Analysis of Selected Business Bankruptcy Provisions of
Senate Bill 625 Providing for Reform of the Bankruptcy Code


Written By:


Hon. Wesley W. Steen
U.S. Bankruptcy Judge
Houston, Texas

Prepared for the American Bankruptcy Institute
Web posted and Copyright © April 14, 1999, American Bankruptcy Institute.

Pending legislation would make a number of revisions to the Bankruptcy Code. In a separate paper, Judge Eugene Wedoff (N.D. Ill.) has analyzed the provisions relating to consumer debtors. The following comments address some of the provisions relating to business cases.(1)

There are a number of comments that can be offered for the improvement of the law, based on the perspective of experience in the operation of the bankruptcy system. For example, the statute proposes to require confirmation of small business chapter 11 plans within 150 days after a small business case is filed. However, the deadline for government proofs of claim is 180 days. As noted below, the new proposal (no doubt intended to make the bankruptcy process more efficient) might have the unintended effect of making the system more inefficient and potentially discharging some government claims.

The purpose of the following comments, therefore, is to suggest considerations for technical and practical improvement of the final legislative package. This paper refers to draft provisions in S. 625, although H.R. 833 is essentially identical.

GENERAL PROVISIONS


Section 403-Meeting of Creditors and Equity Security Holders

This proposal would allow the court, upon request by a party in interest and after notice and a hearing, to dispense with the meeting of creditors that otherwise takes place in every bankruptcy case.

Presumably this provision would work as follows: a debtor with a prepackaged plan would file (with the initial bankruptcy filing) a motion to dispense with the creditors' meeting. The motion would be sent to creditors and equity security holders (some courts might limit the notice), and if no objection is filed, the court could dispense with the meeting. If an objection is filed, the court would hold a hearing and either grant or deny the motion.

If the motion is filed on the first day, and if creditors are given 20 or fewer days to object, it is highly possible that they will not have sufficient time to be informed about the bankruptcy case, to obtain counsel, to decide whether to object, and then to timely object. If the court limits notice to fewer than all of the creditors and parties in interest, there is a potential for inadequate notice. In such situations, some creditors might not get notice of the motion until after it is granted, creating the potential for abuse. Another potential for harm is that some courts might routinely waive the meeting in virtually all cases in which prepackaged plans are filed. This could exacerbate the existing divergence of practice among bankruptcy courts and encourage forum shopping.

Finally, there is no obvious benefit from implementation of this proposal. If the statute is applied conscientiously, there would seem to be no material amount of time or money saved. By the time that all creditors and equity security holders are given notice of the motion to waive the meeting, and by the time that they are given an opportunity to object and a hearing is held, the creditors' meeting could have been held and concluded with essentially the same effort.

Section 405-Executory Contracts and Unexpired Leases

This provision would require assumption of unexpired leases of nonresidential real property (under which the debtor is lessee) within 120 days after the order for relief.

First, clarification would be useful. Must the motion to assume be filed within the 120 days or must the order be entered within 120 days in order to assume the lease? Some bankruptcy judges ride circuit, and do not have the opportunity to visit each division of their court more than every 30 days. At least 20 days' notice (plus 3 days for mailing) is required before a hearing can be scheduled. Therefore, the delay between filing a motion and holding a hearing can easily be 52 days. For example, if a judge is only able to visit a remote location once every 30 days, and a motion is filed 22 days before the judge's next visit, the judge will not be able to hear the motion for at least 52 days. If the order must be entered within 120 days, the effective deadline for filing the motion could be 68 days, not 120 days. In addition, motions filed near major holiday periods cause special problems for judges riding circuit. If the judge cannot hold court on the 30th day because that falls right in the middle of year end holidays, then the deadline for filing the motion to assume the contract could be reduced to under 60 days. This would put debtors in rural communities at a severe disadvantage to those in urban areas where a judge is generally available.

Second, the proposed statute allows lessors to agree to extension of the time period but does not allow the court to grant an extension at the request of the debtor or any other party in interest. The proposal gives significant bargaining power to one party (the lessor) to a transaction at the expense of another. In addition, bankruptcy is not always a simple one-on-one situation. There are other creditors and parties in interest; the lease might be a necessary for a reorganization and management may not be competent or capable to take necessary steps to assume it. In some cases, there might be collusion between a debtor and a lessor. It is not unusual in small cases for the lessor and lessee to be related. In such cases, creditors need time to evaluate the situation and to ask for appointment of a trustee or to propose a creditor plan of reorganization.

The deadline for assumption of a lease should be specified in terms of when the motion must be filed, not in terms of when the order must be entered. To alleviate the concern that the motion might be left undecided for a substantial period of time, the statute might require that the motion be heard and decided within a specified period, e.g., 90 days after it is filed. Second, the court should be given the authority to extend the deadline in appropriate cases on motion of any party in interest, not just the lessor. To protect the lessor, the extension of the deadline could be conditional on payment of rent and compliance with other important provisions of the lease pending assumption or rejection of the lease.

Section 406-Modification of Committee Membership of Creditors' Committees and Equity Security Holders Committees

This provision allows the Court to modify the membership of committees upon motion of a party in interest after notice and a hearing.

The U.S. Trustee has the authority to appoint committees. Some requests for changes in committees may be acceptable to the U.S. Trustee, and therefore not require court action. If the change can be made without court action, the time and expense of sending notices to all parties in the case can be saved and judicial resources can be saved. Therefore, it is submitted that this provision might be amended to require that any party requesting a change in a committee must first submit the request to the U.S. Trustee, then they may file a motion with the court if the U.S. Trustee has not made the requested change within a specified period, e.g., 30 days.

Section 410-Postpetition Disclosure and Solicitation

This proposed change would allow a plan proponent to solicit acceptance or rejection of a chapter 11 plan if the solicitation was made before the commencement of a case and if the solicitation complies with applicable nonbankruptcy law. The provision applies to creditors or equity interest holders ("Holders") voting on a plan of reorganization.

This provision appears to waive any bankruptcy-approved disclosure if two conditions are met: (i) the Holder was solicited prepetition in a manner that is sufficient under state law, and (ii) the postpetition solicitation is sufficient under state law. This provision does not appear to be limited to prepackaged plans.

It is not clear what "nonbankruptcy law" is applicable. Presumably, for stockholders, all SEC and state blue sky laws would apply. The incorporation of all SEC rules into the bankruptcy process would be cumbersome, costly and time-consuming. Even more complex, however, would be the application of state blue sky law. If the debtor is domiciled in one state, a stockholder resides in another, and the bankruptcy court sits in a third state, it is unclear which state law would apply. For creditors (as opposed to stockholders), it is unclear what law would apply. The laws of the various states governing disclosure to creditors asked to accept a reduction in debt is not a clearly organized body of law. There has been substantial litigation over the requirements for disclosure statements under existing Bankruptcy Code § 1125. This proposal suggests substantial additional litigation.

If the statute simply intends to avoid disqualification of Holders merely because they were solicited prepetition, that objective could be achieved with simpler and more limited language. In any event, Holders should be protected by requiring that all Holders receive § 1125-approved post-petition disclosure prior to casting their votes, regardless of what they got pre-petition. If various amendments to the Bankruptcy Code eliminate the need for post-petition disclosure in given cases, then no additional disclosure would be required.



SMALL BUSINESS PROVISIONS


Section 421-Flexible Rules for Disclosure Statement and Plan

This provision would allow form disclosure statements, would allow conditional approval of disclosure statements, and may allow the debtor to combine the plan and disclosure statement. The flexibility of this provision would be very useful in small bankruptcy cases and would materially reduce the cost of many cases.

It is important, however, to recognize that there is a very wide divergence of the business and financial circumstances of Chapter 11 debtors. Some (very few) have meticulous records, careful budgeting and projections, clearly-defined capital structures, and thoughtful business plans. (A good example might be an MBA who lost her job in a major corporate downsizing, became an entrepreneur, and founded a thriving business; she has the knowledge to produce good plans and disclosure statements and keeps good records. The business might simply have grown too fast and outpaced her ability to capitalize it.) Frequently however, one sees the other extreme: a small "family" business (sometimes involving several generations), vague capital structures (with contributions from relatives that have characteristics of both debt and equity), inadequately considered and articulated business plans and projections, and poor or non-existent financial records. (A good example might be a residential roofing business begun by a father and passed down to his sons; they know how to roof houses, but they do not know much about accounting.) Broad latitude must be allowed the judge to match the Chapter 11 documentary requirements to the fact situation and especially to the needs and expectations of creditors. In general, the proposed statute appears to incorporate that concept, which should be kept and emphasized in any final legislation.

Section 422-Definitions

This provision defines Small Business Debtor to include an entity whose aggregate noncontingent, liquidated debt does not exceed $4,000,000 if the U.S. Trustee has appointed a committee of unsecured creditors in the case.

There is considerable debate about how to define a small business debtor. Because facts and circumstances are so different in each case, it is submitted that the court should have discretion to apply the small business rules to debtors who may not precisely fit the definition and the court should have discretion to exclude some debtors (who might technically fit within the definition) when appropriate.

One reason to give the court discretion in this matter would be to avoid litigation over whether a debtor qualifies. In some cases, debtors will be "close to the line." By allowing a judge discretion to determine that a case should proceed under the small business provisions, parties could be discouraged from litigating over whether a debtor's debts were $3,999,999 or $4,000,001. The statute could require the court to consider the intended speed, efficiencies, and economies intended for small businesses (or whatever other factors Congress considered to be important) and allow exception only when these objectives would not be met.

In addition, it is not clear why the proposed statute appears to require a functioning creditors' committee in order to be defined as a Small Business. The businesses that most require special provision are those that do not have functioning creditors' committees.

Section 423-Standard form Disclosure Statement and Plan

Standard forms would be welcome, and would materially reduce expenses and delays in small business bankruptcy cases. Unfortunately, each business (especially its debt structure and ability to restructure debt) is so different that such forms will be difficult to devise. So long as the forms are not mandatory, any effort in that direction would benefit both debtors and creditors.

Section 424-Uniform National Reporting Requirements

This provision would require periodic reports concerning a debtor's profitability, projected financial results, comparison of projections to results, etc.

This information is necessary and compliance would materially improve the administration of the bankruptcy system. Consideration should be given, however, to whether separate statutory treatment is the best way to effect the intended objective. The U.S. Trustee currently requires operating reports that contain much of this information. It would seem that revision of these forms would be a better approach than requiring another full set of reports. In addition, mere reporting will not achieve compliance. The system needs an entity to file appropriate proceedings to assure compliance and to move to dismiss, to convert, or to appoint a trustee if the reports show that reorganization is not likely.

It appears that the proposed reporting requirements as currently drafted will simply increase the costs of the bankruptcy process without measurably improving the results. The U.S. Trustee system has the authority to design and to implement reporting requirements, and should do so in a way that provides this meaningful and necessary data while avoiding duplicate reporting. The U.S. Trustee system can and should enhance its efforts to compel compliance, to appoint trustees, to convert cases, and to terminate cases that should be terminated. The need for additional legislation is unclear.

Section 426-Duties In Small Business Cases

This proposed amendment would require debtors in small business cases: (i) to file balance sheets, statement of operations, cash-flow statements, and federal income tax returns (if these reports exist); (ii) to attend meetings scheduled by the court or U.S. Trustee; (iii) to timely file all bankruptcy schedules and statement of affairs; (iv) to file all postpetition financial and other reports required by the rules or court; (v) to maintain insurance customary and appropriate to the industry; (vi) to file tax returns timely and to pay administrative tax claims, making deposit of trust fund taxes daily; and (vii) to allow the U.S. Trustee to inspect the debtor's business premises, books, and records.

The objectives of this proposal are understandable. As a practical matter, however, some of the provisions may be significantly burdensome without providing significant benefit. Some of the problem may be cured by clarification of the language.

For example, the statute would require senior management to attend all "meetings"scheduled by the court. (Generally, the court schedules "hearings", not meetings.) It is unclear whether the statute requires senior management to attend all hearings. Some hearings involve matters that would not involve senior management. The same is probably true of meetings conducted by the U.S. Trustee. The reorganization effort might be jeopardized if management's time is monopolized by requiring the presence of senior management at a hearing or meeting at which their presence contributes no value. The language of the statute might be clarified to require senior management to attend if specifically required by the court or the U.S. Trustee.

In addition, the requirement for daily deposit of trust fund taxes may present real practical difficulties in many cases. An example might be a debtor in the fast food business or a retail operation with many outlets. It might be difficult, if not impossible, to compute trust fund taxes and deposit them daily. The compliance expense and effort might seriously jeopardize the reorganization effort. Some consideration might be given to allowing more than 1 day, or to allow the court to extend the period when appropriate.

Sections 427, 428, 429-Plan Filing and Confirmation Deadlines

The exclusivity period is shortened from 120 to 90 days. The proposed statute would require plan confirmation in 150 days. These periods can be extended only if the debtor "demonstrates by a preponderance of the evidence that it is more likely than not that the court will confirm a plan within a reasonable period of time." In general, there is a need to expedite the resolution of small cases and there is a need for effective case management. However, there are real practical difficulties with the proposed time periods. (These difficulties were discovered in actual practice. Over the past 18 months, the author of this paper, a sitting bankruptcy judge, has tried to implement the vast majority of these legislative proposals. Although plan confirmation has been significantly expedited, the attempt to achieve plan confirmation within 150 days was unsuccessful, principally for the reasons set forth below.)

The deadline for filing proofs of claim (except for governmental units) is 90 days after the first meeting of creditors; creditors' meetings should occur 20-40 days after the case is filed. Therefore, the deadline for claims is frequently more than 120 days after the case is filed. Requiring the debtor to file a plan prior to the proof of claim deadline can be very counterproductive. If a plan is filed and if notices are sent out prior to the proof of claim deadline, all the cost of producing and mailing the plan will be wasted if a significant claim is subsequently filed. (In addition, the court will have wasted significant time in reviewing and in tentatively approving the disclosure statement.) A second plan must be negotiated and filed. The court will be required to review and to tentatively approve a second set of documents. Creditors will be confused by receiving two sets of plans and disclosure statements and two ballots.

More important, the government proof of claim deadline is 180 days after the order for relief. Therefore, under its present terms, the statute would require that the plan be confirmed 30 days prior to the deadline for filing government proofs of claim. Bankruptcy Code § 1141(d)(1)(A) provides that confirmation of a plan discharges the debtor from all claims that arose prior to the confirmation, whether or not a claim has been filed. Therefore, under the statute as presently written and proposed, it appears that government claims could be discharged even though the deadline for filing the claims has not passed. This could have serious implications for federal revenue because the government might be a priority (but not a secured) creditor in a chapter 11 case, but would be completely unsecured if the case were dismissed. If the assets of the estate were fully subject to liens in a corporate case, the government might be left without recourse under this provision, whereas it might be paid in full as a priority creditor in a confirmed plan.

Another problem is that claims are often disputed. By requiring plan confirmation in 150 days, the proposed statute leaves no time for resolution of disputed claims.

Yet another problem arises because of the tremendous diversity in bankruptcy cases. It is not unusual for a case to change dramatically as a result of negotiation between the debtor and creditors. All negotiation takes time, whether in matters of finance or in matters of international relations. An arbitrary 150 days deadline can significantly alter the prospect for negotiating a solution in everyone's best interests.

Finally, introduction of an absolute 150 day deadline creates the incentive for some parties to engage in strategic litigation rather than good faith bargaining. With an absolute deadline in effect, a party that is fully secured (perhaps over-secured) might actually find it profitable to obfuscate and delay rather than negotiate in good faith. The parties harmed in such a circumstance will most likely include the government (as unsecured priority creditors) and nonpriority unsecured creditors (frequently including the government).

The proposed statute is clear that a bankruptcy judge does not have discretion to extend the 150 day deadline to allow claims to be filed, to allow adjudication of disputed claims, or for any other reason.

In addition, the statute makes no provision for extension of time so that creditors can file motions to appoint a trustee or for creditors to file a plan. Theoretically, a creditor could file a plan on the 91st day, but because of the requirement for two notice periods (of 25 days each) and because of the realities of court schedules, it is unlikely that a confirmation hearing on a creditor plan could be concluded before the 151st day. Under § 1121(e), the court has authority to extend the deadline only if the debtor demonstrates that the court will confirm a plan. There is no authority to extend the time on motion of a creditor or a court-appointed trustee.

The court should be allowed substantial discretion to match the statute to the financial realities of each case.

Section 432 Serial Filer Provisions

This section provides that the § 362 stay would not apply if a small business debtor files a second bankruptcy case within 2 years of confirmation of a chapter 11 plan. Exceptions are made if the second filing is caused by unforeseeable circumstances beyond the debtor's control.

The first problem is that the provision only applies if a plan is confirmed. Does this have some implication that a small business can dismiss a case prior to confirmation and not be affected by this provision? Does this create possibilities for litigation strategy? Second, the remedy is awkward. It establishes a new procedure for retroactively determining whether the stay ever came into effect. There will inevitably be some "gap" period after the filing (but before a court determines whether the exceptions apply) during which no one will know whether the automatic stay is in effect. The result intended by this proposed statute could be achieved in a much smoother process.

Each bankruptcy court in the country has set up a framework for adjudicating motions for relief from the stay within the 30-60 day time frame currently in the statute. The established practice efficiently protects creditor interests. Instead of creating a new set of procedures (with a "gap" period during which no one knows whether the stay is in effect), it would be much more efficient to include appropriate language as grounds for relief from the stay. This could be coordinated with other § 362 provisions to avoid abusive multiple filing.

The current proposal creates different rules for large business cases and small business cases. One set of rules would apply to a debtor with debts of $3.9 million and another set of rules would apply to a business with debts of $4.1 million. One can expect litigation to determine the exact amount of debt. One can even anticipate that some debtors might "create" new debt to escape limitations applicable only to small businesses. The analysis becomes even more complex because both sets of rules differ from proposed legislation that would apply to consumer cases.

The best resolution would be to provide a single remedy to apply to all serial filers, whether they be large or small, business or consumer. Whether or not that is done, it would be a much more seamless solution to provide simply that the court shall grant relief from the stay if the court finds that the debtor is a serial filer. An appropriate definition of serial filer (with exceptions as deemed appropriate) can be incorporated into that part of the statute.

Footnotes

1. There has been insufficient time for considered, collaborative analysis of all of the provisions relating to business bankruptcies. In addition, some provisions are not addressed because it would be inappropriate to take positions regarding policy decisions inherent in some of the legislative proposals. There are other provisions that are not addressed for other reasons.