There's a new bankruptcy law in place. How will it affect businesses?

Much has been written about how the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 will affect individuals who seek bankruptcy protection. As its name implies, the new law is aimed at curbing abuse of the law by making it more difficult for people to walk away from debt in bankruptcy. While the media has extensively covered the hardships the law will visit on consumers who may need bankruptcy protection because of unexpected events such as job loss, catastrophic medical bills, or displacement by last year's Hurricane Katrina, less has been said about how it will play in the business world.

The notoriety of Worldcom and Enron — where corruption, greed and gross incompetence on the part of management ultimately led to bankruptcy — influenced Congress to tighten the reins on business debtors as well, because the new law will also make it more difficult for businesses to reorganize under Chapter 11, especially smaller businesses. While the changes seem to benefit secured lenders, who were not always treated fairly under the old law, Chapter 11 may no longer be the "economic shock absorber" it once was for businesses.

This article will discuss the key changes that will affect Chapter 11 business debtors in:

• getting a plan confirmed;
• obtaining post-petition financing,
• management control;
• retention of key employees; and
• provisions affecting "small business" debtors, as well as the effect the changes will have on the debtor's creditors, employees and shareholders.

The plan — The heart of reorganization in Chapter 11 is the Chapter 11 plan of reorganization (the plan). Through the plan, the debtor can restructure or eliminate pre-petition debt, arrange for new financing or capital infusions, sell off nonperforming assets, and make changes to management and ownership, with the goal of emerging from bankruptcy as a stronger — although often more compact — business.

That is not to say that Chapter 11 has been used merely as a tool to enable businesses to walk away from debt. Getting a plan confirmed over the objections of creditors who stand to get less under the plan than what they contracted to receive can be tricky and complex. Owners of the debtor's business often receive nothing for their equity interests, since bankruptcy law prohibits them from doing that if creditors are not being paid in full. However, it has always been a core principle of Chapter 11 that preservation of business as a going concern, rather than liquidation, is usually in the best interests of creditors, the company's business partners, and employees, if not its stockholders.

As the debtor presumably knows its creditors and its business better than anyone else, the bankruptcy code provides that only the debtor may file a plan for a certain period of time, known as "the exclusivity period." After this expires, any "party in interest" can submit a competing plan. Parties in interest include, for example, a creditors' committee, a creditor, or even a trustee. Plans submitted by parties other than the debtor may favor their constituencies at the expense of the continuation of the business.

Before passage of the new law, 11 U.S.C. §1121 gave the debtor the exclusive right to file a plan for 120 days after seeking relief, and 180 days to have the plan accepted. However, this period could be extended "for cause," with no limitation on the number of possible extensions. In cases involving companies of substantial size, several extensions of the period were often necessary for the debtor to complete the groundwork required to present a confirmable plan. It was not unusual for confirmation of a plan to take two or more years. As a recent example, it took United Airlines nearly three years to confirm its plan in 2005.

The new law puts an 18-month deadline on the debtor's exclusive right to file a plan, and a 20-month deadline on having that plan accepted. The deadline for "small business debtors," discussed below, is even shorter.

An enormous amount of analysis and work is involved in putting together a confirmable plan while continuing to operate. The debtor must modify operations to comply with bankruptcy "debtor in possession" requirements and financial reporting obligations, arrange post-petition financing or find other sources of capital, analyze market conditions, evaluate the performance of business assets to determine where cuts might be made, analyze and evaluate existing contracts and leases and needs for capital, personnel and management, attempt to reach agreements for debt restructure with competing creditor constituencies, and finally, agreements with labor.

To accomplish all these tasks in sufficient time for the debtor to meet the new 18-month deadline for filing a plan, much less one that is capable of being accepted within 20 months, will be difficult in all but the simplest business operations. Large businesses such as airlines, manufacturers and retailers with national operations, may find it next to impossible to file a confirmable plan within the new period, absent extensive advance preparation.

That means that troubled companies will have to devote more time and resources to planning for bankruptcy in advance of actually filing in order to have any hope of reorganizing. "Pre-packaged" bankruptcies, in which agreements are reached with creditors prior to filing, may become more common. Those businesses that have the resources and prescience to plan for bankruptcy in advance may succeed. Those that don't are more likely to fail and end up in liquidation. But many, if not most, distressed businesses may not have the time needed to "plan" for a successful reorganization before they are forced to seek bankruptcy protection from creditors.

On the other hand, the lengthy Chapter 11 process under the old law sometimes unfairly disadvantaged secured creditors. Secured creditors can be forced to accept a stream of plan payments in lieu of recovering their collateral under the "cram down" provisions of §1129 (b)(2)(A), if the plan provides for payments to them equal to the present value of their collateral "as of the effective date" of the plan and meets certain other requirements of §1129 (b).

The "effective date of the plan" is typically the confirmation date. Under the old law, secured creditors might wait years to know whether or not a plan would be confirmed, and, thus, whether they would be permitted to recover their collateral, or forced to accept payments. In addition, the value of the secured creditors' claims (that is, the value of their collateral), for which the plan had to compensate them to pass muster, often must be determined by evidentiary hearing. With the longer period for filing a plan, valuation hearings could be delayed.

Where collateral was subject to waste or depreciation, the secured creditor was hurt not only as a result of not knowing whether it would ultimately recover its collateral (or be crammed down), but also, by the potential for the collateral's loss or diminution in value. The shorter time period for filing and confirming a plan will reduce this problem for secured creditors.

Under the old law, dismissal or conversion of a Chapter 11 case was discretionary with the court. "Cause" for dismissal focused on whether the estate was continuing to lose money and unlikely to be rehabilitated. Revised 11 U.S.C. §1112(b)(1) makes it mandatory for courts to dismiss or convert Chapter 11 cases in the presence of specific new circumstances defined as "cause," absent unusual circumstances specifically identified by the court indicating that dismissal or conversion would not be in the best interests of creditors or the estate. "Cause" for dismissal or conversion under revised 11 U.S.C. §1121(b)(4), is defined to include:

• unauthorized use of cash collateral causing substantial harm to at least one creditor;
• gross mismanagement of the estate;
• failure to comply with any court order;
• unexcused failure to timely satisfy reporting requirements;
• failure to attend creditors' meetings or Rule 2004 examinations (depositions);
• failure to maintain appropriate insurance;
• failure to pay taxes owed after filing.

Thus, the new law may make successful reorganization more difficult by not only making it harder to file a confirmable plan within the shortened exclusivity period, but also by adding new grounds requiring the court to dismiss or convert a case to liquidation under Chapter 7.

Post-petition financing — Finding new sources of funds to operate after filing usually plays a key role in a successful reorganization. More often than not, the debtor's regular banks, who already have a large debt in default on their books, don't wish to, or cannot, advance more money to the debtor operating in Chapter 11. This is where post-petition financiers step in. If the plan is the heart of the reorganization, post-petition financiers supply blood transfusions. These lenders typically loan money to the debtor at higher than market interest rates to fund the debtor's continued operations. In return, they get paid ahead of certain other creditors.

But even with their priority claim status, post-petition loans are risky. Post-petition financiers don't get paid ahead of other priority "administrative" claims, nor are they paid ahead of claims of pre-petition creditors secured by the debtor's assets such as real property, other physical assets, inventory or receivables, unless those creditors consent to subordinate their claims. If the debtor has no unencumbered assets to offer, as is often the case, the source of repayment to post-petition financiers must be cash flow generated by the debtor from continued operations after filing. Post-petition lenders know that in order to be repaid, the debtor must continue to operate, and ultimately, succeed in reorganization.

Other new provisions in the law may also have a negative effect the debtor's cash flow and operations after filing. For example:

• Utility providers can cut off service to the debtor unless the debtor provides the utility with assurance of future payment "satisfactory to" it within 20 days of filing 11 U.S.C. §366;
• The debtors' vendors have 45 days (increased from 10) in which to reclaim goods sold to the insolvent debtor. 11 U.S.C. §546 (c)(1).
• Debtors will have to pay tax claims over no more than five years, shortened from six years. 11 U.S.C. §1129(a)(9)(c).
• Although the time period during which a debtor can decide whether to keep existing commercial leases has been increased to 120 days, this period can only be extended an additional 90 days for "cause." The old law did not limit extensions of the initial 60-day period.

Since all of these changes will make it more difficult for a debtor to successfully reorganize, essential post-petition financing will be harder to get, compounding the problem.

Management control — After filing for Chapter 11 protection, a debtor is permitted to continue to operate its business and manage its day-to-day affairs as "debtor in possession" unless and until a trustee is appointed to do so. The statutory duties of the debtor in possession and an appointed trustee are technically the same and the trustee may perform them perfectly. However, the trustee will not share the debtor's history and contacts in business, not to mention its motivation and interest in keeping the business alive. The appointment of a trustee to operate the debtor's business often foreshadows its ultimate liquidation.

Old 11 U.S.C. §1104 (a)(1) required the court to appoint a trustee or examiner at the request of an interested party when current management had committed "fraud, dishonesty, incompetence, or gross mismanagement." In the Enron bankruptcy, for example, several parties sought appointment of a trustee to manage its affairs.

The Enron court ultimately did not appoint a trustee because the parties seeking its appointment and Enron agreed to a resolution involving the firing of several Enron officers and changes to its board of directors and other management. In addition, the court appointed an examiner with expanded powers to investigate and report on Enron's transactions. In the past, demonstrating that existing management was incompetent, or committed "gross mismanagement, fraud or dishonesty" has been a high bar to reach.

New 11 U.S.C. §1104 (3) expands situations in which the debtor's management may be replaced with a trustee. It provides that if any grounds of mandatory dismissal or conversion exist, the court may appoint a trustee or examiner if it determines such appointment to be "in the best interests of creditors and the estate." Theoretically, that means that a bankruptcy court could appoint a trustee to manage the debtor's affairs if the debtor uses cash collateral without authorization, fails to comply with a court order, or attend a 2004 examination without excuse (all new grounds for dismissal mentioned above), and the court found appointment "to be in the best interests of creditors and the estate."

It may be unlikely that a court would actually appoint a trustee for either of these reasons, but the point is that the new law says it can. Creditors moving to appoint a trustee in order to oust current management will be more likely to succeed, therefore gaining greater leverage on the debtor in negotiations to resolve such motions.

Another new provision requires the U.S. Trustee to move for appointment of a trustee in a Chapter 11 case, where there are "reasonable grounds to suspect " that the debtor's current management has "participated in actual fraud, dishonesty, or criminal conduct in the management of the debtor or the debtor's public financial reporting." Short of arrest, indictment or SEC investigation of members of the current management for such activities, what will constitute "reasonable grounds to suspect" their existence is difficult to say.

Changes to executive compensation — The new law also attempts to remedy perceived excessive executive compensation, including the use of key employee retention plans (KERPs) and so-called "golden parachutes," in troubled companies. Never before regulated by the bankruptcy code, new 11 U.S.C §503(c) limits the amount and extent to which compensation and benefits can be paid to insiders of the debtor (including officers, directors and persons "in control") after filing bankruptcy as follows:

• Retention payments to insiders are prohibited unless the court finds that the services provided by the insider are essential to the business, and, that the insider has a bona fide offer from another company for the same or greater compensation;
• Compensation to insiders may not exceed 10 times the amount of the average compensation given to nonmanagement employees;
• Severance payments to insiders are prohibited unless they are part of a program available to all full-time employees, and do not exceed 10 times the amount of severance paid to nonmanagement employees during the year.

A potential effect of these changes that may not have been considered is the conflict of interest that will arise for key executives involved in the decision to put a company into bankruptcy. Will highly paid executives jump ship from troubled companies just when their expertise is needed most? On the other hand, if a Chapter 11 filing is in the best interests of the company and its creditors, might such executives be tempted to postpone that decision until it's too late for a successful reorganization?

Small business debtors — The new law defines "small business debtor" (SBD) as debtors other than those whose primary business activity is owning or operating real estate, with total aggregate, noncontingent liquidated debts of no more than $2 million. While new 11 U.S.C. §1125(f) cuts SBDs a break by eliminating the need to file a separate disclosure statement if the court determines a plan of reorganization alone provides adequate information, additional requirements imposed on SBDs are significant.

First, the exclusivity period for SBDs under the new law is even shorter than the 18-month period provided for nonsmall business debtors. The period may only be extended to 10 months from the date of filing for relief, unless the SBD demonstrates, by a preponderance of the evidence, that it is more likely than not to have a plan confirmed.

In addition, a brand new section, 11 U.S.C. §1116, adds requirements with which SBDs must comply. For example, the SBD must:

• File financial statements and federal income tax returns within seven days after filing for relief;
• Have senior management attend meetings of creditors and equity security holders;
• Maintain customary insurance appropriate in the industry;
• Timely file tax returns and pay taxes;
• Permit representatives of the U.S. Trustee's office to inspect the debtor's business premises and books and records on reasonable notice.

These more stringent requirements, coupled with the fact that failure to comply with them may be grounds for dismissal of the case under 11 U.S.C. §1112(b)(4), will make it even harder for smaller businesses to reorganize.

It will be tougher to reorganize, so more businesses will ultimately fail. Other casualties will be their business partners, unsecured creditors and employees who will lose their jobs, although one change to the law will benefit retired employees. Revised 11 U.S.C. §1114(l) will permit the court to reinstate retiree insurance benefits if modified by the debtor within 180 days before filing while insolvent.

The law does benefit banks and other secured creditors whose collateral does not consist of going-concern receivables, as the shorter time to administer the cases will mean faster, and probably more complete, recovery. However, to the extent such creditors have unsecured claims, they will also be hurt, as will creditors whose collateral is heavily dependent on continuation of the business. Whether or not the benefits of the law will outweigh the costs to businesses — in terms of the economy as a whole — remains to be seen.