Viewpoint/Daily Bankruptcy Review: August, 2005

Will Bankruptcy Courts Soon Host More Auctions than Sotheby’s?

John D. Penn

The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) was enacted in April 2005 and most of its provisions will apply to new bankruptcy cases filed on or after Oct. 17, 2005. Some have opined that many companies filing for chapter 11 thereafter will be unable to reorganize and will face liquidation. How that could occur is fairly foreseeable, in large part, because of the increased administrative expenses that will face business debtors in bankruptcies under either chapter 7 (liquidation) or chapter 11 (reorganization).

While many commentators have written about BAPCPA’s placing time limits on both a debtor’s exclusive right to file a plan and a debtor’s right to assume or reject real estate leases, administrative expenses are of critical importance to chapter 11 debtors. They are the highest priority of unsecured claims. On the “priority ladder,” administrative expenses are below secured creditors and ahead of “priority” claims. Historically, they have generally been limited to claims arising after the debtor filed its bankruptcy petition. Administrative expenses include the fees of the professionals paid from the estate, including those of the debtor and of official committees.

Administrative expenses are critical to a debtor’s “reorganizability” because a plan of reorganization cannot be confirmed unless either (a) the holder of each administrative expense is to be paid in full, in cash, upon the plan’s effective date or (b) each administrative expense claimant agrees to accept payment under different terms and conditions. Most significantly, administrative expenses must be dealt with individually and cannot be lumped into classes where a majority of administrative expense holders could vote to bind holders that do not agree to separate treatment. In short, they must be paid in full while unsecured claims can be paid substantially less, or no chapter 11 plan can be confirmed. Paying administrative expenses in full requires debtors to monetize assets by either borrowing against them (or selling them outright) to realize equity above all liens.

BAPCPA creates two new types of administrative expense claims that can be quite substantial. The first provides an administrative expense for all suppliers that provided goods to the debtor that were delivered within 20 days before the bankruptcy petition. The second give administrative expense claims to for NLRB awards of back pay and benefits regardless of when the improper act occurred as long as the bankruptcy judge determines that paying such wages and benefits will not increase the likelihood of layoffs or termination of current employees. In cases where a debtor has either pending NLRB actions or substantial deliveries within 20 days before its bankruptcy petition, debtors could lack sufficient unencumbered assets to pay its administrative expenses (also known as being “administratively insolvent”) upon filing or shortly thereafter. When a debtor is administratively insolvent, a plan cannot be confirmed without the specific consent of every administrative expense claimant. This is extremely difficult to achieve and, if it cannot be attained, bankruptcy courts have very few options.

One option is for the court to dismiss the bankruptcy case. The more likely outcome is substantial asset liquidations or auctions. These liquidations can occur at any time during a case—from the outset or after the debtor has been in bankruptcy for months.

Debtors can be liquidated by either a chapter 11 debtor-in-possession or by a trustee appointed under chapter 7. If the debtor believes that its assets’ value is maximized by an orderly liquidation by a debtor in possession, it will lead the efforts to market those assets (or will engage a professional to do so). Otherwise, debtors will likely request that the cases be converted to a chapter 7 liquidation by a bankruptcy trustee.

When bankruptcy courts approve asset sales, the sales can be of separate assets, groups of miscellaneous assets, operating divisions or even entire operating companies. The determining factor is whether the proposed sale process is reasonably likely to maximize the value received by the bankruptcy estate. While this decision can be controversial in some cases, many believe that assets are maximized by a debtor selling its own assets rather than handing them to a trustee for sale since “going concern” sales generally provide higher recoveries than liquidation sales.

The question becomes whether debtors have sufficient unencumbered (or under-encumbered) assets to survive the impact of what is essentially a retroactive placement on “COD.” The debtors who cannot afford these added administrative expenses will become part of an increasing wave of asset sale and auctions. At this point, no one can effectively predict when the wave will begin or whether it will come crashing down on the courthouse. With that in mind, there is little doubt that asset sales in bankruptcy court will continue, and probably increase, for cases filed after Oct. 16.

About the Author

John D. Penn is a partner at Haynes and Boone LLP in Fort Worth, Texas, and the president of the American Bankruptcy Institute. He is board-certified in business bankruptcy law by both the Texas Board of Legal Specialization and the American Board of Certification. Mr. Penn received his B.B.A. from Baylor University and his J.D. from the Baylor University School of Law.