Bankruptcy blues

Changes to the US Bankruptcy Reform Act will affect troubled portfolio companies and their debtholders. By Brian Harvey and Emanuel Grillo

On April 20,2005, President Bush signed into law the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, which will generally take effect on or after October 17, 2005. Although the media has focused almost exclusively on how the Act changes consumer bankruptcy law, the new legislation substantially revises several key aspects of the Bankruptcy Code that pertain to commercial bankruptcy practice.

Although certain of these changes are intended to expedite bankruptcy reorganizations, these changes may make it more difficult and expensive for debtors and their stakeholders to formulate consensual and feasible plans of reorganization. As a result, the balance of competing interests among debtors and their creditors could shift in favor of creditors. This article addresses certain critical amendments to the Bankruptcy Code that will likely affect private equity funds and their troubled portfolio companies, as well as funds and institutions that trade in the junior lien and unsecured debt securities of distressed companies.

Debtors may be forced to hastily formulate and confirm plans that have less likelihood of long term success.

Certain provisions of the Act will undoubtedly shorten the window of opportunity for debtors and their equity sponsors to negotiate and confirm a reorganization plan, and may encourage other parties to become more directly involved in reorganization proceedings. One such provision imposes new limitations on the periods during which a debtor has the exclusive right to file and seek confirmation of a plan of reorganization. Under existing law, a debtor has the exclusive right to file a plan for the first 120 days of the case and 180 days to obtain acceptance of that plan. These periods can be extended an unlimited number of times by the court for cause shown, and are an important source of leverage for debtors and their equity sponsors to obtain creditor concessions. Debtors have also sought and obtained exclusivity extensions where additional time was necessary to assess business performance during critical seasons and construct a business plan accordingly. Under the Act, however, a court may not extend a debtor's exclusive period to file a plan beyond a date that is 18 months after the debtor commenced its case, and may not extend the period for soliciting acceptances beyond 20 months.

There are several possible implications of the Act's exclusivity amendments. One is that debtors may be forced to hastily formulate and confirm plans that have less likelihood of long term success. It also will be increasingly difficult for a debtor to await quarter-over-quarter results to assess the prospects for a turnaround during its chapter 11 case while holding at bay creditors who may desire to sell or liquidate a company. Lastly, these problems could be magnified in complex cases concerning, for example, the rights of asbestos victims or pension beneficiaries, which are issues that take years to resolve and bear directly on the value of the debtor. The consequences of a premature push toward a sale could be dire for many private equity funds holding junior debt or equity securities.

The Act also further limits debtors' time to assume or reject non-residential real property leases. Currently, a debtor initially has 60 days from the commencement of its case to decide whether to assume (keep) or reject (give up) its commercial real property leases, but this time is often extended numerous times, frequently to the hearing on confirmation of a debtor's plan of reorganization at the end of a case. Under the Act, the initial 60-day period has been increased to 120 days, but the courtmay not extend this period for more than 90 days unless the debtor obtains the landlord's written consent. Such consent will likely come at a significant price.

The consequences of this amendment will strike debtors harshly in cases in which real estate comprises the predominate asset, such as retail stores. Such debtors and their equity sponsors will need to focus immediately on the value of business operations related to individual leased locations so that an assumption or rejection decision can be made within the permitted timeframe. The timing of case commencement may also become more critical to the success of the reorganization effort. For instance, assuming a retail debtor's busiest season is the winter holiday season, the debtor may not want to commence its case before late summer or early fall to ensure that it has adequate time to evaluate the performance of its business during the peak season as a means to determining whether to assume or reject. If a debtor, when pressed for time, assumes a lease and later developments require it reject the lease, damages will constitute an administrative expense of the estate instead of a pre-petition claim. Although such administrative expense claims are capped under the Act at two years after rejection or turnover of the premises, those claims must be paid in full to confirm a plan, whereas general unsecured claims are typically paid far less than the face amount of the claims. Thus the failure to act timely can be costly.

Current law permits courts to convert or dismiss cases for ?cause,? but under the Act courts will be required to convert or dismiss if a party seeking conversion or dismissal establishes ?cause.?The Act also enumerates new grounds for showing ?cause,? including (a) substantial or continuing loss to or diminution of the estate and the absence of a reasonable likelihood of rehabilitation, (b) gross mismanagement, and (c) unauthorized use of cash collateral substantially harmful to one or more creditors. Although courts will retain some discretion to avoid dismissal or conversion, the amendment could spark increased litigation and exertmore pressure on courts to appoint examiners or trustees, which could entail less control for debtors and their equity sponsors over reorganization efforts.

In addition to the Act's effects on control and timing issues in bankruptcy cases, other provisions of the Actwill likely exertnew pressure on debtors'balance sheets and, ultimately, the likelihood of a successful reorganization. In particular, several provisions will force debtors to expend far more cash early in the case than what is required under existing law.

Under the Act a seller of goods that were shipped within 20 days prior to the debtor's filing for bankruptcy will receive an administrative expense claim equal to the value of the goods shipped in the event that the seller fails to give timely notice of a reclamation claim. Under existing law such claims are treated as general unsecured claims. Giving these claims administrative status will generally require the debtor to pay the claims early in the case in full, as opposed to paying the claims after confirmation of a plan and in accordance with the dividend payable on account of unsecured claims.

Another amendment effectuated under the Act will require debtors to furnish their providers of water, electricity, telecommunications and other utilities with upfront assurance of payment in the form of cash deposits, letters of credit, certificates of deposit or prepayments. Under existing law, debtors are generally required to provide their utilities with no more than an administrative claim, which entitles the utility to current payment for services provided. For industrial debtors and other debtors with high utility costs, the obligation to make substantial advance payments to utilities at the beginning of the case could be costly and perhaps devastating for their reorganization efforts, and could result in quick sales or liquidations where cash is tight.

The Act also alters debtors'tax obligations under the Bankruptcy Code. Currentlaw allows debtors to stretch out tax payments for as long as six years from the date of assessment, pay interestatmarketrates as opposed to the higher rates demanded by taxing authorities, and structure plans to defer tax payments to the latter partof the six-year period. Under the Act, however, debtors will be required to pay tax claims in full no later than five years from the date of commencement of the bankruptcy case, at rates in effect under non-bankruptcy law during the month that the debtor's plan was confirmed, and in regular installments. A consequence of these changes may be to amplify a debtor's post-confirmation cash flow pressures, thus making it more difficult to demonstrate thata proposed chapter 11 plan is feasible. These pressures may also expose a debtor's non-tax creditor constituencies to the risk that a debtor may not be able to fully consummate a confirmed plan.

Debtors and their equity sponsors may be the first to feel the effects of amendments discussed above, but secured and unsecured creditors may also see a brisk change in the dynamics of bankruptcy reorganizations that could affect their recoveries. The clearest implications of the amendments discussed above are that debtors will be forced to quickly address issues with creditors, commercial landlords and other parties-in-interest, while attempting to formulate feasible business and reorganization plans in an accelerated timeframe. Debtors will also consume more cash early in their cases to pay new categories of administrative expense claims. To generate cash, debtors may be required to sell assets at the expense of their businesses' long-term value, which may in turn reduce the likelihood of a successful reorganization.

The new pressures exerted on debtors could further strain the typically tense relationships between secured and unsecured creditors. For instance, secured bank creditors will quickly recognize that debtors filing after the Actbecomes effective may nothave the cash upfront to satisfy new administrative claims. Moreover, because debtors are permitted to pay pre-bankruptcy secured bank debt over time, butmustprovide for immediate cash payment of administrative claims, the Actmay, in some instances, give certain trade creditors effective priority over secured banks. This could motivate secured banks without a significant equity cushion to push for liquidation to avoid paying trade claims and other administrative claims before paymentof their senior claims.

One or more other creditor groups that may stand in the way of efforts of secured banks to force the liquidation of a debtor are junior lien debtholders and unsecured bondholders. In the event that the liquidation value of the debtor would not pay off much more than the value of the firstlien bank debt, junior lienholders and unsecured bondholders might prefer that the debtor effectuate a reorganization plan that would see the junior debtconverted to equity and senior bank debt paid over time. Given the significant influx of junior lien debt in the private equity and broader markets in recentyears, more of these battles could be forthcoming as all creditors seek to grapple with the Act's modification of certain bankruptcy priorities. In addition, the Actmay spark more trading in the junior lien and bond debt of distressed companies as existing debtholders and newcomers begin assessing how the Actmay affect the values of these securities and the recovery preservation strategies of other creditors.