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News Room

Chapter 11 Working Group Proposal #9:
Pre-Bankruptcy Waivers of Bankruptcy Code Provisions

It is relatively undisputed that courts will not enforce agreements waiving the right to file for bankruptcy or waiving all consequences of bankruptcy. [ FN: See, e.g.,In re Weitzen, 3 F. Supp. 698 (S.D.N.Y. 1933), citing Federal Nat ’l Bank. v. Koppel, 148 NE 379 (Mass. 1925);In re Madison, 184 B.R. 686 (Bankr.E.D.Pa.1995) (agreement not to file bankruptcy for certain time period is not binding). ] Likewise, it was long assumed that specific rights, effects, or obligations provided by the Bankruptcy Code could not be waived in advance. Case law and business practice are calling this assumption into question. With increasing regularity, loan documents and workout agreements contain clauses waiving the applicability of the automatic stay if the borrower files for bankruptcy; the agreement may contain a clause providing that "the borrower will not oppose the lender's motion" to obtain relief from the automatic stay or that the collateral is "not necessary to an effective reorganization." [ FN: Other clauses provide that filing a petition will constitute "bad faith " if intended to forestall foreclosure, or that the debtor agrees to admit the existence of facts that will support a case dismissal order. See generally Edward S. Adams & James L. Baillie, "A Privatization Solution to the Legitimacy of Prepetition Waivers of the Automatic Stay, 38 Ariz. L. Rev. 1, 26 (1996) (listing some sample clauses); Michael St. Patrick Baxter, "Prepetition Waivers of the Automatic Stay: A Secured Lender ’s Guide, "52 The Business Lawyer, 577 (1997) (same).]

This issue has not yet produced an overwhelming amount of published case law, but the court decisions thus far are creating significant uncertainty. Apparently no court has found a waiver to be self-executing, [ FN: Michael St. Patrick Baxter, "Prepetition Waivers of the Automatic Stay: A Secured Lender ’s Guide, "52 The Business Lawyer, 577, 591 (1997) (reporting that there is "no disagreement " that stay waivers are not self-executing).] but some courts have enforced these provisions. Other courts have declined to uphold waivers in the cases before them, but have suggested that waivers may be enforceable in other cases. Still other courts have held that waivers are unenforceable per se.

The Recommendation

Except as otherwise provided in Title 11, section 558 of the Bankruptcy Code should provide that a clause in a contract or lease or a provision in a court order or plan of reorganization executed or issued prior to the commencement of a bankruptcy case does not waive, terminate, restrict, condition, or otherwise modify any rights or defenses provided by Title 11.

Reasons for the Change

Commercial law generally refuses to recognize advance waivers of statutory rights or obligations related to enforcement of remedies or debt collection. Parties in secured transactions, for example, cannot execute loan documents that waive certain collection remedies provided byArticle 9 of the Uniform Commercial Code. [ FN: Section 9-501(3) explicitly precludes waiver of many of the significant provisions of Article 9, such as those delineating the methods of disposition of collateral, borrower ’s right to redeem the collateral, and liability of a secured party for failure to comply with such rules. See U.C.C. §§9-505, 9-506, 9-507.] Similarly, procedures and remedies provided in state mortgage foreclosure laws generally cannot be waived. Bankruptcy law is consistent in this regard, as it also reflects a clearly articulated policy disfavoring pre-bankruptcy agreements that attempt to circumvent some of the consequences of a bankruptcy. For example, section 541(c) of the Bankruptcy Code expressly invalidates any pre-bankruptcy agreement that precludes an item from becoming property of the estate. Similarly, in its governance of non-loan executory contracts and leases, section 365 renders unenforceable contract provisions that in any way are conditioned on a party’s bankruptcy filing to insulate the non-debtor party from the effects of that bankruptcy. [ FN: See, e.g., 11 U.S.C. §365(b)(2), (e)(1).]

Because bankruptcy provides clear rules of treatment on which all parties can rely, it supplants private agreements or transactions that do not comport with the statutory statutory rules, notwithstanding the good faith of the parties. For example, certain pre-bankruptcy transactions can be set aside or avoided under sections 544, 546, 547, and 548. In addition, the bankruptcy system establishes a statutory scheme of priority and treatment for certain types of creditors. [ FN: See, e.g., 11 U.S.C. §§503, 506, 507.] If voluntary creditors wish to obtain priority treatment in the event of a borrower’s bankruptcy, they can take a security interest rather than lending on an unsecured basis. They cannot, however, bargain with the prepetition debtor to be treated in a way that violates the priority scheme. Many other Code provisions illustrate this policy. Claims for unmatured interest that may be perfectly valid outside of bankruptcy are unavailable in certain circumstances under section 502. Congress also decided to limit secured parties’ rights in after-acquired property of a debtor in bankruptcy. [ FN: 11 U.S.C. §544. See generallyIn re Pease, 195 B.R. 431,434 (Bankr. D. Neb. 1996).]

From a policy perspective, it would be somewhat inconsistent if Congress’ comprehensive statutory scheme could be so easily circumvented by a debtor’s prepetition agreement with one creditor, or even several creditors, to waive the applicability of a bankruptcy provision. [ FN: Federal Nat ’l Bank. v. Koppel, 148 NE 379 (Mass. 1925) (refusing to enforce clause in promissory note waiving bankruptcy discharge). "The Bankruptcy Act would in the natural course of business be nullified in the vast majority of debts arising out of contracts, if this were permissible. It would be vain to enact a bankruptcy law with all its elaborate machinery for settlement of the estates of bankrupt debtors, which could so easily be rendered of no effect. The bar of the discharge under the terms of the Bankruptcy Act is not restricted to those instances where the debtor has not waived his right to plead it. " Id., at 380.] Bankruptcy creates an estate that operates on behalf of all parties. The prepetition debtor lacks the capacity to bind the debtor-in-possession, which is vested with an obligation to act in the bestinterest of the estate. [ FN: SeeIn re Pease, 195 B.R. 431 (Bankr. D. Neb. 1996) (stay waivers unenforceable per se).] The inability of the prepetition debtor to bind the estate is illuminated when one considers that prepetition debtors frequently are controlled by different parties than postpetition debtors. Management often is replaced in large chapter 11 cases. [ FN: Lynn M. LoPucki & William C. Whitford, "Corporate Governance in the Bankruptcy Reorganization of Large, Publicly Held Companies, " 141 U. Pa. L. Rev. 669, 676 (1993) (empirical study demonstrating high rate of turnover of management in publicly held corporations).] An ailing business frequently is put in the hands of turnaround management to help resolve economic and operational problems. Some debtors-in-possession are replaced by chapter 11 trustees "for cause." [ FN: See 11 U.S.C. §1104.] The prebankruptcy debtor cannot force these parties to adhere to a contract that contravenes the Bankruptcy Code’s requirements when these parties operate in the context of a collective proceeding that is a creature of federal statute.

The prepetition debtor does not have the authority to make bargains that affect the statutory rights of its other creditors. [ FN: See, e.g., William Bassin, "Why Courts Should Refuse to Enforce Pre-Petition Agreements That Waive Bankruptcy ’s Automatic Stay Provision, " 28 Ind. L. Rev. 1, 4 (1994), citing Maritime Elec. Co. v. United Jersey Bank, 959 F.2d 1194, 1204 (3d Cir. 1991) ( "stay protects creditors by preventing particular creditors from acting unilaterally in self - interest to obtain payment from a debtor to the detriment of other creditors ").] The ability of one creditor to negotiate privately with the debtor for special treatment in bankruptcy runs counter to the principle of equitable treatment and could have significant distributional consequences. Indeed, a frequent subject of prebankruptcy waivers is the automatic stay, one of the most fundamental components of the bankruptcy system. The automatic stay stops the "inefficient dismembering of the debtor" by individual collection efforts and thus promotes the orderly and efficient administration of the estate for the benefit of all creditors. [ FN: Daniel B. Bogart, "Games Lawyers Play: Waivers of the Automatic Stay In Bankruptcy and the Single Asset Loan Workout 43 UCLA L. Rev. 1117, 1141 (1996) ( " Enforcement of these devices derogates from the Code's carefully drawn limitations on the ability of private parties to reorder their entitlements in bankruptcy "). Waivers also affect other fundamental policies, i.e. the breathing spell and the opportunity to reorganize. William J. Burnett, "Prepetition Waivers of the Automatic Stay: Automatic Enforcement Equals Automatic Trouble, " 5 J. Bankr. Law & Practice 257 (1996).] If a debtor could limit the scope of the automatic stay, the interests of other creditors could be severely undermined. [ FN: Maritime Elec. Co. v. United Jersey Bank, 959 F.2d 1194, 1204 (3d Cir. 1991), citing Commerzanstalt v. Telewide Systems Inc., 790 F.2d 206, 207 (2d Cir. 1986).] Courts’ concern about protecting the interests of other creditors have been central to their refusal to uphold certain prepetition agreements.

Even if these contracts were enforceable, this would not necessarily entitle the creditor party to specific performance. Under section 365, the trustee assesses whether to elect to perform or breach the contract and the judge scrutinizes whether the trustee’s decision is in thebest interest of the estate. [ FN: 11 U.S.C. §365(a).] While contracts are not avoided, the non-debtor contract party rarely is entitled to specific performance, and instead receives damages in a pro rata distribution along with creditors of similar priority.

For some of the aforementioned reasons, many courts have declined to uphold prepetition waivers in the cases before them. Other courts, however, have offered several different justifications for the potential enforceability of waivers. Some have concluded that the refusing to enforce waivers would deter out-of-court workouts. [ FN: See, e.g.,In re Powers, 170 B.R. 480 (Bankr. D. Mass. 1994) ;In re Club Tower, L.P., 138 B.R. 307, 311 (Bankr. N.D. Ga. 1991).] Others have disregarded the bankruptcy and relied on non-bankruptcy contract law principles; if the debtor could not prove grounds for rescission, the provision necessarily stands. Courts also have reasoned that the debtor is not conclusively entitled to have the automatic stay in place throughout the course of the case. [ FN: See, e.g.,In re Atrium High Point, Ltd, 189 B.R. 599, 605 (Bankr. M.D.N.C. 1995) (waiver precluded debtor ’s right, but not other creditors ’ rights, to object to creditor ’s motion).] In addition, they also have contended that waiving one component of bankruptcy is different than waiving the right to file for bankruptcy, since the debtor would remain free to use whatever other tools that the debtor has not bargained away. [ FN: Id. Others, however, have noted that in some instances the waiver of a specific component of the bankruptcy system is the functional equivalent of restricting access to bankruptcy altogether.]

In gauging the enforceability of waivers, some courts explicitly consider factors that independently would support a motion to lift the stay absent a prepetition contractual

agreement. [ FN: See, e.g.,In re Powers, 170 B.R. 480 (Bankr.D.Mass.1994) (ordering evidentiary hearing to consider effect of enforcement on other creditors, likelihood of successful reorganization, benefit debtor received from workout agreement as whole, and extent creditor waived rights or would be prejudiced if waiver is not enforced).] Other courts do so implicitly. Thus, there is a consistent theme throughout the majority of published decisions in which courts have announced they were upholding the waivers: the presence of factors already providing grounds for lifting the stay under section 362(d)(1) [ FN: See, e.g.,In re Club Tower L.P., 138 B.R. 307 (Bankr. N.D. Ga. 1991);In re Citadel Properties, 86 B.R. 275 (Bankr. M.D. Fla. 1988). See generally Michael St. Patrick Baxter, "Prepetition Waivers of the Automatic Stay: A Secured Lender ’s Guide, "52 The Business Lawyer 577 (1997) (waivers upheld when no likelihood of reorganization).] or for dismissal under section 1112 or under section 305. [ FN: Daniel B. Bogart, "Games Lawyers Play: Waivers of the Automatic Stay In Bankruptcy and the Single Asset Loan Workout, " 43 UCLA L. Rev. 1117 (1996) (citing support for use of section 305 to dismiss case involving two party dispute when bankruptcy forum would be no more efficient in handling dispute).] Rather than granting relief solely on these statutory bases, the courts also uphold the contractual waivers. In effect, the support forcontract waivers is dicta in virtually every case. Yet, in purporting to uphold the waivers, courts are creating law applicable to all cases, [ FN: In fact, the decision that represents the "high water mark " of enforceability of stay waivers is a chapter 13 case. SeeIn re Cheeks, 167 B.R. 817 (Bankr. D. S.C. 1994) (upholding waiver in forbearance agreement, and noting that courts enforcing waivers did not limit their holdings to single asset cases).] not just "dead on arrival" single asset real estate cases, which often are the subject of these decisions. Some opinions indicate that they are upholding the waivers because these single asset real estate cases are being filed in bad faith. If this is the case, this should be addressed directly. Likewise, if circumstances reveal that these cases have no hope of reorganization, the Code already provides a variety of potential responses. [ FN: See Baxter, at 585, fn 48, 602 (acknowledging that waivers generally are upheld only when the debtor has no likelihood of reorganization, but noting that a secured creditor might wish to obtain a waiver for other reasons).]

The fact that courts sometimes uphold waivers in cases that are likely to fail anyway should not lead one to underestimate the impact of the waivers. Lenders increasingly are including contingencies in loan documents, indentures, and workout, forbearance, and settlement agreements that waive certain rights of the borrower upon filing for bankruptcy. [ FN: " ‘[P]ractically every loan modification or business workout agreement drafted today ’ contains bankruptcy waiver provisions. "In re Powers, 170 B.R. 480 (Bankr.D.Mass.1994), citing Jeffrey W. Warren and Wendy V.E. England, Pre - Petition Waiver of the Automatic Stay is Not Per Se Enforceable, Am. Bankr. Inst. J. 22 (March 1994).] The potential enforceability of pre-bankruptcy waivers is having a pervasive effect on a wide range of private negotiations between lenders and borrowers of every size, from the largest businesses to individual borrowers, [ FN: See, e.g.,In re Cheeks, 167 B.R. 817 (Bankr. D. N.C. 1994) (upholding automatic stay waiver in forbearance agreement of individual chapter 13 debtor). Cf.In re Pease, 195 B.R. 431 (Bankr. D. Neb. 1996) (in individual chapter 11 case, finding automatic stay waiver in "Debt Resolution Agreement " unenforceable per se).] both before and after a waiver is incorporated into a loan or workout agreement. Although both borrower’s and lender’s counsel generally are aware that the enforceability of such waivers is questionable, and counsel typically will not give a legal opinion on the enforceability of such waivers in opinion letters, waivers are becoming boilerplate language in loan documentation, and the borrower usually is not in a position to insist that the clause be excluded from the agreement. [ FN: See Memorandum from Harvey R. Miller & Paul M. Basta dated April 7, 1997 re: Enforceability of Prepetition Waivers of the Automatic Stay (enforcing stay waivers enables creditors with greater economic leverage to obtain these agreements and circumvent Bankruptcy Code provisions intended to benefit all parties in interest).]

The proposed amendment would clarify that these contract provisions are not effective to limit or alter provisions of Title 11. The Working Group proposes generic language because the waivers at issue do not exclusively involve the automatic stay. This general restriction would apply equally to analogous provisions in prior plans of reorganization and dismissal orders, which raise the same issue as prepetition waivers.

With only one exception, the Working Group discussion participants, many of whomregularly represent secured creditors, supported this proposal. They noted that this recommendation would not preclude a court from considering the circumstances surrounding a prior workout attempt when hearing a motion to lift the automatic stay or other matters.

Competing Considerations

Some people might criticize this proposal as impinging upon individuals’ freedom to enter into contracts. As indicated in the discussion of commercial law, however, this proposal is consistent with the general tenet precluding advance waivers of statutory rights and remedies. Innumerable other laws on local, state and federal levels restrict parties’ freedom to contract when such restrictions are beneficial in light of a broader range of considerations. For example, many states have adopted usury laws that impose caps on interest rates, regardless of the potential willingness of parties to enter into loan agreements with higher interest rates. This proposal clarifies the intention of Congress to restrict the enforcement of contractual rights in bankruptcy, as is illustrated throughout the Code.

The few courts that have upheld the enforceability of contract clauses have noted that such clauses promote out-of-court workouts. [ FN: See, e.g.,In re Powers, 170 B.R. 480, 483 (Bankr. D. Mass. 1994). See also Edward S. Adams & James L. Baillie, "A Privatization Solution to the Legitimacy of Prepetition Waivers of the Automatic Stay, 38 Ariz. L. Rev. 1, 26 (1996) (case law supports notion that enforcing waivers encourages lenders to attempt workouts outside of bankruptcy).] In some cases, workouts can be less costly and more efficient than a chapter 11 case. The chapter 11 Working Group supports the encouragement of out-of-court workouts and has sought to make recommendations that will clarify legal questions to facilitate such negotiations. Enforcing waivers of bankruptcy rights, which have never been held to be self-executing, does not necessarily promote efficiency. Even if waivers were not invalid per se, parties still would find themselves in bankruptcy court litigating over the enforceability of particular clauses based on the circumstances of each case. [ FN: See William J. Burnett, "Prepetition Waivers of the Automatic Stay: Automatic Enforcement Equals Automatic Trouble, " 5 J. Bankr. Law & Practice 257, 285 (1996) (arguing that enforcement of waivers does not necessarily promote efficiency and does not help solve debtor ’s insolvency problems) .] A lender may find it more efficient to proceed with a lift-stay motion solely on the statutorily-provided grounds rather than having the court do a retrospective analysis of the validity of the waiver.

 

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