Roundtable Discussion

Listen to this article

Bankruptcy Reform

Part II

With most of the talk about the Bankruptcy Reform Act focusing on consumer bankruptcy, it is important to realize that commercial debtors and their lawyers will face some changes when dealing with Chapter 11.

Bruce G. Arnold, of Whyte Hirsch-boeck Dudek in Milwaukee, observed that there are significant changes to Chapter 11 that will affect a company’s ability to reorganize. Arnold started by highlighting a change in the priority for trade creditors.

He offered the example of businesses that provided merchandise to K-Mart right before it went into bankruptcy. Those creditors fared well early in the bankruptcy after convincing the bankruptcy judge in the Northern District of Illinois that they were critical vendors. The Seventh Circuit Court of Appeals eventually reversed the bankruptcy court’s decision.

Critical Vendors

"Congress reacted to that decision and now created a new provision that allows creditors that ship goods — not services — within 20 days preceding the filing of the petition to receive the same level of priority as, frankly, bankruptcy professionals receive," Arnold explained.

The new act establishes that as an administrative expense claim, which is significant because a Chapter 11 plan cannot be confirmed unless all administrative claims are paid in full. Although that may help a business obtain the goods it needs, it could complicate the approval of the Chapter 11 plan.

"It may have the impact in the near term of causing these creditors to continue to extend goods on credit subsequent to the filing of the bankruptcy petition," Arnold said. "But when it comes to confirming the plan, it will have an enormous effect on the debtor’s ability to succeed if they can’t come up with the cash to pay all of their administrative expense claims in full."

Under the existing bankruptcy code, Arnold noted that when it came to the question of reclaiming goods that were shipped prior to the bankruptcy filing, the courts followed Articles 2 and 9 of the Uniform Commercial Code.

Reclamation of Goods

The modified bankruptcy code will establish a 45-day reclamation period for getting goods back. "The 2005 act, very curiously, appears to eliminate the option that debtors previously had of not returning the goods to a reclaiming seller and trying to work things out," he said.

Typically in bigger cases such as the one involving Bergner’s, suppliers such as Levi Strauss or Estee Lauder would tell the company to keep the merchandise and give them an administrative expense claim, Arnold explained.

"That’s not an option any more," he observed. "Now the bankruptcy court has to literally go through the exercise of having the debtors segregate the goods which are subject to reclamation. And, literally, the creditors will line the trucks up at the debtor’s place of business to reclaim their goods, unless they’re able to achieve some kind of consensual resolution."

The new law also changes the guidelines for preference actions. Under the current law, when a Chapter 11 trustee or a Chapter 7 trustee sued a company to recover payments made within 90 days preceding the filing of a bankruptcy, those companies faced an uphill battle, he observed.

"You had to prove that the payment was both ordinary in the business relationship between the creditor and the debtor, as well as in the industry that the creditor and the debtor were in," Arnold said.

"That law’s been changed. Now the test is disjunctive. You only have to prove that it was in the ordinary course either of the parties’ own relationships, or within the industry in which they sit. Moreover, Congress decided to create sort of a de minimus transfer exception or safe harbor. No bankruptcy preference of $5,000 or less can be sought anymore."

Home Jurisdiction

Timothy Nixon, of Godfrey & Kahn, noted that is not the case for consumer bankruptcies. He added that in commercial cases, companies that received modest payments will not have to travel to another jurisdiction.

"If the case is for a preference action seeking the recovery of $10,000 or less, the lawsuit must now be brought in the home court of the defendant corporation that received the alleged preference as opposed to being forced to defend, still a relatively modest case, in the judicial district where the bankruptcy is pending," Nixon explained.

The new act also extends the period of time to look back at allegedly fraudulent transfers from one year to two years.

"Unlike Wisconsin’s version of the Uniform Fraudulent Transfer Act contained in Chapter 242 of the Wisconsin Statutes, the federal bankruptcy fraudulent transfer statute does not require the existence of a creditor still in existence from the time that the original fraudulent transfer was made," Arnold said. "So this going from a one-year to a two-year look back for the fraudulent transfer could be a big deal."

Landlords Do Well

One group that came out particularly well in the Bankruptcy Reform Act is landlords, Arnold observed. The current bankruptcy law set a 60-day deadline for debtors to decide whether they would assume or reject their leases on commercial property. However, the bankruptcy courts had the ability to extend that deadline.

In a few cases, the bankruptcy judge extended that period for several years.

Under the new law, courts cannot extend that period beyond 210 days unless the lessor agrees.

"I think that will have a deleterious impact on debtors, particularly in liquidating Chapter 11s," he predicted.

Arnold offered an example where the judge’s ability to extend that deadline helped creditors in the case. He served as creditor’s counsel during J.H. Collectibles’ Chapter 11. The manufacturer of high-end women’s clothing had leases at top malls throughout the country.

When Judge Margaret Dee McGarity extended the lease deadline, it gave J.H. Collectibles a chance to sell those lease locations for a significant amount of money.

"That case returned a dividend of almost 45 cents on the dollar to unsecured creditors," Arnold recalled. "That’s not an option that exists any more."

The bankruptcy panelists noted that many of the changes in the 2005 Bankruptcy Reform Act were developed in an effort to help creditors. As an example, Arnold pointed to changes in the period of time that a debtor has to file a plan and get it confirmed. The new law has removed the bankruptcy court’s ability to extend that "exclusivity period." That will change the dynamic of Chapter 11s and how plans are developed, but not necessarily the way Congress intended, he said.

	Related Links Roundtable – Part I

Nixon also predicted some significant changes in Chapter 11 cases arising from the new law. He indicated that "a lot more cash is going to be required up front in the case" to help pay landlords, utilities and more.

He added that changes designed to make creditors committees more democratic have actually made them "a lot less desirable to be on." Those changes also have raised questions regarding the communication lawyers who represent creditors committees, need to have with their creditor constituencies.

"If I’m deciding to assume or reject a lease, do I have to poll the creditor body? It’s not clear," he said. "[It’s] probably not quite that extreme, but cautious lawyers will do that."

That will lead to increased bankruptcy costs, which will have to be borne by secured creditors to the detriment of unsecured creditors, he predicted.