On December 8, 2014, the American Bankruptcy Institute’s Commission to Study the Reform of Chapter 11 issued an extensive report detailing hundreds of recommended changes to the Bankruptcy Code to address significant economic and financial developments since the enactment of the Bankruptcy Code in 1978. The recommendations aim to reduce the cost of chapter 11, increase the predictability of disputes by resolving ambiguous and divergent case law, provide more flexibility for debtor in possession financing, curb the power of senior lenders, and increase protections for creditors when a debtor sells its business under section 363. Among some of the Commission’s important recommendations are:
- Appointment of “Estate Neutral”: Under the current Code, the Court can appoint an examiner to investigate claims only if it makes the determination that appointment of an examiner would be in the best interest of all parties. The Commission suggests that, rather than an examiner, an “estate neutral” should be appointed by the Court when doing so would be in the interest of the estate—appointment need not serve the interest of all parties. The estate neutral would have a flexible role that would be tailored by each bankruptcy court.
- Restrictions on DIP Financing Terms: The Commission’s proposals seek to reduce the level of control secured lenders currently enjoy over chapter 11 cases without disrupting the market for debtor in possession (DIP) financing, which is often vital to successful reorganizations. Collectively, these changes would give more power to debtors and junior creditors vis-à-vis DIP lenders, but such significant changes have the potential to discourage lenders from providing DIP loans or to substantially increase the cost of such loans. The Commission recommendations regarding DIP financing are:
- Courts should not permit DIP financing provisions that grant DIP lenders liens on avoidance actions or subject the debtors to milestones or benchmarks within 60 days of filing.
- Courts should not approve certain provisions on an interim basis: directing the debtor to satisfy certain conditions, stipulate that liens are valid, or “roll-ups” in which DIP financing is used to pay off prepetition secured debt, in effect converting it to postpetition debt. The report further recommends tightening the standards for roll-ups when the debtor’s prepetition lenders provide DIP financing.
- Judges should reject roll-ups in DIP financing provided by prepetition lenders except where DIP financing repays the prepetition debt in cash and provides “substantial” new credit on better terms than any alternative.
- Debtors should be prohibited from waiving their right under 506(c) to surcharge a secured lender’s collateral for the costs and expenses of preserving that collateral. Debtors often waive that right, making the estate, rather than the secured lender, responsible for professional fees and certain administrative claims that the secured lender does not expressly agree to pay.
- Courts should allow junior lenders to offer debtors DIP financing, even if prohibited from doing so by an intercreditor agreement with a senior lender, so long as the proposed financing does not prime the loans of senior lenders and the senior lender is given the opportunity to offer financing on the same terms. Encouraging competition between junior and senior lenders could enhance debtors’ negotiating position when seeking DIP financing.
- 60-Day Breathing Room Period: In recent years, expedited sales under section 363 of substantially all of the debtor’s assets have become increasingly common. The Commission expressed concern that excessively fast 363 sales risk reducing the value of the estate. In particular, the Commission was sensitive to the harm to junior creditors when a senior lender demands that a debtor rush through a bankruptcy sale quickly in order to pay its senior secured loans without regard to whether the sale will maximize the value of the debtor’s assets for all of its stakeholders. To correct the problem, the Commission proposes a 60-day moratorium on sales of substantially all assets under section 363, unless clear and convincing evidence establishes that the debtor’s circumstances are extraordinary.
- Protection for Creditors in 363 Sales: Because 363 sales of substantially all assets generally affect creditors’ rights to the same degree as reorganization under a chapter 11 plan, the Commission suggests that creditors should have the same level of substantive and procedural protection as they would in connection with the confirmation of a chapter 11 plan.
- “Redemption Value Rule” to Provide a Return to Junior Creditors: The Commission expressed concern that cases are often run for the benefit of senior creditors, who receive full payment on their claims while junior creditors receive nothing. In many bankruptcies, the debtor is at a low point in value when its case is commenced, and immediately junior creditors—those ranking directly below the senior creditors in priority—could have received a distribution if the debtor had sold or reorganized at some later date. The Commission suggests a “redemption value rule” that would, in short, provide a distribution to junior creditors in cases where the senior class receives full or nearly full payment. Junior creditors would receive a distribution from the estate based on the hypothetical option to purchase the reorganized debtor within three years of the petition date, which would compensate them for value lost due to the timing of the bankruptcy. The “redemption value rule” would apply for both reorganizations and 363 sales.
- Intellectual Property under the Bankruptcy Code: While some courts have prohibited a debtor in possession from assuming a license when that license prevents assignment to a third party, the Commission recommends allowing assumption, and allowing Debtors to freely assign such licenses to third parties unless the licensor could demonstrate that the hardship imposed by the assignment would significantly outweigh the benefit to the estate. The report also recommends changing the Code’s definition of intellectual property to include trademarks, service marks, and trade names.
- Curbing Unwarranted Preference Actions: The Commission recommends changing the Code to require a trustee to perform reasonable due diligence before bringing a preference action. Preference complaints would have to properly plead facts supporting each element of a preference. The Commission also recommended barring preference actions for less than $25,000.
- A New Scheme for Smaller Companies: The Commission also outlines an alternative restructuring scheme for small and medium-sized companies.
The above represent only a small portion of the many suggested changes. Among other things, the Commission also recommends approval of alternative fee arrangements with estate professionals, the alteration of the valuation method used to calculate adequate protection, removal of 546(e) safe harbor protections for some leveraged buyouts, changes to the treatment of executory contracts and real estate leases, clarification as to which vendors will be entitled to administrative claims under section 503(b)(9), and elimination the requirement that some impaired creditors vote to accept a non-consensual plan. It remains to be seen which of the Commissions suggestions, if any, will make it into the next iteration of the Bankruptcy Code.
The full report can be found here: