ABI Commission Unveils Chapter 11 Recommendations

The ABI Commission to Study the Reform of Chapter 11 unveiled a summary of its recommendations at the Winter Leadership Conference on December 4 in La Quinta, California.   The full report will be released on December 6 and contains 240 recommendations in a report spanning four hundred pages and twelve hundred footnotes. The Report was adopted unanimously by the eighteen commissioners suggesting that the group placed a high value on consensus and compromise.  

Introduction

Commission Co-Chairman Al Togut stated that “with some changes this Code can work better” and that “for the most part Chapter 11 is a very good statute.”   Commission Reporter Michelle  Harner sounded a slightly different note stating that “we need an effective and robust business bankruptcy system” but that the current regime is not working effectively for most parties.    In particular, she noted the “grave concern” that small and medium-sized companies seek to avoid chapter 11 at all costs.   

Co-Chairman Robert Keach sounded a defensive note, stating that there is something called the internet and that it has “a lot of stuff out about what we will do.”   He said that the “idea that we will be shutting down credit markets” was to be discounted.   He said that the witnesses who testified before the Commission did not support the proposition that their proposed reforms would negatively affect credit markets.     (Note:   This blog has not speculated about the outcome of the Commission’s Report and certainly has not sounded a Chicken Little alarm.).

According to the Commission, its recommendations follow four key themes:

• Reduce barriers to entry
• Facilitate certainty and more timely resolution of disputed matters
• Enhance exit strategies for debtors
• Create an effective alternative restructuring scheme for small and medium-sized firms.

From a more structural side, the Commission’s recommendations stressed reducing opportunities for obstruction and granting more flexibility to bankruptcy judges.

The recommendations include many novel ideas such as:

• Eliminating the existing small business bankruptcy procedures and replacing them with new procedures for both small and mid-market cases;
• Creating new rules for sale of substantially all assets of a business under proposed section 363X; and
•  Creating a new entity called an estate neutral which would be a cross between an examiner and a trustee and could be structured to meet the needs of specific cases.  

SME Reforms

One topic highlighted by the Commission members were the proposed reforms for Small and Medium Sized Business Entities or SMEs.    The proposed rules would replace the existing small business rules and would mandatorily apply to businesses with assets or liabilities under $10 million and could be invoked for companies with assets or liabilities up to $50 million.   However, they would not apply to Single Asset Real Estate Entities.

According to Co-Chairman Keach, 80-90% of chapter 11 cases filed would be SMEs.  Co-Chairman Togut said that from a philosophical view, these cases have an enormously great impact.   He said that the very vibrancy of the American economy depends on the entrepreneurs starting businesses and that bankruptcy should offer a vehicle for entrepreneurs who run into trouble.   However, he said that the current Bankruptcy Code is a deterrent to filings by this class of businesses because “the owners who created it are likely to lose it.”   He said that the Code should eliminate the deterrent effect so that companies would file earlier.   He analogized distressed businesses to cancer patients who need to file earlier in order to have a better chance at surviving.    Mr. Keach said that the absolute priority rule is “a real impediment” in SME cases and that it results in “excluding the people most interested in the reorganization.”

Among the more creative proposals was eliminating the absolute priority rule so long as unsecured creditors received 85% of the value of the reorganized company, requiring a “classic debt for equity swap.”   However, the equity the creditors received would be largely non-voting except for items such as insider compensation, dividends and selling the business.   

In order to reduce costs, creditors’ committees would not be the norm and would only be allowed on motion in SME cases.

The Commission is also proposing that section 1129(a)(10) and the section 1111(b) election be eliminated in SME cases.   Commissioner Jim Markus said that SME cases should focus on the trinity of feasibility, viability and valuation rather than encouraging legal maneuvering and erecting barrier after barrier to confirmation.    (While he said this, I could just hear Judge Richard Schmidt and the band singing “I Can’t Get to Confirmation.”).   

Confirmation Standards in Other Cases

Commissioner Ken Klee reported on several proposed changes to confirmation requirements in non-SME cases.    The Commission recommended eliminating the section 1129(a)(10) requirement for large cases as well.    They recommended retaining the ability to designate ballots as cast in bad faith which would be clarified and broadened.    They also suggested that debt purchasers only be allowed to count all of their claims as a single vote in determining numerosity.    

The Commission also recommended that gifting between senior and junior classes be expressly condemned.   

The Commission suggested adopting the standards for third party releases contained in In re Master Mortgage Investment Fund, Inc., 168 B.R. 930 (Bankr. W.D. Mo. 1994):

(1)   There is an identity of interest between the debtor and the third party, usually an indemnity relationship, such that a suit against the non-debtor is, in essence, a suit against the debtor or will deplete assets of the estate.

(2)   The non-debtor has contributed substantial assets to the reorganization. 

(3)   The injunction is essential to reorganization. Without the it, there is little likelihood of success. 

(4)   A substantial majority of the creditors agree to such injunction, specifically, the impacted class, or classes, has "overwhelmingly" voted to accept the proposed plan treatment. 

(5)   The plan provides a mechanism for the payment of all, or substantially all, of the claims of the class or classes affected by the injunction.

The Commission also recommended allowing exculpation clauses “as is customarily done.”   I was not clear as to whether they meant that exculpation is something which is generally done and should be allowed or that it should only be allowed to the extent customarily done.

The Commission recommended retaining the absolute priority rule in large cases but including a provision where out of the money creditors could retain an “option value” which would apply if the company went up in value within some period after the plan was confirmed.   They also proposed to codify the new value corollary to the absolute priority rule.

They also recommended that valuation standards be clarified.  The value to be subject to adequate protection would be “foreclosure value,” a new concept which would be much more nuanced than fire sale value.   However, in the context of a plan, the secured creditor would be entitled to reorganization value.

The Commission recommended rejecting the Till interest rate standard for large chapter 11 cases.  Instead, they recommended a market based standard or, if there was not a market, a risk adjusted rate including traditional standards to evaluate risk.   They mentioned a case which illustrated this approach but I didn't get it in my notes.

 Reducing the Cost of Chapter 11/Creative Compensation Procedures

According to Commissioner Jack Butler, proposals to reduce the cost of chapter 11 are contained across the Commission’s 240 recommendations.   He said that the “cost of chapter 11 is increasingly cost prohibitive.”    He proposed to give more flexibility to courts and resolving circuit splits to achieve uniformity and avoid litigation costs.

Mr. Butler said that the Commission recommended that all payments of professionals from estate funds, including those to professionals employed by creditors, be transparent and subject to approval as reasonable.   

He recommended separating out ordinary course professionals from bankruptcy professionals.  He pointed out that the costs of bankruptcy are overstated when costs attributable to professionals the debtor would have employed independently of bankruptcy are lumped in with bankruptcy professionals.

He said that the Commission encouraged innovation and approaches other than the billable hour.   He said that given a sufficient evidentiary record on the front end, alternative fee arrangements would not be subject to challenge on the back end.   He said that the Commission wished to “empower the judiciary and estate professionals to bring the best market creativity to the courtroom” in terms of compensation arrangements.

IP Reforms

Commissioner Deborah Williamson discussed proposals on intellectual property.   She said that IP should be “all in” including trademarks and foreign intellectual property.   She said that the Commission proposed to eliminate the “angels dancing on the head of a pin” discussion of whether an IP license could be assumed based on whether it was the actual debtor or a hypothetical debtor.     She also said that all intellectual property should be freely assignable unless assignment was sought to a competitor of the IP owner.

Labor Reforms

Commissioner Bill Brandt discussed the Commission’s labor reforms.   He said that provisions relating to labor contracts should encourage “rehabilitation and consensus.”

He said that the Commission would recommend that debtors no longer need permission to pay employee wages so long as they were within the priority wage claim, eliminating a common first day motion.  He said that the Commission proposed to increase the priority for wage claims to $25,000 and eliminate the 180 day limitation.   He also said that the new higher threshold would include all forms of benefit payments.    

Estate Neutrals

Commissioner Bettina Whyte discussed the new concept of an “estate neutral.”   She pointed out that in one study of over 500 cases where an examiner could have been appointed, the request was only made 87 times and granted 39 times.   She said that courts had experimented with examiners with expanded powers or trustees with limited powers to try to get around the rigid categories under current law.  

She said that the Commission proposed mandatory appointment of an estate neutral where the amount in controversy and best interests of creditors warranted it.    She said that the Court would define the powers of the estate neutral, including duration and cost, and that the U.S. Trustee would appoint the actual person.   She said that estate neutrals could help to “facilitate resolutions” and “increase the speed of the process.”  Co-Chairman Keach stressed that the estate neutral would be defined on a case by case process.    From what I heard, the new estate neutral would be a cross between an examiner, a trustee and a mediator.

363 Sales

Commissioner James Sprayregen spoke about the new proposed section 363X.   He said there would be a moratorium on sales of substantially all of the debtor’s assets for 60 days after filing.   Mr. Sprayregen said that today many chapter 11 cases end in 363 sales with some occurring quite quickly.   He expressed the concern that some of these sales were rushed through for strategic or tactical reasons.    He said that often there was not sufficient discovery and that valuations were not as robust as they could be.

   

While the new proposal would allow a relief valve for sales that were true emergencies, the evidentiary standard would be clear and convincing evidence.   

Co-Chairman Keach added that post-petition financing motions could not be used to lock a debtor into a forced sales process during the initial 60 days either.   He described it as giving judges “permission to say no” and said that the provisions would allow relief in “genuine rather than creative emergencies.”

Trade Creditor Issues

Commissioner Geoffrey Berman stressed that the Commission had given serious concern to trade creditor issues, holding a field meeting with the National Association of Credit Managers.   He said that the Commission recommended retaining section 503(b)(9) and opposed adding service providers to its provisions.   However, in return, these creditors could not take advantage of critical vendor status.   Additionally, section 503(b)(9) would apply in lieu of existing reclamation procedures.  

 

He said that the credit managers wanted to see preferences eliminated but that “sorry, that’s not going to happen.”   Instead, the Commission recommended that the minimum floor for a preference claim be increased to $25,000 and that claims under $50,000 would have to be brought in the defendant’s home venue.   

Mr. Berman said that the Commission would require a good faith effort to review preference claims before filing and would ensure that the pleading requirements of Iqbal and Twombly be enforced.   

 

 What the Commission Did Not Recommend

Commissioner Ken Klee summarized a list of topics that the Commission did not recommend, including:

• A mandatory surcharge on the collateral of secured creditors where the case is being run primarily for their benefit
• Eliminating adequate protection
• Significantly curbing post-petition financing
• Eliminating the ability to sell substantially all of a company’s assets
• Eliminating credit bidding
• Eliminating claims trading
• Eliminating the financial safe harbor provisions
• Requiring more disclosure by creditors (presumably with regard to acquisitions of claims)
• Eliminating in pari delicto except as applied to a chapter 11 trustee
• Eliminating creditors’ committees
• Eliminating section 503(b)(9)
• Changing the deadline for assuming or rejecting unexpired leases of real property
• Extending exclusivity
• Adopting the Till interest rate
• Changing the venue rules.

(In fairness to Commissioner Klee, I should point out that he gave his “no” list toward the beginning of the presentation and I moved it to the end of my post.  As a result, his no list, which is also impli-cated by many of the yes recommendations, was not redundant at the time he delivered it).

Venue

In response to a question from this author, several Commissioners spoke about the decision not to recommend a change in the bankruptcy venue rules.    Co-Chairman Keach said that an important statistic for the Commission members was that 75% of motions to transfer venue in Delaware and New York are granted such that there is already an “effective mechanism” for dealing with venue and that courts were “doing a good job.”   He also said that another reason for not tackling venue was that there was a “tremendous amount of debate” with strong positions on both sides such that they didn’t feel that making a recommendation would make a difference.   As a result, he said that “not taking a position was the thing to do.”

Commissioner Bill Brandt stated that “the debate is abroad in the land” and that the debate has been fully exhausted.   

Commissioner Deborah Williamson said that by eliminating circuit splits as recommended by the Commission, there would be less reason for attorneys to fear malpractice liability if they did not file in a certain forum.   

While I am a strong proponent of reforming the venue rules (and have said so in this blog), I think that Co-Chairman Keach has a point when he says that most venue transfer motions are granted.   While I am a little skeptical about the 75% figure, the fact is that most venue abuses are not challenged by the parties.   If tactical venue filings were challenged on a regular basis, then either the percentage of transfer motions granted would drop precipitously (in which case reform would be shown to be needed) or they would continue to be granted in which case the problem would likely resolve itself.   

Where Does It Go From Here?

One topic that the Commission did not talk about Saturday was what they would do with their report.    There have been several notable studies on reforming insolvency law.   One helped bring up the Bankruptcy Code of 1978.   On the other hand, the National Bankruptcy Conference’s 1994 report titled Reforming the Bankruptcy Code was notable in that Congress ultimately adopted legislation diametrically opposed to its recommendations some eleven years later. 

 

In these days of Congressional gridlock, it will be difficult to get Congress interested in something as technical as large-scale bankruptcy reform.  Because the Commission’s report consists of a large number of very specific changes, it is possible that only a handful will receive serious legislative consideration.

However, in the absence of strong champions on Capitol Hill, this report will generate a lot of debate among professors, professionals and bloggers, but little action.   Now that the Commission has generated its report, the real work begins.   As an eternal optimist, I hope that the issues raised by the report, if not the specific recommendations, will receive bipartisan attention from legislators interested in making the laws that we have function more efficiently.