Over the past few months, the media has doggedly reported on the progress and final passage of the new federal bankruptcy law, focusing on its effects on individuals. The impact that it will have on business has gotten little attention.
Yet the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, adopted on April 20, will make seeking Chapter 11 protection a more onerous process, according to legal and turnaround management experts.
In some cases, it will force struggling companies to liquidate assets rather than focus on restructuring, says bankruptcy attorney Jon Schneider of Goodwin Procter LLP. That’s because provisions in the new law, which amends parts of the U.S. Bankruptcy Code, have the effect of requiring bankrupt companies to generate more upfront cash to pay administrative claims.
Other provisions narrow the timeframe for making decisions about whether to assume or break existing real estate leases, points out William Lenhart, a turnaround expert with BDO Seidman’s Financial Recovery Services. That’s likely to hurt retailing and other industries that need flexibility in planning locations, he notes.
At the same time, the provisions of the act, most which go into effect in late October, cut a wide swath across many aspects of corporate bankruptcy law. The new law is bound to introduce complications for bankrupt companies in such diverse areas as administrative-claim status, retention pay, inventory, utility payments, and relations with investment bankers.
Here, from a corporate-finance perspective, are some of the practical implications of the changes.
• Quicker decisions on leases. One of the more troublesome changes of the new law, an amendment to Section 365(d)(4) of the bankruptcy code, pertains to real estate leases and the amount of time a bankrupt company has to decide whether to retain or break them. Before the law’s enactment, companies that filed for Chapter 11 had 60 days (from the filing date) to make their decision. As a matter of practice, says Lenhart, bankruptcy judges routinely granted as many extensions to the 60-day period as necessary.
But companies must now make their lease decisions within 120 days, and are only permitted one 90-day extension, for a maximum of 210 days. The new cap is sure to cause problems for retailers, restaurant chains, or any kind of operation that relies on multiple locations for success, says Lenhart.
In the past, legitimate extensions served as a testing period for reorganization plans, he explains. The time was used to track and analyze sales data so that management could figure out which locations were profitable and which ones to shutter. For the analysis to be effective, however, businesses had to operate at least during one heavy selling season, such as the Christmas rush.
Speeding up the testing period could force management to make rash decisions, reckons Lenhart. As a result, companies may emerge from bankruptcy with ineffective plans and end up either liquidating assets, or — in what lawyers lightheartedly refer to as Chapter 22 — a second bankruptcy.
If a company decides to break a lease, it would be on the hook for the greater of one year’s rent, or 15 percent of the remainder of the lease — which could be a significant payout on a 30-year lease, the turnaround expert says. Under the old law, debtor liability was limited to one year on a broken lease.
Perhaps more important, the new law reclassifies back rent as an administrative claim rather than as an unsecured debt. As an administrative claim, back rent takes a priority position in the bankruptcy-creditor hierarchy, landing behind secured debt in the payout queue but leapfrogging ahead of unsecured creditors. Since unsecured debt is paid after the reorganization plan is finalized, reclassifying rent as an administrative claim will force bankrupt companies to shell out a whole lot more in upfront funding.
• More upfront funding. Generally, administrative claims are the costs incurred to run a business while it’s in Chapter 11. Those expenses include wages, taxes, and legal costs. By hiking the number of claims that qualify as administrative, the amendments essentially force insolvent companies to generate more upfront cash, according to Schneider. For bankrupt companies, generating cash almost always requires selling off assets, which can deplete a company’s value and potentially hurt its chances of emerging from bankruptcy, he says.
Several provisions of the act will require insolvent companies to pony up more money or return inventory before reorganization plans are set. For example, a change to Section 503(b)(9) of the code will grant administrative-claim status to any goods shipped within 20 days of a company’s filing for bankruptcy, as long as the shipment was made during the normal course of business. Although “the normal course of business” is a subjective term, attorneys agree that the criterion is very broad and includes any regular commerce between a vendor and the insolvent company.
The new administrative status entitles the trade creditor to immediately get 100 cents on the dollar for the shipped goods, rather than waiting until the reorganization plan is finalized — as holders of unsecured-debt claims must do. In practical terms, the priority status affords creditors two benefits: Once again, the creditor is pushed ahead of unsecured-debt holders in the payout pecking order, and the creditor must be paid in full. Generally, unsecured-debt holders get a much smaller percentage of what they’re owed, notes Schneider.
The new law also helps trade vendors stuck with unpaid invoices for goods received by corporate bankruptcy filers. Section 546(c) expands the administrative-claim status to cover goods received by debtors within 20 days of filing for bankruptcy. Previously, the claims period was 10 days. What’s more, trade creditors have the right to reclaim any goods in the possession of an insolvent company that were received within 45 days of the Chapter 11 filing. The reclamation period used to be 10 days.
Further, an amendment to Section 366 of the code states that companies in Chapter 11 are required to provide upfront assurance via such things as cash deposits, letters of credit, certificates of deposit, or prepayments to utility companies. That will enable the company to pay electric, heat, and water bills while it reorganizes. In the past, “assurance” of payment was left undefined and did not require cash deposits.
• Hampered exclusivity. Participants in large, complex bankruptcy cases will feel the sting of an amendment to Section 1121 of the code. The provision deals with a debtor’s exclusive right to propose a reorganization plan. Historically, debtors could avoid draconian creditor proposals by requesting extensions of the period in which it had the exclusive right to file a plan. In that way, the bankrupt company could work out more favorable terms for itself. Now any interested party can file a reorganization plan 18 months after a debtor files for bankruptcy, effectively weakening companies’ ability to delay reorganization, according to Schneider.
The change to the exclusivity rules will likely attract distressed-debt buyers to bankrupt companies. “There’s a lot of money chasing default debt as a way of taking control of a company,” notes the attorney. The consequence of such a provision may once again be to promote asset sell-offs rather than rebuilding the company, he notes.
• Capped retention pay. Another amendment, to Section 503(c) of the code, puts a severe limit on retention pay and bonuses for executives — in essence, denying most pay incentives. It was typical to offer key executives or new ones a financial inducement to stay on through a bankruptcy, notes Lenhart. But that carrot is gone.
While Lenhart agrees that the change will stop bonus payouts to executives that mismanage bankrupt companies, he points out that the law hobbles the ability of companies to retain good managers needed to reorganize the business.
• Investment banks invited. Investment bankers should be happy with Section 101(14). That provision waives the “disinterested party” rule, which originally guarded against potential conflicts of interest among bankruptcy advisors. Previously, investment banks that underwrote securities — and thus had a vested interest in a company — were banned from acting as a restructuring advisor. The ban, says Schneider, gave rise to boutique advisory firms.
The new law invites investment banks back to the restructuring table, enabling them to compete head-to-head with boutique firms that dole out advice to insolvent companies.
• Short shrift for small businesses. Small businesses — companies identified as having less than $2 million in secured and unsecured debt — get a break under the new law. The new rules aim to speed up the processing of cases by consolidating filing procedures for smaller filers. For instance, small businesses can file a combined plan and disclosure statement and ask for combined approval from the courts, a two-step process for larger companies.
The amendments to the code also give small businesses an extra 20 days—a total of 180 days—within which to do their newly consolidated filing. That’s still a considerably shorter amount of time than the 18 months bigger companies were given under the changes.
Like big companies, small businesses lose their previous right to unlimited extensions under the new law. Unlike the case for bigger companies, however, if a smaller company’s reorganization plan (submitted by either the debtor or an interested party) isn’t handed down within 300 days of filing for Chapter 11, the business will lose its bankruptcy protection.
What’s more, small businesses are now responsible for filing more financial information then they had in the past, says Schneider. The list of new items includes profitability statements; projected and actual cash receipts and disbursements; attestation of the debtor’s compliance with the bankruptcy code; and reports on whether taxes and other administrative costs were paid on time and, if not, a statement of how the company plans to remedy the situation.
The new reporting requirements seem so onerous that it may be worth incurring more than $2 million worth of debt just to avoid being classified as a small business, one lawyer joked.