United States: Impact of the Bankrupcty Amendments: The First Three Months

More than three months have passed since the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (the BAPCPA) became effective. Now that several significant Chapter 11 cases have been filed which are subject to its provisions, it is perhaps the time to take a close look at the ways the new law may impact certain types of creditors and also the changes for international insolvencies.

I. Landlords and BAPCPA

Congress used the amendments of the BAPCPA to announce its intention to level the playing field between debtors and landlords of commercial real estate, and to shift certain powers back to the landlords (due to perceived abuses under the old Section 365). At the same time, Congress chose to negate certain protections that landlords had over time come to appreciate.

The new provisions contain significant changes that will drastically affect the owners of non-residential real estate property.

This section focuses on three significant rules of the BAPCPA as they pertain to the world of commercial property:

• Restrictions on Assignment of Shopping Center Leases (Positive for Commercial Landlords): BAPCPA now increases protections to all shopping center landlords by enacting restrictions on assignments of commercial leases.
• Cure of Non-Monetary Defaults (Negative for Commercial Landlords): If non-monetary obligations exist (i.e., constant occupation), the court will no longer enforce these obligations.
• Time Period for Assumption/Rejection – Section 365(d)(4) (Draw for Commercial Landlords): The time period in which a debtor must assume or reject non-residential real property has decreased. This provides some relief for landlords at the beginning of a bankruptcy proceeding, but may result in frustrations farther down the road.

Restrictions on Assignment of Shopping Center Leases

Let’s begin with the positives. Pursuant to the terms of Section 365(b)(1), before a debtor can assume a lease under default, it must: (1) cure the default or provide adequate assurance that the default will be promptly cured; (2) compensate or provide adequate assurance that the debtor will compensate for any pecuniary loss to the landlord; and (3) provide adequate assurance of future performance under the lease.

More importantly, with respect to commercial leases in shopping centers, Section 365(b)(3) provides that adequate assurance of future performance includes, among other things, that assumption or assignment shall be subject to all of its provisions including, but not limited to, provisions regarding radius, location, use, and exclusivity. Notwithstanding Section 365(b)(3), Section 365(f)(1) provided that terms or conditions in a lease that would prohibit, restrict, or condition the assignment of that lease – often read by courts to include use and exclusivity clauses – would not be enforceable.

Through the recent amendments to Section 365(f)(1), Congress has solidified the enforcement of restrictive clauses in shopping center leases protected by Section 365(b)(3) by adding the words "[e]xcept as provided in subsections (b) and (c) of this subsection."

Cure of Non-Monetary Defaults

The most negative change to Section 365 of the Code, as it relates to landlords, is the change to the requirement that the debtor cure all defaults under the lease prior to assumption. Prior to the BAPCPA, Section 365(b)(2)(D) excepted from cure "the satisfaction of any penalty rate or provision relating to a default arising from any failure by the debtor to perform nonmonetary obligations under the … unexpired lease." This ambiguous language led to a split in interpretation between the Ninth Circuit – holding that all nonmonetary defaults needed to be cured unless such default requires a payment of a monetary penalty – and the First Circuit – holding that debtors could assume leases without first curing any nonmonetary defaults.

Through the amendments of the BAPCPA, Congress has attempted to address this split in the circuits. First, Section 365(b)(2)(D) was modified such that it now reads that "[t]he satisfaction of any penalty rate or penalty provision related to default …" is now excepted from cure. By adding the word "penalty" to modify both "rate" and "provision," Congress has agreed with the interpretation of the Ninth Circuit that a debtor's cure obligation does not require a payment of a penalty provision, but does not provide a catch-all for nonmonetary defaults. However, to reduce the harsh effects illustrated by the First Circuit, Congress modified Section 365(b)(1)(A) to exempt from the cure requirement "a default that is a breach of a provision relating to the satisfaction of any provision … relating to a default arising from any failure to perform nonmonetary obligations under an unexpired lease of real property, if it is impossible for the [debtor] to cure such default by performing nonmonetary acts at and after the time of assumption." Notably, the revised language does not except every nonmonetary obligation, but only those that are "impossible," a term that will likely be debated in the years to come. The new provision also adds the requirement that if "such default" arises from the failure to operate in accordance with such lease, it must be cured "by performance at and after the time of assumption in accordance with such lease," and that the lessor is entitled to compensation for pecuniary losses related to the default. Accordingly, the debtor and its successors are compelled to prospectively comply with all operational terms in commercial leases following the assumption – and, if applicable, assignment – of such lease.

Notably, the revised language does not except every nonmonetary obligation, but only those that are "impossible" to cure, an imprecise term that likely will trigger considerable debate in the years to come. The new provision also adds the requirement that if "such default" arises from the failure to operate in accordance with such lease, it must be cured "by performance at and after the time of assumption in accordance with such lease," and that the lessor is entitled to compensation for pecuniary losses related to the default. Accordingly, the debtor and its successors are compelled to prospectively comply with all operational terms in a commercial lease following the assumption – and, if applicable, assignment – of such lease.

BAPCPA Increases Initial Period for Assumption/Rejection

The BAPCPA increased the initial period in which the debtor must assume or reject a commercial lease, but has restricted the ability of the court to grant multiple extensions of this time period. The debtor now has an initial 120-day period, or until the date of the entry of an order confirming a plan, whichever is earlier, to assume a lease of non-residential real property.

The court may extend the 120-day deadline once for cause. However, this extension must be granted prior to the expiration of the initial deadline and can only be for a 90-day period. Subsequent extensions of the deadline to assume a commercial lease may only be granted by the court upon prior written consent of the affected landlord. As was the case under the earlier law, any lease not assumed within the applicable deadline shall be deemed rejected.

This Change Reduces Landlords’ Period of Uncertainty

These changes to Section 365(d)(4) will significantly reduce the period of uncertainty for commercial landlords regarding the status of their leases. It will also put an end to the series of long-term extensions available under the prior law which had been used to facilitate a debtor's ability to sell, or assign the rights to sell, its commercial real estate assets.

For all bankruptcy cases filed on or after the effective date of the amendments – October 17, 2005 – a debtor will be allowed a maximum of 210 days to assume or reject a lease without obtaining the consent of the affected landlord. In practice, this will require negotiations between a debtor and a landlord to accommodate the needs of both parties. For example, while a landlord may seek to avoid uncertainty with respect to its lease, it may prefer the certainty of a tenant during the holiday season. Alternatively, in a situation where the landlord believes the premises can be re-let quickly and at a higher rate, the debtor may encounter difficulty in securing the landlord's agreement to extend the assumption period under Section 365(d)(4).

Prior to the enactment of the amendments of the BAPCPA, a landlord whose lease was assumed and subsequently rejected by a debtor would be entitled to an administrative claim for the full amounts due and owing under the lease. Lawmakers were aware that the recent amendment to Section 365(d)(4) may force debtors to assume leases before they can properly determine whether such leases will be truly essential to their reorganization. To account for this, a new provision was added to Section 503(b) of the Code limiting the landlord's claim in this circumstance to a priority claim for the rent due for a period of two years following the rejection of the lease or turnover of the premises, whichever is later. The balance of the landlord's remaining claim would be relegated to unsecured status, subject to the cap on rejection damages imposed by Section 502(b)(6).

Importantly, even if a lease is ultimately rejected, the debtor still must pay, in the form of cash or an allowed administrative claim, for the benefits that it received under the lease prior to the effective date of the rejection.

II. Lenders’ Position: Sometimes Strengthened, Sometimes Weakened

The BAPCPA provisions to the Bankruptcy Code, which include controlling preferences, exclusivity periods, and the claims of competing creditors, both strengthen and weaken the positions of lenders in bankruptcy cases. As a result of changes to the provisions governing preferences, lenders are no longer subject to the will of debtors in certain small cases, and they have stronger defenses that can prevent recovery of their transfers from debtors. Lenders also have a stronger position to push cases to an expeditious resolution because of new limits placed on exclusivity periods.

However, lenders may have lost some ground to vendors and utilities as a result of changes to reclamation and adequate assurance provisions. The amendments often force debtors to pay their vendors and utilities very early in business bankruptcy cases, meaning that less cash will be available to pay lenders’ claims. Furthermore, the priority of administrative expense claims over other types of claims means that lenders may take a back seat to vendors whose reclamation claims receive administrative status.

Changes in Preference Rules Strengthen Lenders’ Position

BAPCPA amends the Bankruptcy Code provisions governing preferences, which are transfers by the debtor of an interest in its property to its creditor within 90 days of the debtor’s bankruptcy petition filing under certain conditions.¹ A debtor (or a bankruptcy trustee) may bring suit against a creditor to avoid the preference and recover the property transferred, subject to defenses available to the creditor.² Transfers include cash payments on account of an existing debt, making preferences a particular concern to lenders who are entitled to receive periodic installments such as monthly payments.

New Provisions Limit When and Where to File Preference Cases

Changes to the preference-related Bankruptcy Code provisions appear to limit preference plaintiffs’ discretion and strengthen the position of lenders. First, two new Bankruptcy Code provisions set limits on when and where preference cases may be filed. Under new Section 547(c)(9), trustees and debtors in possession may not pursue preference actions worth less than $5,000. New Section 1409(b) states that preference cases worth less than $10,000 must be filed in the district court for the district in which the preference defendant/creditor resides. Both these sections place limits that did not exist under former Bankruptcy Code provisions on plaintiffs’ discretion in preference cases. These limits will affect common practices of debtors, such as filing relatively small claims in a court far away from a creditor’s place of business, leaving the creditor with the unattractive choice of settling or incurring the expense to defend the case in a distant court.

Second, a newly amended provision changes the definition of when a transfer that creates a security interest can be made for purposes of preference recovery. Under former Section 547(e)(2), lenders had a ten-day grace period during which they could perfect security interests to prevent them from becoming preferential transfers. The amendment to this section increases the grace period to 30 days. These additional 10 days arguably strengthen lenders’ positions by giving them additional time to shield their security interests from preference claims.

Stronger Defenses for Lenders on Preferential Transfers

Third, BAPCPA entitles lenders from whom trustees or debtors attempt to recover preferential transfers to newly strengthened defenses under the Bankruptcy Code. Among these defenses is the ordinary course defense.

Under former Section 547(c)(2), a transfer was not recoverable as a preference if the defendant/creditor could prove that: (1) the debtor transferred the interest in property in order to pay a debt incurred in the ordinary course of the debtor’s business; (2) the transfer itself was made in the ordinary course of the debtor’s business; AND (3) the transfer itself was made according to ordinary business terms. This provision required a preference defendant/creditor to meet both "objective" and "subjective tests" of ordinariness: (1) that the transfer was ordinary according to the terms of the business regularly conducted by the plaintiff with the defendant; and (2) that the transfer was ordinary according to the terms of the market in which the defendant regularly conducted business. Often, it was necessary or desirable for the creditor to prove market terms by calling an expert witness at substantial expense.

Under the amended Section 547(c)(2), however, a preference defendant need meet only one of these two tests. The ordinary course defense has been made available to more defendants, because a transfer is not recoverable as a preference if a creditor can prove that it was achieved in either the subjective OR the objective ordinary course of business. A lender will therefore have an easier time establishing this defense to a preference claim.

The amendments also slightly expand the new value defense to preference recovery. Under former Section 547(c)(3), a transfer was not recoverable as a preference if the defendant/creditor could prove that the transfer created a security interest (1) that secured new value for a debtor’s purposes of acquiring property; and (2) that was perfected by the defendant/creditor on or before 20 days after the debtor received the acquired property.

Amended Section 547(c)(3) lengthens the period during which a creditor must perfect the security interest to 30 days. Like the changes to the ordinary course defense, these additional 10 days allowed for perfection strengthen lenders’ new value defense to preference recovery.

New Limits on Exclusivity Periods Also Strengthen Lenders’ Leverage

The Bankruptcy Code provides 120- and 180-day periods during which only debtors in Chapter 11 cases may propose reorganization plans and solicit acceptances of those plans.³ These exclusivity periods begin to run from the date a debtor files its bankruptcy petition.⁴

In the past, debtors could request and often received numerous extensions of their exclusivity periods for cause. Although the extensions were not defined by the Code, courts routinely found cause for these extensions, and cases sometimes continued for years without putting a reorganization plan in place despite creditors’ objections.

BAPCPA amendments to Section 1121(d) of the Bankruptcy Code place new limits on extensions of these plan exclusivity periods. Under the new Section 1121(d), courts cannot extend a 120-day exclusivity period to a date that is more than 18 months after a petition was filed. Likewise, courts cannot extend a 180-day exclusivity period to a date that is more than 20 months after a petition was filed. These new limits curtail the bankruptcy courts’ discretion in deciding how many times to extend exclusivity. The new limits also strengthen lenders’ leverage to push a bankruptcy case to resolution.

Competing Creditors

Reclamation Claimants’ Position Stronger

The Bankruptcy Code provides vendors of goods the opportunity to reclaim goods delivered shortly before or after debtors file bankruptcy petitions.⁵ These vendors receive reclamation claims in bankruptcy cases for the actual goods delivered or their value.

BAPCPA changes to two reclamation-related Bankruptcy Code provisions will likely strengthen the position of reclamation claimants relative to lenders.

First, reclamation claimants have what is arguably a new federal right to reclaim. Former Section 546(c) stated that a vendor was entitled to exercise its reclamation rights under applicable state law provided that the vendor demanded its goods from the debtor in writing before 10 or 20 days after receipt by the debtor, depending on when the debtor filed its petition. Courts were therefore often forced to examine state law in order to determine the validity and value of reclamation claims in bankruptcy cases.

The new Section 546(c) makes no reference to state law and provides simply that a vendor may reclaim goods sold in the ordinary course during the 45 days before a debtor files its petition. A vendor must still demand its goods in writing, but now has 45 days after the debtor received them to do so, or 20 days after petition filing if the 45-day period expires after the debtor files its petition.

Since BAPCPA’s passage, at least one court has observed that while the former Section 546(c) merely validated state-based rights to reclaim, the newly amended provision may create a federal right to reclaim and make application of states’ Uniform Commercial Code principles unnecessary in this context.⁶ If interpreted in that manner, this federal right to reclaim will strengthen vendors’ positions relative to lenders by making reclamation claims more predictable and certain.

Second, vendors have a new and improved position as administrative expense claimants. In the past, reclamation claims received general unsecured status because their priority was not specifically addressed by the Bankruptcy Code. As a rule, general unsecured claims are last in the claims hierarchy and are paid if and when all other claims have been paid. Under new Section 503(b)(9), however, claims for goods received by a debtor in the ordinary course of business within 20 days before its petition filing receive administrative expense priority. Administrative expense claims are first in the claims hierarchy and must be paid in full before a reorganization plan can be commenced.⁷ This new classification strengthens the position of vendors relative to lenders because more cash will be used to pay reclamation claimants early on in bankruptcy cases and, of course, less cash will be available later to pay lenders’ lower priority claims.

Utilities Stronger Relative to Lenders

The Bankruptcy Code provides that utilities may not alter, refuse, or discontinue service to a debtor solely for filing a bankruptcy petition.⁸ A utility may, however, require a debtor to provide adequate assurance of payment following the petition filing.⁹

A Bankruptcy Code provision amended by BAPCPA regarding adequate assurance appears to have strengthened the position of utilities relative to lenders in two ways.

First, adequate assurance has been explicitly defined for the first time in the Code. In the past, a debtor could pay adequate assurance to a utility in any form approved by a court. Under the amended Section 366(c), however, adequate assurance may only be paid as a cash deposit, letter of credit, certificate of deposit, surety bond, prepayment, or another mutually agreed upon form.

More importantly, a debtor cannot pay adequate assurance by granting a utility an administrative expense priority claim for the amount due. Without the option to grant an administrative claim and thereby postpone payment to utilities, debtors will be forced more often to pay adequate assurance to utilities in cash quickly after filing their petitions. This amended provision strengthens a utility’s position relative to a lender because, as in the vendor’s position described above, less cash will be available to pay lower priority claims after utilities’ adequate assurance has been paid in cash very early in bankruptcy cases.

Second, adequate assurance paid by a debtor must be satisfactory to a recipient utility. Under the former Section 366(b), a utility could alter, refuse, or discontinue service if a debtor did not furnish adequate assurance within 20 days after filing its petition. As discussed above, this adequate assurance could be paid in any form approved by a bankruptcy court.

According to the new Section 366(c), however, a utility may discontinue service if it does not receive satisfactory adequate assurance within 30 days after a petition is filed. The term "satisfactory" is not defined by the Bankruptcy Code, but a bankruptcy court has recently addressed the interplay between this satisfactory requirement and the Section 366 adequate assurance deadlines. In In re Lucre, the debtor requested an extension of the Section 366(b) 20-day injunction against discontinuing service because the utility at issue refused to respond to the debtor’s offer of adequate assurance.¹⁰ The debtor argued that the injunction should be enforced because it had made a good faith offer and Section 366(c) would otherwise give the utility authority to discontinue service in 30 days if it deemed the offer unsatisfactory.¹¹ The bankruptcy court stated that modification of adequate assurance under 366(b) requires acceptance by both parties, and the court refused to extend the injunction beyond 30 days because the utility had not accepted the debtor’s offer.¹²

Although the court suggested that a utility may have an implicit obligation to bargain in good faith, it held that the debtor had no right to prevent the utility from exercising its right to discontinue service under Section 366(c).¹³ The new Section 366(c) therefore strengthens a utility’s position relative to a lender by giving it power to discontinue service and seriously affect a debtor’s business based on a subjective standard of satisfactoriness.

Footnotes

This article is intended to provide information on recent legal developments. It should not be construed as legal advice or legal opinion on specific facts. Pursuant to applicable Rules of Professional Conduct, it may constitute advertising.