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Bar News - November 4, 2005 Small Business Aspects of New Bankruptcy Code By: Joshua E. Menard
Small business owners should be aware that the Act makes it much tougher to declare bankruptcy, which has its pros and cons for small business owners. Easier Reimbursement The Act will make it easier for small businesses to be reimbursed in full (as a so-called “administrative expense”), if they delivered their goods or services in the ordinary course of business 20 days before a company files for bankruptcy protection.1 Under the old law, these businesses would be considered unsecured creditors and would get paid only after the court approved a debtor’s Chapter 11 reorganization plan or Chapter 7 liquidation. Secured creditors almost always get paid first, but if there’s anything left thereafter, administrative expense claims have priority. Better Defense Against Preference Actions Preference actions have also been overhauled. An extraordinary payment made by a debtor to a creditor within 90 days before the debtor’s bankruptcy filing is called a “preference payment.” In providing for recovery of preference payments, the Bankruptcy Code seeks to prevent debtors from “preferring” one creditor, or a select group of creditors, over others. Preference actions enable the debtor’s bankruptcy “estate” to pull all such preference payments back into the “collective pot” so that they can be redistributed to all unsecured creditors on a pro rata basis. The debtor’s intent is immaterial in determining whether or not a payment is a preference under the Bankruptcy Code. It is the effect of the transaction that is controlling—basically, if a creditor receives a non-ordinary course payment within 90 days prior to the filing, and if the payment results in the creditor getting more than it would have ended up with in a pro rata distribution from Chapter 7 liquidation, the pre-bankruptcy payment is “avoidable”—i.e., has to be paid back —as a preference. The Act makes it much easier for creditors to defend against preference actions. Importantly, the threshold for bringing a preference case has been raised. Allegedly preferential transfers to a creditor that aggregate less than $5,000 are no longer avoidable. (The previous limit was $600 and only applied to consumer debts.) Also preference actions concerning a consumer debt from a non-insider of less than $15,000 or any other debt from a non-insider of less than $10,000 can only be brought in the creditor/defendant’s home district. Gone are the days of a non-insider business creditor in New Hampshire being sued for a small preference in a Delaware bankruptcy case and having to ante up simply because the cost of defending in Delaware was too high. Now the tables are turned and the Delaware plaintiff will have to come to New Hampshire to pursue the preference action. You can expect a number of these small preference cases will not be pursued.
Theoretically the Act will make it easier for small businesses to collect debts from individuals who file for bankruptcy protection. Under the Act, many consumers will no longer be eligible to file for Chapter 7. Instead, they will have to file under Chapter 13 and commit to a payment plan requiring them to pay back a portion of their debts over a five-year period. Many predict that the new and more onerous requirements and provisions of the Act, and subsequent higher costs, will result in a dramatic drop in consumer filings resulting in an increasing number of informal “work-out” agreements between creditors and debtors. Either through a Chapter 13 payment or consensual work-out agreement, it appears that the Act heightens creditors’ chances of recovering previously lost debt.
The old bankruptcy law allowed a trustee or debtor-in-possession 60 days in which to decide whether to assume or reject a commercial lease, with extensions allowed “for cause.” In most bankruptcy courts, extensions were liberally granted as long as the trustee or debtor-in-possession was making payments. The act dramatically changed that. The initial period in which the trustee or debtor-in-possession has to decide whether to assume or reject a commercial lease has expanded to 120 days, but no longer will the trustee or debtor-in-possession be able to get endless extensions. Only a single 90-day extension will be allowed, if “cause” is established, without the landlord’s consent. This change is certainly pro-landlord. Once a commercial lease is assumed, all future rental obligations are classified as administrative claims, with priority over most other claims. As a result, even if the case eventually fails, the lease obligation, subject to a two-year cap, will be paid before unsecured creditors see any distribution. The Automatic Stay There have been some significant changes to the automatic stay. In a case under Chapter 7, 11 or 13 filed within one year after dismissal of a previous case, the automatic stay terminates 30 days after the filing of the most recent case. The automatic stay may be extended on motion if the debtor can show good faith; however, a case is presumptively filed in bad faith if there was a previous case and the debtor failed to (1) file documents as required by the court, (2) provide adequate protection as ordered by the court, (3) perform under the terms of a confirmed plan, and (4) if there has not been a substantial change in the debtor’s circumstances. If a debtor filed two cases within the one-year period following dismissal of case within that term, the automatic stay does not go into effect with the third filing. On request of party in interest, the bankruptcy court “shall promptly enter an order confirming that no stay is in effect.” There are now two “eviction exemptions” to the automatic stay as well. (1) If a landlord of residential property has obtained a pre-bankruptcy judgment for possession against the tenant/debtor, the automatic stay does not apply to that eviction proceeding and the landlord may proceed with obtaining possession of the premises.2 (2) If an eviction action seeks possession of the residential property in which the debtor resides as a tenant and if the eviction is based on “endangerment of such property or illegal use of controlled substances on such property,” the landlord may file a sworn certification. The certification must assert that an eviction proceeding has begun or that the necessary endangerment or illegal use has occurred within 30 days of the bankruptcy filing. The debtor must file an objection within 15 days and a hearing must be held within 10 days. Retention Pay Capped There have been several high-profile bankruptcy cases in which the company’s management, prior to the bankruptcy case, received substantial bonuses or new employment agreements with significantly enhanced compensation and benefits, including severance pay. Under the Act, creditors will be able to recover a transfer to an officer or director under an employment contract if the transfer was not made in the ordinary course of business. It will be much harder for management to effectively give itself substantial compensation benefits shortly before a bankruptcy case is filed. Under the current Bankruptcy Code, a debtor’s obligations to taxing authorities can be paid over six years from the date of assessment. The Act shortens this to five years and requires that the IRS be treated at least as favorably as top-tier unsecured creditors. Business Filers Also Face Tough Scrutiny The Act isn’t at all friendly to small businesses that have to file for bankruptcy protection. It will be harder for small businesses to reorganize under Chapter 11, work out payment plans with their creditors, and stay in business. In Chapter 11, debtors with less than $2 million in debt will be subject to the Act’s new “small business” provisions. The new provisions require additional paperwork and reporting burdens, and the company must have its books and records examined by a bankruptcy trustee to ensure that the company has a plan to succeed. If the trustee determines that the business doesn’t have a good chance of surviving, he can move the case from Chapter 11 to Chapter 7. Under Chapter 7, a company’s assets are simply liquidated to pay off creditors. Endnotes
2 Note this exemption is delayed for 30 days giving the debtor the opportunity to file a sworn certification stating that there exists circumstances that would allow the debtor under applicable non-bankruptcy law that would permit the debtor to cure the entire monetary default that gave rise to the judgment for possession, the automatic stay would then be effect until the bankruptcy court ordered otherwise.
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