARE debtor, together with its affiliates has aggregate debt greater than $5,000,000.

The impact of the change. Many more businesses would be eligible for the small business provisions of the Bankruptcy Code.

Section 232. ("Flexible Rules for Disclosure Statement and Plan.")

Section 1125(f) of the Bankruptcy Code currently provides liberal rules for disclosure and solicitation of acceptances of a plan of reorganization which expedites the process by which a small business debtor may reorganize. Section 232 proposes to add substantially more flexibility to the requirements of section 1125(f). Specifically, section 232 would grant the court the flexibility to determine whether a disclosure statement provides adequate information by weighing the complexity of the case and a creditor's need for such information against the cost associated with providing such information. Additionally, section 232 would allow a court to combine the disclosure statement process with plan confirmation if the plan provides information that the court deems adequate for creditors to determine how their claims will be treated. Section 232 likewise would attempt to expedite the disclosure and confirmation process for small business debtors by allowing a court to conditionally approve a disclosure statement.

Section 233. ("Standard Form Disclosure Statements and Plans.")

To promote uniformity in Chapter 11 proceedings of small business debtors, Section 233 would require the Advisory Committee on Bankruptcy Rules of the Judicial Conference ("Advisory Committee") to develop and adopt a standard form of disclosure statement and plan.

Section 234. ("Uniform National Reporting Requirements.")

To balance the streamlined nature of a small business debtors' Chapter 11 proceeding with the creditors' need for information, section 234 would create new Bankruptcy Code section 308 which would require a small business debtor to file periodic financial and other reports not presently required.

Section 235. ("Uniform Reporting Rules and Forms.")

Section 235 would require the Advisory Committee to propose amended federal rules of bankruptcy procedure and official forms consistent with new Bankruptcy Code section 308.

Section 236. ("Duties of Debtor in Small Business Cases.")

Section 236 would create a new Bankruptcy Code section 1115 which would create additional duties for a debtor to provide more timely information to the courts, its creditors and the Office of the United States Trustee.

The impact of the change. Section 236 of H.R. 3150 would impose quicker reporting requirements on debtors absent "extraordinary and compelling circumstances" as determined by the bankruptcy judge. The bankruptcy judge retains considerable discretion.

Section 237. ("Plan Filing and Confirmation Deadlines.")

Section 237 of H.R. 3150 would amend section 1121(e) of the Bankruptcy Code to shorten by 30 days the debtor's exclusive period within which only a debtor may propose a plan of reorganization. Furthermore, the threshold showing which a small business debtor would need to establish to extend such exclusive period is considerably higher and would essentially require a hearing and a showing by the debtor that it is "more likely than not that the court will confirm a plan in a reasonable amount of time."

The impact of the change. Like section 236 of H.R. 3150, this section although continuing to give great discretion to the bankruptcy judge, indicates Congressional intent that a small business debtor cases should proceed to confirmation more quickly than larger cases. Failing this, the creditors will have greater rights to file their own plan of reorganization or liquidation in a small business Chapter 11 case.

Section 238. ("Plan Confirmation Deadline.")

Section 238 would mandate that a plan be confirmed within 150 days after the order for relief is entered. The 150 day deadline could only be extended by the Bankruptcy Judge if the debtor established that it is "more likely than not that the court will confirm a plan within a reasonable time period."

The impact of the change. Like sections 236 and 237, section 238 of H.R. 3150 is designed to expedite small business Chapter 11 cases.

Section 239. ("Prohibition Against Extension of Time.")

Section 239 would modify section 105(d) of the Bankruptcy Code by incorporating a higher standard for extension of time in a small business Chapter 11 case.

The impact of the change. Section 239 would not effect the level of equitable discretion accorded a bankruptcy judge, it is merely instructive as to the level of proof which must be maintained by a small business debtor in order to avail itself of the equitable powers of the Bankruptcy Court to extend time deadlines. Again, this indicates Congressional intent that such small business cases should move more quickly than has occurred in the past.

Section 240. ("Duties of the United States Trustee and Bankruptcy Administrator.")

Section 240 would greatly expand the responsibilities of the Office of the United States Trustee in small business bankruptcy cases.

The impact of the change. The United States Trustee would become more involved in the activities of debtors. The United States Trustee would be responsible for additional tasks and monitoring the activities of the small business debtor to ascertain whether a plan is confirmable. In order to ensure effective performance of such additional duties, the Office of the United States Trustee may need to be expanded.

Section 241. ("Scheduling Conferences.")

Currently, the Bankruptcy Code allows for optional status conferences regarding any case or proceeding. Section 241 would make such status conferences mandatory to the extent they are "necessary to further the expeditious and economical resolution of the case." The authority of the Bankruptcy Court to issue orders at such conferences appears to be expanded by deletion of the limiting language.

Section 242. ("Serial Filer Provisions.")

Section 242 would create a broad exception to the automatic stay under new Bankruptcy Code section 362(i). It would allow all actions described in Bankruptcy Code section 362(a) in a voluntary or collusive involuntary case if any of the following four conditions are met: (1) the debtor is already in a pending small business case when the current petition is filed; (2) the debtor was in a small business case which was dismissed by a final order for any reason within 2 years prior to the entry of the order for relief in the second/current bankruptcy case; (3) the debtor was in a small business case wherein a plan was confirmed within 2 years prior to the entry of the order for relief in the second/current bankruptcy case; or (4) the debtor has succeeded to substantially all of the assets or business of a small business debtor described in (1), (2) or (3) unless the debtor can prove that the current bankruptcy filing is due to circumstances beyond the control of and not foreseeable to the prior debtor when its case was pending, and that it is more likely than not that the court will confirm a feasible, non-liquidating plan within a reasonable time.

The impact of the change. While seeming to address the problem of serial filings by small businesses by making the automatic stay inapplicable for bankruptcy filings within 2 years of each other, Section 242 would not, by itself, prevent delays of a creditor's actions by serial filings. Assuming that the applicable provision above is debatable - for example, whether the new debtor succeeded to "substantially all" of the prior debtor's assets - a creditor would be unlikely to take action without first obtaining a comfort order from the Bankruptcy Court. This is because the creditor runs the risk of losing the litigation concerning the proposed new section 362(i)(4) and thus being sanctioned for willfully violating the automatic stay pursuant to Bankruptcy Code Section 362(h).

Alternatives. One alternative would be to allow for relief from the stay or grant comfort orders on an expedited basis unless the debtor could prove one of the four exceptions listed above. Additionally, another alternative would be to amend Bankruptcy Code section 362(h) to provide that it does not apply to creditors who in good faith believe the automatic stay does not apply because of the application of Bankruptcy Code section 362(i).

Section 243. ("Expanded Grounds for Dismissal or Conversion and Appointment of Trustee.")

Section 243 would clarify and codify existing case law concerning conversion from a Chapter 11 case to a case under Chapter 7 or dismissal of the case pursuant to Bankruptcy Code section 1112(b). Additionally, it would provide for the appointment of a Chapter 11 trustee if cause existed for conversion or dismissal pursuant to Bankruptcy Code section 1112.

Single Asset Real Estate Debtor

As noted earlier, the major changes proposed by H.R. 3150, with respect to SARE debtor cases, are the elimination of the $4,000,000 ceiling for entities that are SARE debtors as well as the codification of the controversial "New Value Exception" to the "Absolute Priority Rule." Additionally, the start date for post-petition payments to mortgage lenders is extended until the completion of litigation over the issue of whether or not the debtor is, in fact, a SARE debtor. All these issues have been fonts of bankruptcy litigation and the proposed changes would only eliminate litigation over the cap issue. Contested valuation and confirmation hearings in "New Value Exception" matters as well as litigation over the SARE status of debtors would continue.

Section 251. ("Single Asset Real Estate Defined.")

Under current law, in order to qualify as a SARE case, the debtor must have "aggregate noncontingent, liquidated secured debts in an amount no more than $4,000,000." In addition, SARE status is presently limited to debtors whose asset is not residential real property with less than four residential units and whose asset "generates substantially all of the gross income of [the] debtor and on which no substantial business is being conducted by [the] debtor other than operating the real property." Section 251 would eliminate the $4,000,000 cap for a single project or development but exclude a debtor whose property is being used by a "commonly controlled" group of entities, all of which are concurrently debtors in a Chapter 11 case, for a substantial business other than the real estate business. In short, SARE debtors whose affiliates operate a business on the debtors' property are not covered. For example, a single purpose property holding company that leases land to its affiliate which operates a computer factory on that land would not be considered a SARE debtor under the new bill.

The impact of the change. The principal change is the elimination of the $4,000,000 cap.

Alternatives. The cap could be increased instead of being eliminated. Several other pending bills have addressed this issue. H.R. 73, if enacted, would also eliminate the $4,000,000 cap. H.R. 764, if enacted, would raise the $4,000,000 cap to $15,000,000. A $15,000,000 cap would cause many, if not most, real estate developer cases to be excluded from the SARE provisions. H.R. 764 was passed by the House of Representatives on November 12, 1997 and received in the Senate the following day.

Section 252. ("Plan Confirmation.")

Under current law, a plan of reorganization shall be confirmed if: (a) all the classes of creditors that would receive less than their full claim under the plan vote in favor of the plan; or (b) if one such class of creditors votes in favor of the plan and the court finds that the plan does not discriminate unfairly and is "fair and equitable" with respect to the classes that would not receive full payment on their claims under the plan. The latter alternative, colloquially called a "cram down" among bankruptcy practitioners, is a classic tactic employed by SARE debtors.

For example, suppose Dan Developer, Inc., a debtor in possession in a Chapter 11 bankruptcy, owns as its only significant asset a large apartment complex called Black Acre Apartments worth $3,000,000. Additionally, assume that the following claims have been filed against Dan Developer, Inc.: (i) Ace Insurance Corp. claim in the amount of $4,000,000 secured by a first mortgage on Black Acre Apartments and (ii) $100,000 in various general unsecured claims. Because Ace Insurance Corp.'s claim is undersecured, Ace Insurance Corp. has the right to elect to be treated as having a secured claim in the amount of $4,000,000 or having a secured claim in the amount of $3,000,000 and an unsecured claim in the amount of $1,000,000. 11 U.S.C. § 1111(b). Assume that Ace Insurance Corp. elects the latter treatment and has its claim bifurcated.

Dan Developer, Inc., as a debtor-in-possession, presumably wants to retain control of the Black Acre Apartments. However, under what is commonly referred to as the "Absolute Priority Rule," a junior unsecured claim cannot receive any property or interest in property unless the unsecured claims senior to that claim receive an amount equal to the allowed amount of those senior unsecured claim(s). Therefore, the holder of equity shares in the debtor, cannot retain their equity interests because Dan Developer, Inc. does not have enough assets to pay the senior unsecured claims - Ace Insurance Corp.'s unsecured claim and the general unsecured claims - their full allowed amounts.

There may be an exception, however. Under the former Bankruptcy Act of 1898, the Supreme Court established the "New Value Exception" in Case v. Los Angeles Lumber Products Co., 308 U.S. 106 (1939). The New Value Exception allows debtors to keep their equity interests, despite the Absolute Priority Rule, if they contribute new value to the debtor. In re Bonner Mall Partnership, 2 F.3d 899, 908 (9th Cir. 1993), cert. granted, 510 U.S. 1030, case dismissed as moot, 513 U.S. 118 (1994). Current case law has established five requirements for the use of the New Value Exception. Id. The new value must be: (1) new; (2) in money or money's worth; (3) substantial; (4) necessary; and (5) reasonably equivalent to the interest retained. Id. It is worth noting that there is significant controversy over whether the New Value Exception survived the passage of the Bankruptcy Code in 1978 which codified the "Absolute Priority Rule" but not the "New Value Exception." See generally 4 Collier on Bankruptcy ¶ 1129[4][c] (15th rev. ed. 1998).

In its plan of reorganization, the plan proponent typically classifies the claims. Returning to our hypothetical, Dan Developer, Inc. may classify the unsecured claims separately if a court approves the classification as "reasonable and necessary for administrative convenience." 11 U.S.C. § 1122(b). Assuming that the New Value Exception has survived the passage of the Bankruptcy Code, under current law, Dan Developer, Inc. may propose the following treatment of claims in its plan of reorganization: Class One, consisting of administrative expenses such as attorneys fees and United States Trustee fees will be paid in full out of cash; Class Two, consisting of Ace Insurance Corp.'s secured claim, will continue as a secured claim on the property and will be paid according to the existing contractual payment schedule or an agreed upon payment schedule; Class Three, consisting of Ace Insurance Corp.'s unsecured claim, will be paid 10 cents on each dollar of unsecured claim or $10,000; Class Four, consisting of the general unsecured claims, will be paid 10 cents on each dollar of claims or $10,000; and, Class Five, consisting of the equity shareholders, will retain their equity interests in Dan Developer, Inc. and will contribute at least $500,000 in new value. (Note: there is no bright line test that determines the necessary amount of new value).

Ace Insurance Corp. will likely vote against the plan because it would rather own the property and the upside potential rather than immediately lose $900,000 and have no upside potential. The general unsecured creditors will vote in favor of the plan. After this vote, Dan Developer, Inc. will ask the court to "cram down" the plan pursuant to Bankruptcy Code section 1129(b)(1). This type of plan is generally referred to as a "New Value - Lien Stripping Plan." Courts, to date, have "crammed down" or confirmed such a plan over the objection of secured creditors such as Ace Insurance Corp., Inc. See generally Matter of 203 N. LaSalle St. Partn., 126 F.3d 955 (7th Cir. 1997).

Section 252 of H.R. 3150 would amend Bankruptcy Code section 1129(b) to codify the "New Value Exception" in SARE cases. Under section 252, a New Value-Lien Stripping Plan would be "fair and equitable" as is required by Bankruptcy Code section 1129 if three conditions are satisfied. First, the new value must be contributed on or before the effective date of the plan of reorganization, must be in cash and must be contributed as equity that cannot be converted into or exchanged for debt. Second, the new value must be applied on the effective date towards the reduction of the secured claims to at least a 75% loan to value ratio. Third, the payments and other terms for the remainder of the secured debt must satisfy the then-prevailing local market terms for new loans secured by liens on similar real estate regarding maturity dates, amortization, interest rates, fixed-charge coverages and loan documentation.

The impact of the change. There has been considerable controversy over both whether the New Value Exception has survived the passage of the Bankruptcy Code, as well as whether the New Value Exception should be applied to SARE cases, or even any other type of case. While this section would provide clarity in an area that has been the subject of considerable litigation, it could circumvent the "higher and better offer" requirement thereby allowing a debtor to "purchase" its equity at a price lower than a third party might be willing to pay for it, to the detriment of the creditors, particularly to secured creditors. Since the "New Value Exception" is popular with real estate developers, passage of this provision would probably lead to more Chapter 11 filings by SARE companies. Lenders would receive a 25% cushion against further declines in property values. Lenders would gain no economic benefit if property values thereafter increased with all such appreciation being retained by the SARE debtor's owners. This provision would weaken the Absolute Priority Rule thus giving more leverage to SARE debtors in plan negotiations.

Section 253. ("Payment of Interest.")

Section 362(d) of the Bankruptcy Code currently provides that the Bankruptcy Court shall grant relief from the stay to a creditor whose claim is secured by an interest in the real property of a SARE debtor if the debtor has not filed a feasible reorganization plan within 90 days of the entry of an order for relief, or commenced monthly payments to the secured creditor by such date. Section 253 would loosen the time restrictions within which a debtor must file its plan or commence making monthly payments to creditors secured by the real estate and modify Bankruptcy Code section 362(d) in two ways. First, section 253 specifies that relief from the stay will not be granted until after the later of the 90 day period or 30 days after a determination is made by the court that the debtor qualifies as a SARE debtor. Section 253 clarifies that the monthly payments that the debtor must make to the secured creditor may be made from rents generated from the property. Additionally, section 253 provides that the interest rate used to calculate payments is the then applicable nondefault contract rate, rather than the "current fair market rate" as now specified.

The impact of the change. This proposed change delays the commencement of monthly payments by a SARE debtor (or lifting of the stay) until 30 days after the Bankruptcy Court decides the issue of whether the debtor is a SARE debtor. Since this issue will be hotly litigated, the 90 days rule will rarely come into play from the day of the order for relief or the 90th day thereafter to avoid tactical litigation over SARE status merely aimed at delaying the start date for the payment of interest.