The New Code—Should Creditors Declare Victory?
Michael P. Richman, Mayer, Brown, Rowe & Maw LLP
A number of recent columns have described the changes to the Bankruptcy Code that just went into effect as the clock ticked past midnight on October 17, 2005. In the weeks leading to October 17, there were a few major chapter 11 filings that appeared at least in part to have been prompted by a desire to reorganize under the old laws, and many thousands of individual chapter 7 cases were filed by people hoping to avoid the new law’s channeling of debtors with the “means” into chapter 13 repayment plans. At some courthouses on the last business day before the law changed, the lines of people hoping to file individual cases before the deadline snaked out of the courthouses into the streets.
All this activity, combined with several months’ worth of media coverage (mostly on the changes to consumer/individual bankruptcy laws) has created the impression that the new laws are decidedly pro-creditor. Closer scrutiny, especially of the changes to business bankruptcy provisions, suggests the contrary. While creditors have more “tools” than before, there are a number of reasons to believe that creditor recoveries in large, commercial chapter 11 cases will on average decline under the new law.
If we measure benefit on the basis of larger dividend recoveries for creditors, then it seems clear that this will likely be achieved only in respect of the consumer bankruptcy law revisions. For individual debtors with income above the state’s median, and the “means” to make repayment as determined by the statute and the Court, creditors will necessarily recover more under a chapter 13 repayment plan than would likely be possible in a chapter 7 liquidation.
By contrast, the most significant changes to the business bankruptcy provisions appear destined to increase the duration of chapter 11 cases, litigation activity, administrative expense and creditor recovery risks. This can be seen by looking more closely at two of the most significant changes to the business bankruptcy provisions, for plan exclusivity and commercial lease rejection/assumption.
The most significant overarching change in the law is the placement of an absolute 20 month limit on the time that a chapter 11 debtor can retain exclusivity in bankruptcy (18 months from the petition date for filing the plan; 20 months maximum for soliciting acceptances). Prior law permitted unlimited extensions for cause of the periods applicable to filing and soliciting acceptances. The Bankruptcy Court no longer has the power or discretion to extend the 20-month period.
The motivation or objective behind these changes appears to have been to benefit creditors by either shortening the duration of chapter 11 cases, reducing the expenses therefor, or both. But whether this objective can or will be met by these changes is highly questionable. While this appears to confer a new “tool” upon creditors, namely the right to file a plan when debtor exclusivity ends, creditors already possessed the leverage of such a right as a practical matter by being able to move for the termination of exclusivity for cause under prior law. The hallmark of the prior system of exclusivity and the extended periods that Courts could allow was debtor-led negotiations toward a consensual plan among all significant constituencies. The periodic expiration of exclusivity and the need to move for its extension was the occasion for the debtor to make a progress report to the Court and parties. The creditors’ ability to seek to terminate or limit exclusivity was always an undercurrent.
So what will be accomplished by a termination of exclusivity after 20 months, no matter the circumstances? Will this lead to a shortened chapter 11 case or reduced fees? Will creditors obtain better results? The answers are (a) not necessarily and (b) maybe not at all. First, plans can be amended, sometimes many times. Thus, it is to be expected that most debtors will file even ill-formed or incomplete plans either before or after exclusivity ends. But in the new regime, we will have a much greater potential for competing plans filed by creditors or committees. The existence of competing plans inevitably means they will be contested, and litigated, with a concomitant increase in the duration of the case and the associated fees and costs.
Bankruptcy courts still retain discretion on the scheduling and process of plan confirmation, and will probably still retain their aversion to litigation. So we can potentially layer on top of this new regime of contested plan processes the appointment of plan examiners, at additional fees and costs, to facilitate mediation and consensual plans from among the warring parties. At the end of the day the goal will still be to achieve a consensual plan, so it is entirely possible that what Congress has wrought is a more expensive and lengthier functional equivalent of the old system when debtors could retain exclusivity.
Let’s examine another significant change to deadlines and judicial discretion, the time periods applicable to commercial lease rejection or assumption. Prior to October 17, under Section 365 of the Bankruptcy Code, a debtor/lessee had 60 days to determine whether to assume or reject its commercial leases, but such time could be extended for cause forever. Under the new law, the debtor/lessee has until the earlier of 120 days or the entry of a plan confirmation order to make the assumption/rejection decision, and may move to have that period extended once, for 90 days, for cause. After that, no extension is possible unless the landlord consents. In other words, all important commercial lease decisions must be made within 7 months, unless the landlord consents to a longer time. It does not matter how large the case, or how many the number of leases. There are no relaxed standards for mega-cases. The bankruptcy judge has no discretion to do more.
How will this change play out insofar as creditors are concerned? The answer is that while it is clearly beneficial to landlords, it is likely detrimental to creditors. Market conditions will dominate the question whether the debtor will request or the landlord will consent to extend the assumption/rejection deadline. If the commercial lease is above market (i.e., there is no assignment value to the debtor as the landlord is already receiving more than it could likely get on the market), the debtor will probably not seek to extend (even though the landlord would happily consent) unless there is a particular strategic (non-economic) reason to retain the lease. If the lease is below market, the debtor will want to extend but the landlord will want it back so it can re-lease the space to someone else at a higher rate. Of course, it is the latter case where there is the most value for the debtor and its creditors if they can retain the lease and assume or assign it.
The change in law will require in the case of below-market leases that the debtor either relinquish the value at the end of the 7-month period, to the detriment of its creditors, or assume the lease and have the estate and creditors take all the market risk associated with that decision. Under related changes to Code Section 503, the landlord’s claim for a lease that is assumed under Section 365 and later rejected is capped at two-years’ worth of postpetition rent. Thus, at the critical 7-month mark, a debtor with below-market leases will have to look into the future, forecast the duration of its case and the market variabilities, and balance rejection, with the give-up of potential value for creditors times the number of leases, against assumption, with the potential damages and loss of creditor value of 2 years’ worth of rent times the number of leases. The economic impact of a decision to assume that later proves to have been improvident could be hugely detrimental to a successful reorganization and creditor recoveries.
Was it better for creditors when debtors could postpone their lease decisions until they were ready or nearly able to confirm a plan and better able to understand the market conditions? In the old regime, debtors and landlords were still protected (landlords still received monthly rent during the bankruptcy case), and so were creditors. In the new regime, this is a significant tilt toward landlords and detrimental to both debtors and creditors generally.
When we add to these examples the fact that under the new rules, (a) significantly more cash may have to paid to utilities to constitute adequate assurance under Section 366, (b) reclamation rules have been greatly expanded so that more cash will have to be paid out early in a chapter 11 case than was previously the case, and (c) creditors’ committees have to provide information access for all creditors while balancing confidentiality and privilege, it is apparent that the new regime will have the potential for additional layers of increased administrative expense and chapter 11 cost, all of which in the aggregate will have a depressing effect on creditor recoveries.
Some people still think the changes in the law are pro-creditor.
About the Author
Mr. Richman is a partner in the Bankruptcy and Reorganization Practice Group of the law firm Mayer, Brown, Rowe & Maw LLP in New York and is the Immediate Past-President of the American Bankruptcy Institute. Mayer Brown's bankruptcy practice is focused primarily on the representation of financial institution and other creditors in workouts and complex chapter 11 cases. Richman is the group's most experienced bankruptcy litigator and bankruptcy court advocate. He can be reached at Mayer, Brown's New York office at 212-506-2505 or via email at firstname.lastname@example.org.