This is the fourth in a series of Alerts regarding the proposals made by the American Bankruptcy Institute Commission to Reform Chapter 11 Business Bankruptcies. We discuss here the Commission’s efforts to require that debtor’s management act in a more transparent fashion. For copies of this or any prior articles about the Commission, please contact any BakerHostetler bankruptcy attorney.

There is often friction between a debtor’s management and the other stakeholders in a bankruptcy. Creditors will take a loss, and may be sued for a preference. Equity investors will be wiped out. Employees jobs are at risk. To smooth these frictions, the Commission recommends several steps to increase the opportunity for negotiation, share information on key topics with creditors, and reduce the need for costly legal battles.

The “Estate Neutral”

Under current law, the appointment of an “examiner” is essentially mandatory in all but the smallest cases. The examiner is a neutral party, paid by the bankruptcy estate, with authority to investigate and report upon alleged misconduct or incompetence. In many cases, however, the examiner may be duplicating the efforts of creditors’ committees, at added cost, without providing value.

The Commission believes that a knowledgeable neutral party, properly directed by the court, could help reduce costs by mediating disputes, facilitating plan negotiations, and centralizing investigations that might otherwise be undertaken separately by competing groups.

The Commission proposes to refashion the examiner as an “Estate Neutral” who can be authorized to take on those roles if it is in the best interests of the estate as a whole. The Commission would also eliminate the mandatory appointment of an examiner. To reduce costs, the Commission proposes a presumptive maximum of one Estate Neutral per case.

The VIP Information Package

Companies that enter bankruptcy are required to file limited financial reports. Those reports can often be delayed, and may not be GAAP compliant or provide a complete picture of the debtor’s business. This can create obstacles for creditors who must evaluate a bankruptcy plan, asset sale, or a critical motion such as for post-petition financing. But management has good reason to fear divulging financial and strategic information that may find its way into the hands of competitors or other hostile interests.

Ultimately, the Commissioners propose to resolve this friction by requiring bankrupt companies to compile a “Valuation Information Package” (the “VIP”), containing the past three years’ tax returns and annual financial statements (audited if available), the most recent appraisals of material assets or the business enterprise, and all business plans or projections prepared within the past two years that were shared with creditors, investors or lenders. To protect the debtor, only a list of the information contained in the VIP would be filed. If a party requests access to the information, access can be made subject to confidentiality and trading restrictions.

Limiting Nuisance Preference Suits

Few things are more frustrating than receiving a preference lawsuit demanding the return of what little the creditor received before the bankruptcy. The Bankruptcy Code allows the debtor to recover certain payments or concessions it made to creditors shortly before bankruptcy. These provisions were originally enacted to maximize the value of the estate for unsecured creditors, and to prevent one unsecured creditor from getting an unequal share of the recovery.

However, in modern Chapter 11s most of the preference recoveries end up going to secured creditors and administrative claimants. To alter this result, and further the goal of equality of distribution, the Commission recommends prohibiting secured creditors from obtaining liens on these avoidance actions so that general unsecured creditors can have the opportunity to share in the recoveries.

The Commission also recommends requiring debtors to investigate preference claims, including knowable defenses, before sending a demand letter or instituting a suit for recovery and requiring such claims to be plead with particularity. Lastly, the Commission recommends logistical barriers to nuisance preference suits, such as barring business preference suits under $25,000 and moving preference suits involving less than $50,000 to the defendant’s home district. The Commission recognized that trustees would be less likely to pursue frivolous preference suits if they must hire out-of-state counsel.

Continuing Work Under Executory Contracts

Debtors have many contracts to provide continuing services, including leases, supply agreements, etc. These “executory contracts” can represent critical benefits or burdens for the company. The Bankruptcy Code provides a process by which the debtor may assume (keep) beneficial contracts, and reject (breach) burdensome contracts.

The Bankruptcy Code does not define the term “executory contract.” The Commission proposes adopting the dominant “Professor Countryman” definition, which provides that a contract is executory when the obligation of both the debtor and the non-debtor are so far unperformed that failure of either to complete performance would constitute a material breach, excusing the other from performance.

Additionally, while the debtor is deciding whether to assume or reject a contract (called the “gap period”), it is not clear to what extent the contract is enforceable. The Commission proposes keeping the traditional rule that the debtor cannot be forced to perform burdensome obligations during the gap period, to give the debtor “breathing space” to rehabilitate itself. However, a counterparty may demand performance during the gap period if the benefit to the creditor significantly outweighs the costs to the debtor.

Similarly, the debtor would have no real breathing space if a critical counterparty could stop shipments. For that reason, the Committee recommends clarifying that the debtor can demand full or partial performance from the counterparty during the “gap” period. However, to protect the creditor, the debtor must pay the counterparty for post-petition goods and services in a timely manner, according to the contract terms.

Commercial Leases During the Gap Period

In most cases, there is no deadline by which the debtor must assume or reject a contract unless the court imposes one. However, commercial real estate leases are deemed rejected unless they are assumed within the first seven months of bankruptcy. Congress was concerned that extended periods of uncertainty are unfair to commercial real estate landlords. The testimony before the Commission indicated that it is very difficult for a large retailer, in particular, to determine which stores it should keep in the first seven months of its filing. The short period jeopardizes the retailer’s ability to reorganize. The Commission, therefore, recommends allowing businesses up to one year to decide whether to assume or reject a commercial lease to provide a better chance for retailers to create a business plan and reorganize.

Employment and Labor

Employees are obviously critical to business reorganization, and the Commission recommended several changes to the labor relations provisions of the Bankruptcy Code. In a unionized business, the debtor may be tempted to reject the collective bargaining agreement in order to impose pro-company terms. The Bankruptcy Code allows a debtor to do so after good faith bargaining, and with the court’s approval. The debtor, however, can force the court to rule within two months. As a result, many debtors treat the negotiations as a formality so they can seek greater concessions by filing a motion to reject the labor agreement.

To encourage good faith negotiation, the Commission recommends extending the two month “cap” to six months, and requiring the parties to confer with the court and exchange information early on. The Commissioners also propose that if the debtor elects to modify payments to retirees under a similar provision of the Bankruptcy Code, the debtor must pay benefits until the order rejecting the contract is entered.

Finally, if a company engages in mass layoffs without providing sixty days’ notice, it can be required to pay damages similar to severance pay under the WARN Act. If the sixty-day period straddles the bankruptcy filing, it is not always clear whether those claims are valuable post-bankruptcy administrative expenses or general unsecured pre-bankruptcy claims, which are typically worth pennies on the dollar. The Commission recommends that employees have an administrative claim for whatever portion of their sixty days’ severance accrues after the bankruptcy filing.

The Commission engaged in considerable debate, particularly regarding the commercial lease and labor relation provisions described here. The objections of landlords in particular resulted in a compromise one-year period to determine whether to keep store leases, even though many Commissioners felt a longer period was advisable. The Commission believes that these changes will help to improve recoveries to all stakeholders by reducing uncertainty, and the consistent friction of wasteful litigation.