SC Lawyer, May 2007, #4. The Bankruptcy Reform Act's Impact on Commercial Debtors and Their Creditors.

• Author: By Michael M. Beal and Michael H. Weaver

South Carolina Lawyer

2007.

SC Lawyer, May 2007, #4.

The Bankruptcy Reform Act's Impact on Commercial Debtors and Their Creditors

South Carolina LawyerMay 2007The Bankruptcy Reform Act's Impact on Commercial Debtors and Their CreditorsBy Michael M. Beal and Michael H. WeaverThe Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, Pub. L. No. 109-8, 119 Stat 23 [hereinafter "BAPCPA" or the "Reform Act"] was signed into law on April 20, 2005. However, the vast majority of the Reform Act's provisions did not go into effect until October 17, 2005 (general effective date). While BAPCPA was enacted in an effort to curb perceived abuses of the bankruptcy system by consumer debtors (see Helen Elizabeth Burris et al., You Say You Want a Revolution, South Carolina Lawyer, July 2005, at 40 for a discussion of BAPCPA's effects on consumer debtors), a number of its provisions affect commercial debtors as well as the creditors who do business with them. This article discusses some of the major changes Congress made to the Bankruptcy Code through the Reform Act and how these changes have impacted commercial debtors and creditors more than one year after the general effective date.

I. Impact of BAPCPA on case filings in general

If you ask the bankruptcy bar, they will tell you that BAPCPA's most obvious impact has been on the number of case filings. In the months and days leading up to the general effective date, an unprecedented number of cases were filed in South Carolina and nationwide, and a precipitous drop in the number of filings occurred immediately thereafter. For example, according to the U.S. Bankruptcy Court for the District of South Carolina's records, between January 2003 and September 2005, the average number of Chapter 7, 11 and 13 filings was approximately 1,300 per month. In October 2005, more than 3,550 cases were filed; however, in November 2005 (just after the effective date), only 218 cases were filed. While the average number of Chapter 7, 11 and 13 filings each month has increased gradually since the general effective date (e.g., in 2006 there were, on average, 500 cases filed each month), the number of filings is still well below pre-Reform Act levels.

Nationwide, the number of commercial debtors filing for either Chapter 7 liquidation or Chapter 11 reorganization has been down since the general effective date as well. The significant reduction in Chapter 11 filings is not entirely attributable to BAPCPA. A combination of historically low interest rates, unprecedented liquidity in the capital markets and a fairly strong economy have helped some marginal businesses survive outside of Chapter 11. However, as oil and gas prices, interest rates and insurance premiums continue to rise across the country, the housing, automotive and manufacturing industries, among others, will be faced with formidable cash-flow challenges. These factors have led some analysts to predict that the number of commercial bankruptcy cases will increase significantly in 2007. Consequently, companies that are teetering on the edge of insolvency and companies that do business with them need to be aware of many notable changes in the Reform Act and how each may impact them.

II. Preferential transfers

Perhaps one of the most unpopular provisions of the Bankruptcy Code with creditors is § 547, which deals with a bankruptcy trustee's ability to avoid (i.e., recover) transfers or payments that a debtor made to or for the benefit of a creditor on account of an aged debt on or within 90 days before the debtor filed for bankruptcy (this period is expanded to one year for insiders of the debtor), which enabled the creditor to receive more than it would have received if the transfer had not been made and the debtor had filed for Chapter 7 relief. As a practical matter, this section almost always means that any unsecured creditor who was paid on account of an aged invoice within 90 days of the debtor's bankruptcy filing received a preferential transfer. The goals behind § 547 are to (i) treat similarly situated creditors equally, (ii) discourage creditors from racing to the courthouse to carve up the debtor and (iii) encourage vendors to continue to do business with their financially troubled customers. Even if a creditor receives a preferential transfer, the creditor may have certain affirmative defenses available to it that would except the preferential transfer from avoidance.

a. The ordinary course of business defense

One of the most commonly asserted defenses is the "ordinary course of business defense." Prior to the Reform Act, this defense required the creditor to show that the transfer was in payment of a debt incurred by the debtor in the ordinary course of business or financial affairs of the debtor and creditor, was made in the ordinary course of business or financial affairs of the debtor and creditor and was made according to ordinary business terms.

The pre-Reform Act ordinary course of business defense's three-pronged test was often difficult for creditors to satisfy because all elements of this conjunctive test had to be satisfied. While debtors oftentimes conceded that the first prong of the test was satisfied, parties routinely litigated over the remaining prongs. The second prong, requiring that the creditor show that the transfer was made in the ordinary course of business or financial affairs of the debtor and creditor required a subjective, fact intensive analysis involving a review of the debtor's transactions with the creditor. The third prong was objective, requiring testimony from expert witnesses as to what the ordinary payment terms in the creditor's industry were at the time of the transfer to see whether the transfer subject to avoidance fit within the industry's payment term parameters.

Perhaps responding to pressure from creditors displeased with the ramifications of § 547, Congress modified the ordinary course of business defense in the Reform Act and made it easier for creditors to assert and prove this defense at trial by changing the test from a conjunctive one to a disjunctive one. Now, in cases filed after the general effective date, if the transfer was in payment of a debt incurred by the debtor in the ordinary course of its and the creditor's business or financial affairs, then the creditor must only show that the transfer was either made in the ordinary course of business or financial affairs of the debtor and creditor, or was made according to ordinary business terms. However, one court within the Fourth Circuit recently held that the creditor must show that the transfer was ordinary for both the creditor's and debtor's industry in order to demonstrate that the payment was made according to ordinary business terms. See In re National Gas Distributors, LLC, 346 B.R. 394 (Bankr. E.D.N.C. 2006). This requirement is a departure from the pre-Reform Act line of cases that held that only the creditor's industry was relevant for purposes of analyzing the defense, and time will tell whether other jurisdictions adopt similar holdings.

b. Expansion of time to perfect security interests

Prior to the Reform Act, if a creditor perfected its security interest within 10 days of the transaction, the transfer would be deemed to have occurred on the transaction date. If the creditor perfected its interest after 10 days, the transfer would be deemed to have occurred on the date the creditor's interest was perfected.

The Reform Act increased the time within which a creditor may perfect its security interest and claim the earlier date as the date of the transfer. Now, pursuant to § 547(e), a transfer will be deemed to have occurred on the transaction date if the interest is perfected within 30 days (rather than 10 days). Thus, if the creditor sells goods to a debtor on the 110th day prior to the bankruptcy filing and the debtor grants the creditor a security interest that is not perfected until the 80th day prior to the bankruptcy filing (i.e., within the preference period), the transfer will be deemed to have occurred on the 110th day prior to the filing and will thus be outside of the preference period (unless of course the transferee was an insider), and the trustee will therefore not be able to avoid the transfer under § 547.

The Reform Act also extended the time in which creditors have to perfect purchase-money security interests. Purchase-money security interests now must be perfected within 30 days to take advantage of this safe harbor (rather than the pre-Reform Act period of 20 days).

c. Statutory cap on minimum recovery

Another frustration for creditors with respect to defending avoidance actions is the relatively high cost of defending them. Prior to the Reform Act, there was no jurisdictional dollar amount threshold, and it was often left up to the trustee to decide the minimum amount to seek recovery of in avoidance action. By the time a creditor has its counsel review the company's books and records, respond to a demand letter, go through the discovery process and hire an expert witness, the legal bill could easily be in the tens of thousands of dollars. Consequently, creditors oftentimes would just send checks in for the demand amount even though they may have had defenses to the avoidance action. The Reform Act addresses this problem through amended § 547(c)(9), which prohibits a trustee from recovering an aggregate amount of less than $5,000 in cases where the debtor's debts are not primarily consumer debt.

d. Jurisdictional limit

The Reform Act also changed the venue for an action brought by the trustee against a creditor for the avoidance of a preferential transfer. Now, pursuant to 28 U.S.C. § 1409(b), any avoidance action for an amount less than $10,000 must be brought in the district court for the district in which the defendant resides. This jurisdictional bar will make it more costly for trustees and the estate to recover from an out-of-state creditor where that creditor received less than $10,000.

III. Fraudulent transfers - extension of the look back period

Prior to the Reform Act, under § 548 a trustee could avoid transfers made within one year before the petition date by showing actual fraud existed or by demonstrating the existence of constructive fraud. Constructive fraud could be shown by demonstrating that the transfer was made while the debtor was insolvent or by showing that, by making the transfer, the debtor became insolvent and did not receive something of equal value on account of the transfer.

The Reform Act has extended the look back period for fraudulent transfers from one year to two years, beginning with all cases commenced on or after April 20, 2006, and has liberalized the definition of a "fraudulent transfer." Now the trustee, in addition to other pre-Reform Act means and without looking at the debtor's financial condition, can show that a fraudulent transfer to an insideroccurs if the transfer to the insider was made pursuant to an employment agreement that was not in the ordinary course of business and the debtor did not receive reasonably equivalent value from the insider on account of the transfer.

IV. Employee claims and Key Employee Retention Programs (KERPs)

a. Priority status for pre-petition wages

Prior to the Reform Act, up to $4,925 of an employee's claim for wages, salaries or commissions, including vacation, severance and sick leave pay earned by that employee within 90 days prior to the petition date was entitled to priority status under § 507(a)(4). This allowed all or part of employee claims earned within the 90 day period prior to the petition date to be paid ahead of other general unsecured creditors' claims. Recognizing a need to provide additional protection to employees, Congress broadened the provisions dealing with employee claims' priority status. The Reform Act doubled the time period and the amount by providing the employee with priority status for wages, salaries or commissions earned within 180 days of the petition date in an amount not to exceed $10,000. Any unpaid amount for wages, salaries or commissions earned by an employee within 180 days of the petition date in excess of $10,000 or earned outside of the 180 day period will be treated as a general unsecured claim. This portion of the Reform Act became effective upon BAPCPA being signed into law and is an exception to the general effective date. This provision, while beneficial to employees, will make it more difficult for corporate debtors to emerge from a Chapter 11 bankruptcy if there are substantial § 507(a)(4) claims because the claims must be paid on or before the effective date of the plan.

Section 507(a)(5), which provides a priority for unsecured claims for contributions to an employee benefit plan and must be calculated after all 507(a)(4) claims are paid, was also amended by the Reform Act. Now, unsecured claims for contributions to an employee benefit plan arising from services rendered by the employee within 180 days prior to the petition date or the cessation of the debtor's business, whichever is earlier, has been increased to $10,000.

b. Key Employee Retention Plans

Prior to the Reform Act, it was common in large commercial bankruptcy cases for bankruptcy courts to approve large retention bonuses and incentive payments in order to induce executives, many of whom were at the helm of the beleaguered company when it ran aground, to stay with the debtor through its restructuring and, hopefully, its successful reorganization. This type of incentive package is referred to as a Key Employee Retention Plan (KERP).

Congress perceived that there had been abuses with executive compensation in bankruptcy cases, so it amended § 548 to address pre-petition abuse (see above) and amended § 503 to address court-sanctioned post-petition abuse. While the Reform Act still allows for KERPs to be used, before a court can approve a KERP, severance payment or payment of retention bonuses to officers and directors of the debtor, the debtor must first show that (a) the KERP is essential in order to retain the particular individual and (b) that the individual the debtor wishes to retain has a bona fide job offer from another company at or above the individual's compensation rate provided by the debtor. Furthermore, the court must determine that the officer or director provides services to the debtor that are essential to its survival. Lastly, in order to have a court approve a KERP in a case filed after the general effective date, the amount must not exceed ten times the mean of a similar kind of bonus plan the company has given to non-management employees for any purpose during the calendar year. In the event that the company has not made any similar bonus payment to non-management employees, the amount of the KERP must not be greater than 25 percent of the amount of any similar transfer made or incurred for the benefit of an insider of the debtor within one calendar year before the enactment date of the KERP.

The effect of this amendment will likely mean that KERPs will be eliminated in bankruptcy cases because few, if any, employees with a bona fide offer in hand from another financially sound company will elect to stay with a company in bankruptcy for equal or less compensation.

V. Time limits to accept or reject unexpired non-residential real property leases

Prior to the Reform Act, the Bankruptcy Code provided that an unexpired non-residential real property lease under which the debtor was the tenant would be deemed rejected if the trustee or debtor-in-possession did not accept it within 60 days of the petition date unless the court extended the deadline. The statutory framework of § 365(d) offered trustees and debtors-in-possession the opportunity to continually seek extensions of this period, all the while leaving the creditor-landlord in limbo awaiting a decision by the debtor-in-possession or trustee.

Congress, through the Reform Act, addressed landlords' concerns about protracted extensions of the period of time to assume or reject unexpired non-residential real property leases. Now, the unexpired non-residential real property lease will be deemed rejected after 120 days unless the court, for cause, extends the period. However, under the Reform Act, the court may not extend the period beyond 270 days without the landlord's prior written consent.

Trap for the unwary: Under the Reform Act, an order extending the 120 day period must be entered by the court prior to the expiration of the 120 day period or the lease will be deemed rejected. See In re Tubular Technologies, LLC, 348 B.R. 699 (Bankr. D.S.C. 2006).

VI. Conclusion

While the jury may still be out regarding whether the Reform Act really has addressed the perceived abuses with the bankruptcy system, it is undeniable that it has had an impact on the number of bankruptcy cases filed in South Carolina. However, as interest rates, oil and gas prices and insurance premiums continue to rise, so too should the number of bankruptcy filings as corporations and consumers feel the squeeze and are pressured by unfavorable debt positions.

In light of these increasing pressures, more commercial debtors will look to the bankruptcy court for relief in the coming months and years, and these debtors, as well as the vendors that do business with them, should be mindful of the Reform Act and the significant changes it has had on bankruptcy law.

Mr. Beal is a shareholder in McNair Law Firm, PA's Columbia office and represents distressed companies and financial institutions in out of court restructurings, bankruptcies and related litigation and transactional matters. Mr. Weaver is an associate in McNair Law Firm, PA's Columbia office and represents commercial debtors and financial institutions in bankruptcy matters. The comments of the authors do not reflect any position of McNair Law Firm, PA or any of its clients.