BAPCPA

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Business Bankruptcy Issues Recent Developments The Financially Troubled Company

The Best Of Both Worlds: Can A Secured Creditor Get A Section 503(b)(9) “20 Day Goods” Administrative Claim Too?

In a decision from August 17, 2007, just released for publication, the Ninth Circuit’s Bankruptcy Appellate Panel (BAP) faced a previously unanswered question under Section 503(b)(9) of the Bankruptcy Code, the section enacted as part of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (known as BAPCPA).  Is a Section 503(b)(9) administrative claim available to secured creditors or only to unsecured creditors? You may find the BAP’s answer surprising.

A Section 503(b)(9) Refresher. For those who haven’t dealt with this relatively new section, here are the highlights. Section 503(b)(9) gives vendors an important right beyond the expanded reclamation claim also enacted as part of BAPCPA. Vendors are entitled to an administrative priority claim for "the value of any goods received by the debtor within 20 days before" the date a bankruptcy petition was filed "in which the goods have been sold to the debtor in the ordinary course of such debtor’s business." 

  • In most cases, particularly Chapter 11 cases in which a plan of reorganization is confirmed, administrative claims are paid in full on the effective date of the plan. General unsecured claims, by contrast, often receive only cents on the dollar, and even secured creditors can be "crammed down" and forced to accept payments over a period of time. This new administrative claim is therefore a significant benefit, in effect putting vendors selling goods to a debtor in the 20 days before the bankruptcy filing on par with vendors selling goods after the bankruptcy filing. It’s available even if a seller of goods fails to provide the required notice to have a post-bankruptcy reclamation claim. 
  • For a more detailed analysis of Section 503(b)(9), you may find this earlier post entitled "20 Day Goods: New Administrative Claim For Goods Sold Just Before Bankruptcy" useful, as well as a later post giving an update on a few early court decisions on the section. 
  • For more on the changes BAPCPA made to reclamation, you may want to read an earlier post entitled "Reclamation: Can A Vendor "Get The Goods" From An Insolvent Customer" and this post on some of the limitations of reclamation.

The Brown & Cole Stores Case. It was against this backdrop that the BAP analyzed the question before it in the In re Brown & Cole Stores, LLC case. Brown & Cole is a privately held grocery chain operating in Washington state. Its principal supplier and wholesaler, Associated Grocers, Incorporated (AGI), is a cooperative whose largest shareholder is Brown & Cole itself. In Brown & Cole’s Chapter 11 case, AGI asserted a "20 day goods" claim of more than $6 million, and also asserted that it was a secured creditor with a pledge of AGI’s own stock owned by Brown & Cole. Brown & Cole alleged a number of claims against AGI and argued that it had a right of setoff on those claims against any "20 day goods" claim.

When AGI moved for allowance of a Section 503(b)(9) claim, Brown & Cole argued that AGI was not eligible for that administrative claim because it was a secured creditor. The bankruptcy court rejected that argument and granted AGI’s motion. It also denied Brown & Cole’s request for a setoff of its own prepetition claims against the administrative claim, among other reasons because of what the bankruptcy court found to be Brown & Cole’s inequitable conduct in ordering goods just prior to its bankruptcy filing.

The BAP’s Decision. After hearing the appeal, the BAP issued its opinion and identified the first question presented as "Is a secured claim entitled to an administrative priority pursuant to section 503(b)(9)?" The opinion’s introduction shows that the BAP was aware of the interest creditors would have in its decision:

This case presents us with an issue of first impression regarding new section 503(b)(9) (“§  503(b)(9)”) of the Bankruptcy Code, as amended in 2005. We expect that the issue is of great importance to many sellers of goods to troubled companies. The new provision gives expense-of-administration priority (“administrative priority”) to a claim for the value of goods received by a debtor within 20 days before the commencement of the case and sold in the ordinary course of business (“twenty-day sales”). The bankruptcy court granted administrative priority to a claim that may also be secured and denied the debtor’s claim of setoff. We AFFIRM the grant of administrative priority; we REVERSE the denial of setoff.

(Footnotes omitted.)

Secured Creditors Are Entitled To Section 503(b)(9) Claims. In reaching its holding, the BAP majority rejected Brown & Cole’s primary argument that the Court should interpret Section 503(b)(9) as applying only to unsecured claims. Brown & Cole argued that at the same time as it added Section 503(b)(9), BAPCPA amended another subsection of Section 503 dealing with tax claims, specifically Section 503(b)(1)(B)(i), to clarify that it was available to "secured or unsecured" creditors.  In contrast, Congress did not include the words "secured claim" in Section 503(b)(9). This difference, Brown & Cole argued, should lead the BAP to hold that the "20 day goods" administrative claim is not available to secured creditors. The BAP’s response was clear:

We reject that invitation. The provision is not ambiguous; as such, we must enforce it according to its terms and should not inquire beyond its plain language. Lamie, 540 U.S. at 534. Apart from finding no ambiguity in § 503(b)(9), we note that Congress also declined to put the word  “unsecured” into the same statute. The obvious conclusion, therefore, is that all claims arising  from twenty-day sales are entitled to administrative priority.

(Footnote omitted). The BAP majority also rejected a policy argument advanced by Brown & Cole (B&C), and adopted by Judge Alan Jaroslovsky in his dissent:

We can do nothing about B&C’s contention that giving priority to a secured creditor may be inequitable to other creditors. First, it is up to Congress to decide which creditors have leverage and which do not. More importantly, if AGI’s twenty-day sales claim is fully secured, then payment of it by B&C will free the value of the security for that claim for the benefit of other  creditors. If AGI’s claim proves to be undersecured or unsecured, then to deny administrative priority would be to ignore the statute, something we cannot do.

In a footnoted response to the dissenting opinion, Judge Dennis Montali, writing for himself and Judge Randall L. Dunn, expanded on the point:

The dissent is concerned that we are ignoring bankruptcy policy that permits a Chapter 11 debtor to “cramdown” a secured claim in full over time. Congress gave tremendous leverage to a twenty-day sales claimant such as AGI by permitting it to demand full payment as of confirmation, and in doing so, perhaps dramatically affecting the outcome of the case. The fact that the claim is also secured represents less leverage (albeit more than held by non-priority general unsecured claims) than having administrative priority. It is not our place to reallocate that leverage. In any event, if the dissent’s view were the law, the holder of a twenty-day sales claim could simply waive its security, obtain administrative priority, and have equally powerful influence over the outcome of the case.

Setoff May Be Proper. The BAP (the dissent joined in this part of the majority opinion) also reversed the denial of Brown & Cole’s setoff request, holding that although prepetition unsecured claims (the kind Brown & Cole asserted against AGI) cannot generally be set off against administrative claims because of a lack of mutuality, here the administrative claim itself arose prepetition, specifically in the 20 days before the bankruptcy filing. On the finding of inequitable conduct in ordering goods and receiving just prior to bankruptcy, the BAP held that there was insufficient evidence of inequitable conduct and that a "debtor contemplating reorganization is under no legal obligation to inform suppliers that it is contemplating a bankruptcy filing." The BAP reversed and remanded that issue to the bankruptcy court.

A Dissenting Voice. Judge Jaroslovsky dissented from what he described as the majority’s "overly-sterile conclusion that a fully secured creditor can also have rights under § 503(b)(9)," stating that "[n]ot only is my statutory analysis different, but I see compelling policy reasons for a different result." He found that the plain language of Section 503(b)(9) did not resolve the question of whether secured creditors could be entitled to the administrative priority in light of the change made to Section 503(b)(1)(B)(i). He then turned to the policy issues:

Moreover, some fundamental policy considerations are at stake in this case. While allowing a priority claim to a secured creditor may not have a big impact in most Chapter 7 cases, it can  make a huge difference in a Chapter 11 case like this one. If AGI’s $6 million claim is entitled to priority status, § 1129(a)(9)(A) requires that it must be paid in full in cash upon confirmation. If  it is treated as a secured claim, it still must be paid in full but is subject to cramdown pursuant to § 1129(b)(2)(A). If we incorporate by implication the “secured or unsecured” language into § 503(b)(9), we may be in effect giving a secured creditor veto power over a plan of reorganization when § 1129(b)(2)(A) and sound bankruptcy policy dictate that a secured creditor can be forced  to accept a plan which is fair and equitable to it, honors its secured status and pays its secured claim in full over time.

I would weave the new § 503(b)(9) into the tapestry of American bankruptcy law, preserving the clear intent of Congress to protect recent suppliers of goods to debtors without unraveling other provisions of the Code meant to facilitate reorganization. I prefer this result to the crazy quilt patched together by my brethren.

In his footnote to the prior paragraph, Judge Jaroslovsky stated: "Specifically, I would hold that a creditor would not be entitled to priority status for its twenty-day sales claim to the extent the claim is indubitably secured, applying any security first to claims other than the twenty-day sales claim. I note that AGI might well end up with an allowed priority twenty-day sales claim under this rule."

More Leverage For Secured Vendors. As both the majority and dissent discussed, a secured creditor who has the benefit of a Section 503(b)(9) administrative claim will have considerable leverage in getting paid in full upon confirmation of a Chapter 11 plan. Most secured creditors lend money instead of supplying goods, but a number of vendors do hold collateral for their claims. Even though BAP decisions (in contrast to Court of Appeals decisions) generally are not binding precedent, other courts may find this decision persuasive. If followed widely, secured creditors entitled to assert a Section 503(b)(9) claim will have a noticeable advantage in getting paid. In addition, as the dissent noted, this decision may also make it more difficult for debtors to confirm Chapter 11 plans unless they have the cash to pay all "20 day goods" administrative claims upon their exit from bankruptcy.

Business Bankruptcy Issues Recent Developments

Northern District Of California Bankruptcy Court Proposes Amendments To Local Rules

As bankruptcy lawyers know, complying with local rules is an essential part of appearing before a particular court. In response to the changes made by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (known as BAPCPA), as well as the implementation of the electronic case filing system (called ECF), the Bankruptcy Judges for the Northern District of California have proposed a set of amendments to the Court’s local bankruptcy rules.

  • You can find a clean version and a redline version of the proposed amended local rules by clicking on the appropriate link in this sentence.
  • Attorneys or others wishing to comment on the local rules may do so by going to this website form or by sending those comments to the address indicated on that page. The deadline is September 27, 2007.

Among the amendments affecting Chapter 11 corporate bankruptcy cases are those governing  replacement of a "responsible individual" for a Chapter 11 debtor or debtor in possession, entry of a final decree closing a case, and the general electronic case filing procedures. A number of other revisions are aimed at consumer bankruptcy cases.

Although the changes do not appear to be dramatic, attorneys who practice before the Northern District of California, and businesses with cases or adversary proceedings pending in that court, will want to stay up to date on these local rule amendments.

Business Bankruptcy Issues Recent Developments

Lack Of Recognition: New Case Shows That Chapter 15 International Bankruptcy Protection Isn’t Automatic

On August 30, 2007, in twin decisions in recent cases involving two Bear Stearns hedge funds (available here and here), Judge Burton R. Lifland of the U.S. Bankruptcy Court for the Southern District of New York made clear that recognizing a foreign insolvency proceeding in a Chapter 15 cross-border bankruptcy case is not to be "rubber stamped by the courts."  The decision is of particular interest because Judge Lifland was one of the authors of Chapter 15 and the Model Law on Cross-Border Insolvency on which it is based.

The Bankruptcy Court’s Ruling. In a nutshell, the Bankruptcy Court held that although the two hedge funds were organized under the laws of the Cayman Islands, their business operations were in New York and not in the Cayman Islands. As such, the Bankruptcy Court would not recognize the Cayman Islands insolvency proceeding as either a "foreign main proceeding" or a "foreign nonmain proceeding." If you’re unfamiliar with this terminology, keep reading for an overview of Chapter 15 and more details on the decision.

A Chapter 15 Refresher. On October 17, 2005, as part of the Bankruptcy Abuse Prevention and Consumer Protection Act (known as BAPCPA), a new Chapter 15 of the Bankruptcy Code went into effect governing ancillary and other cross-border cases. (For those already familiar with ancillary proceedings, Section 304 of the Bankruptcy Code, which previously governed those proceedings, was repealed although many of its concepts were retained in Chapter 15.)

  • The main purpose of enacting Chapter 15 was to incorporate the Model Law on Cross-Border Insolvency as part of the Bankruptcy Code. 11 U.S.C. § 1501(a). My partner Adam Rogoff, who has significant experience with international insolvency matters, has prepared a very helpful chart comparing Chapter 15 and the Model Law’s provisions.
  • Chapter 15 is used principally by representatives of, or creditors in, foreign insolvency proceedings to obtain assistance in the United States, by a debtor or others seeking to obtain assistance in a foreign country regarding a bankruptcy case in the United States, or when both a foreign proceeding and a bankruptcy case in the United States are pending with respect to the same debtor. 11 U.S.C. § 1501(b). 

Several important terms involving the different types of foreign insolvency proceedings are key to understanding the scope of Chapter 15 and Judge Lifland’s ruling. 

  • A “foreign proceeding” means “a collective judicial or administrative proceeding in a foreign country, including an interim proceeding, under a law relating to insolvency or adjustment of debts in which proceeding the assets and affairs of the debtor are subject to control or supervision by a foreign court, for the purpose of reorganization or liquidation.” 11 U.S.C. § 101(23). 
  • For purposes of Chapter 15, “debtor” means “an entity that is the subject of a foreign proceeding.” 11 U.S.C. § 1502(1). 
  • A "foreign main proceeding" means a foreign proceeding pending in the country where the debtor has the center of its main interests which, in the absence of contrary evidence, is presumed to be the location of the debtor’s registered office. 11 U.S.C. §§ 1502(4) and 1516(c). 
  • A "foreign nonmain proceeding" means a foreign proceeding, other than a foreign main proceeding, pending in a country in which the debtor has an “establishment,” defined as a place of operations where the debtor carries out a nontransitory economic activity. 11 U.S.C. §§ 1502(2) and (4). 

Chapter 15’s basic procedure is straightforward. A case is commenced when a foreign representative, often a liquidator or provisional liquidator, files a petition for recognition of a foreign proceeding. 11 U.S.C. §§ 1504 and 1515(a). If properly filed, the bankruptcy court is entitled to presume that the facts stated in the petition are correct and the attached documents are authentic. 11 U.S.C. §§ 1516(a) and (b). As long as recognition would not be manifestly contrary to the public policy of the United States, the court must enter an order recognizing the foreign proceeding (here’s an example order). 11 U.S.C. §§ 1506 and 1517(a). 

Evidence Trumps Presumptions. With all this in mind, Judge Lifland held that the Cayman Islands proceeding could not be considered either a "foreign main" or a "foreign nonmain" proceeding. Despite Chapter 15’s presumption that the registered office or place of incorporation, here the Cayman Islands, would be a debtor’s "center of main interests" (known in the trade as the "COMI"), other evidence showed that the actual center of their activity was in New York. This, Judge Lifland held, precluded recognition of the Cayman Island proceeding as a foreign main proceeding. Also, without a true business presence there, the Bankruptcy Court could not conclude that the Cayman Islands was a place where the funds had "nontransitory economic activity," precluding foreign nonmain recognition. Judge Lifland held that even in the absence of objection, Chapter 15 places the burden of proof on these issues on the foreign representatives. Here, the facts in the petition and related papers showed that New York, and not the Cayman Islands, was the COMI for the funds.

Is Non-Recognition The End Of The Road? One of the most interesting aspects of Judge Lifland’s decision is the door he left open to the foreign representatives. Although the two hedge funds could not get protection under Chapter 15 of the Bankruptcy Code based on their filing in the Cayman Islands, they have the option of filing an involuntary Chapter 7 or Chapter 11 bankruptcy case in the United States.

  • Although Section 304 of the Bankruptcy Code, the old "ancillary proceedings" section, was repealed when Chapter 15 was enacted, Section 303 — and the ability of foreign representatives to file an involuntary Chapter 7 or Chapter 11 bankruptcy case — was not repealed.
  • Judge Lifland noted that Section 303(b)(4) of the Bankruptcy Code allows a foreign representative, such as the provisional liquidators appointed by the Cayman Islands court, to file an involuntary bankruptcy petition against the hedge funds and obtain bankruptcy protection in this manner.

Additional Reading In The Blogs. For more on the case, be sure to read Jordan Bublick’s informative post on his Miami Florida Bankruptcy Law blog and Chris Laughton’s commentary on his Insolvency Blog out of the UK. For the hedge fund industry’s perspective, you may find this post on the Hedgefunds Weblog of interest.

A Few Observations. With many offshore investment funds operating in the United States, Chapter 15 filings may become even more commonplace in the future, especially if we continue to encounter the kind of turbulence recently seen in the financial markets. Although the enactment of Chapter 15 made it easier for foreign representatives to get bankruptcy protection in the United States, the process is not automatic. As Judge Lifland’s decision shows, bankruptcy courts will scrutinize the facts — even in essentially unopposed cases — before agreeing to formally recognize a foreign proceeding. Without such recognition, foreign representatives will have to fall back on the more cumbersome involuntary bankruptcy process or find themselves with no U.S. bankruptcy protection at all.

Business Bankruptcy Issues Recent Developments The Financially Troubled Company

Delaware Bankruptcy Court Considers Whether Key Employee Incentive Plan Milestones Can Be Lowered Without Triggering The Restrictions On Retention Plans

One of the significant changes made by the Bankruptcy Code amendments that took effect in October 2005 was the imposition of severe restrictions on "key employee retention plans," known in the bankruptcy world as KERPs.  In this post I’ll discuss how several courts have handled these issues in the year and a half since the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, known as BAPCPA, became effective. The most recent decision, issued late last week by the Delaware Bankruptcy Court in the Nellson Nutraceutical case, gives debtors added flexibility when trying to craft plans consistent with these new restrictions.

Changes Aimed At Curbing KERPs. Prior to BAPCPA, KERPs were a very popular way of making sure that a company could retain its most important officers and employees to guide it through bankruptcy. Citing perceived abuses, however, Congress added language in BAPCPA that requires debtors to satisfy nearly impossible standards before courts would be permitted to approve payment of retention bonuses (or severance payments) as administrative claims to officers and other insiders of a bankrupt company. The restrictions apply only to insiders; no similar limitations have been placed on payment of retention bonuses and severance to non-insiders.

The New Law’s High Hurdles. To give you a flavor of the restrictions BAPCPA added to Section 503(c) of the Bankruptcy Code, a debtor company must now prove the following before it can gain approval for payment of a retention bonus to an insider:

  • the transfer or obligation is essential to retention of the person because the individual has a bona fide job offer from another business at the same or greater rate of compensation;
  • the services provided by the person are essential to the survival of the business; and

  • either

  • the amount of the transfer made to, or obligation incurred for the benefit of, the person is not greater than an amount equal to 10 times the amount of the mean transfer or obligation of a similar kind given to nonmanagement employees for any purpose during the calendar year in which the transfer is made or the obligation is incurred; or
  • if no such similar transfers were made to, or obligations were incurred for the benefit of, such nonmanagement employees during such calendar year, the amount of the transfer or obligation is not greater than an amount equal to 25 percent of the amount of any similar transfer or obligation made to or incurred for the benefit of such insider for any purpose during the calendar year before the year in which such transfer is made or obligation is incurred.

The requirement of a bona fide job offer in particular has led some to observe that if an officer of a company in Chapter 11 really had such an offer he or she would probably just take it, mooting the entire retention issue. In any event, these provisions have had their desired effect. It is now rare to find a debtor proposing a KERP that seeks to make retention payments to officers or other insiders.

Debtors Opt For Plan B. Despite these restrictions, debtors still usually want to keep their key officers and may worry that they will leave for more stable companies absent some incentives to remain with the debtor. So what are debtors doing? Since October 2005, they have shifted gears and are proposing not retention plans but incentive plans instead. To date, only a few decisions, discussed below, have addressed what is necessary for an incentive plan to pass muster. In other instances, incentive plans have been approved with little or no opposition. Perhaps the earliest such approval came in May 2006 when Judge Burton R. Lifland approved one in the Calpine Corporation Chapter 11 case.

The Dana Corporation Case. The first significant contested plan motion came shortly after the Calpine incentive plan’s approval. Dana Corporation, whose Chapter 11 case was also pending before Judge Lifland, filed a motion seeking approval of a plan similar to that approved in the Calpine case. After considering objections filed by various creditors and others, however, in September 2006 Judge Lifland refused to approve Dana Corporation’s proposed plan, finding that it was a prohibited retention plan. For an excellent and entertaining discussion of the circumstances leading to denial of that first effort in the Dana Corporation case, including why the Calpine plan was approved while the first Dana plan was not, be sure to read Steve Jakubowski’s detailed post on the Bankruptcy Litigation Blog.

A few months later, on Dana Corporation’s second try, Judge Lifland approved the revised incentive plan. In his second ruling, he found that with certain modifications the debtor’s revised proposals met the sound business judgment test required for approval. In addition, he ruled that the new plan incentivized the key officers "to produce and increase the value of the estate" and, because the benchmarks in the plan were difficult targets to reach and not easy "lay-ups," the proposal was an actual incentive plan and not a retention plan in disguise.

Evaluating Incentive Plans. In evaluating whether the Dana plan represented the exercise of sound business judgment, Judge Lifland considered the following factors:

  • Is there a reasonable relationship between the plan proposed and the results to be obtained, i.e., will the key employee stay for as long as it takes for the debtor to reorganize or market its assets, or, in the case of a performance incentive, is the plan calculated to achieve the desired performance? (emphasis added)
  • Is the cost of the plan reasonable in the context of the debtor’s assets, liabilities and earning potential?
  • Is the scope of the plan fair and reasonable; does it apply to all employees; does it discriminate unfairly?
  • Is the plan or proposal consistent with industry standards?
  • What were the due diligence efforts of the debtor in investigating the need for a plan; analyzing which key employees need to be incentivized; what is available; what is generally applicable in a particular industry?
  • Did the debtor receive independent counsel in performing due diligence and in creating and authorizing the incentive compensation?

These factors provide useful guidance not only to bankruptcy courts but also to boards of directors of financially troubled companies, whether in or out of bankruptcy, when considering proposals for retention or incentive plans.

The Global Home Products Decision. In March 2007, Judge Kevin Gross of the Delaware Bankruptcy Court approved two incentive plans in the Global Home Products case. In that decision, as the Delaware Business Bankruptcy Report described here, the court followed the analysis Judge Lifland used in the Dana Corporation case and approved the two incentive plans. Specifically, Judge Gross found that the plans were true incentive plans, which he called "pay for value" plans and were not KERPs, or "pay to stay" plans. For this reason, Judge Gross evaluated the plans under the business judgment standard of Section 363 of the Bankruptcy Code, holding that the strict Section 503(c) limitations simply did not apply.

The Nellson Nutraceutical Decision. On May 24, 2007, Judge Christopher S. Sontchi of the Delaware Bankruptcy Court issued a decision in the Nellson Nutraceutical Chapter 11 case approving revisions to a previously-approved incentive plan. There, the debtors’ first incentive plan provided for certain performance milestones based on target levels of EBITDA, or earnings before interest, taxes, depreciation, and amortization. Unfortunately, the debtors did not achieve those EBITDA milestones and sought to lower them to align with what they considered to be more realistic performance goals. After receiving testimony that the debtors had made similar reductions in bonus targets in the past, Judge Sontchi concluded that the debtors’ current proposal was in the ordinary course of business and involved a good faith business judgment.

On the issue of whether Section 503(c)’s retention payment restrictions applied, Judge Sontchi found that the lowering of the incentive plan milestones did not turn the plans into retention plans. He held that if the primary purpose of a plan is to incentivize insiders and other employees, rather than merely retain them, it remains an incentive plan:

Under the facts of this case, although the modification of the 2006 bonus program has some retentive effect, it is for the primary purpose of motivating employees and, thus, the limitations of section 503(c)(1) are not applicable.

*     *    *

The [United States Trustee] argues with some force that if an incentive plan is based on achievement of EBITDA targets and those targets are not achieved, yet the bonus is still received, that the plan cannot be an incentive plan but must, in fact, be solely a retention plan.

*   *    *

While the Court agrees that the payment of bonuses under the modified 2006 [plan] has some retentive effect, the Court disagrees with the [United States Trustee’s] argument that its sole or primary purpose is retention. Consistent with the Debtors’ pre-petition practice, the 2006 [plan] must be considered as a whole. It consists of two parts: the establishment of ‘aspirational goals’ in the early part of the year; and a review at the end of the year to consider whether those goals have been met and, if not, why. In this case, the Debtors did just that and determined that the 2006 [plan] served its purpose by motivating the employees to do a ‘great job’ in connection with the matters that those employees could reasonably be expected to influence. As such, the Debtors seek to award bonuses at a reduced level to compensate the employees for their success (albeit somewhat limited) in 2006 and to motivate the employees in 2007.

Finally, Judge Sontchi held that Section 503(c)(3)’s additional limitations, which among other things prohibit transfers to insiders that are "outside of the ordinary course of business and not justified by the facts and circumstances of the case," by its terms apply only to payments outside of the ordinary course of business. Given his earlier holding that the debtors’ plans and their modifications were made in the ordinary course of business, Judge Sontchi concluded that Section 503(c)(3)’s requirements did not apply at all.

Conclusion. BAPCPA has effectively ended the use of KERPs for officers and other insiders of a debtor. However, more than a year and a half after BAPCPA became effective, bankruptcy courts in New York and Delaware, and perhaps elsewhere, are willing to approve incentive plans for insiders. The Nellson Nutraceutical decision goes further and, in the right circumstances, will allow the incentive plan’s performance milestones themselves to be lowered without jeopardizing the "incentive" character of the plan. This area of the law is plainly evolving, so stay tuned for more developments.

Business Bankruptcy Issues Recent Developments

In Important New Ruling, New York Bankruptcy Court Applies Prior Lien Defense To Post-BAPCPA Reclamation Claims

On Thursday, April 19, 2007, in perhaps only the second decision on reclamation since the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) took effect in October 2005, Judge Burton R. Lifland of the U.S. Bankruptcy Court for the Southern District of New York issued this Memorandum Decision in the In re Dana Corporation Chapter 11 bankruptcy case. Employing an analysis similar to that of Judge Sontchi in his January 2007 decision in In re Advanced Marketing Services, Inc. (discussed in this post), Judge Lifland valued all pending reclamation claims in the Dana Corporation case at zero, effectively denying them in their entirety.

A Quick Primer On Reclamation Under BAPCPA. Section 546(c) of the Bankruptcy Code, as amended by BAPCPA, gives vendors the ability to assert a reclamation claim for goods received by a debtor in the 45 days prior to the bankruptcy filing. In addition to extending the reclamation period to 45 days, BAPCPA also added a provision in Section 546(c) making reclamation claims "subject to the prior rights of a holder of a security interest in such goods or the proceeds thereof." This quoted language refers to a secured creditor with a prior senior lien in the same goods, a defense to reclamation often referred to as the "Prior Lien Defense." (For more details on reclamation claims, both before and after a bankruptcy is filed, you may find this earlier post on reclamation of interest.)

The Reclamation Claims Process. As is typical in large Chapter 11 cases, a reclamation procedure was established in the Dana Corporation case. After setting a deadline for the filing of reclamation claims, the following events unfolded:

  • As debtor and debtor in possession, Dana Corporation filed a motion seeking bifurcation of the Prior Lien Defense from the more fact-based defenses it also intended to advance.
  • The Bankruptcy Court granted the motion and entered this bifurcation order, which separated out the Prior Lien Defense for discovery, briefing, and decision while staying discovery and other efforts relating to the remaining defenses.
  • The debtor then filed an initial brief on the Prior Lien Defense and related arguments, asserting that the scores of reclamation claims filed by creditors all were "subject to" pre-existing liens on the goods in question, rendering the reclamation claims valueless. Relying on the pre-BAPCPA case of In re Dairy Mart Convenience Stores, Inc., 302 B.R. 128 (Bankr. S.D.N.Y. 2003), the debtor argued that the use of DIP financing with liens on the goods in question to satisfy prepetition loans meant that those goods were effectively disposed of, were not subject to reclamation, and that reclamation claims based on them were valueless.
  • Many reclamation claimants filed objections to the debtor’s motion (this objection is representative of the types of arguments advanced). They contended that reclamation claims are valueless only if the goods sought to be reclaimed are actually used to pay the lien of the secured creditor to which they are "subject." Relying on In re Phar-Mor, Inc., 301 B.R. 482, 497 (Bankr.N.D. Ohio 2003), amended on rehearing, 2003 Bankr. LEXIS 2009 (Bankr.N.D.Ohio Dec. 18, 2003), they argued that the prepetition loans were repaid with funds from the DIP loans, not from liquidation of the goods subject to the reclamation claims.
  • The debtor then filed this reply brief, again arguing that Dairy Mart is still good law and that its principles made all reclamation claims valueless in this case.

The Dana Corporation Decision. In his 21-page decision, Judge Lifland made two important rulings. First, he addressed whether amended Section 546(c) creates a new federal common law of reclamation or whether it still relies on the Uniform Commercial Code and other state law:

The Reclamation Claimants contend that the deletion of the reference to state law in the amended section 546(c) no longer incorporates the state law right of reclamation, and instead creates a brand new federal bankruptcy law right. I disagree.

*           *           *

It is not a section dedicated to granting an independent federal right of reclamation nor does it create a coherent comprehensive federal scheme for reclamation. First, Congress did not use the language of creation – Congress did not say that “a seller may reclaim goods when….”

*          *          *

Moreover, if amended section 546(c) was a new federal reclamation right arising under the Bankruptcy Code, it would not be subject to the avoiding powers. [footnote omitted]

Second, having concluded that amended Section 546(c) did not supplant existing reclamation law, Judge Lifland examined Phar-Mor, Dairy Mart, and related case law and ruled that the Prior Lien Defense made the reclamation claims valueless in this case:

Here, the prepetition collateral, including the reclaimed goods, was subject to the Prepetition Lien. Pursuant to the Interim DIP Order, the Debtors were authorized to use the Prepetition Lenders’ cash collateral, with the Replacement Lien providing a replacement security interest in all of the Debtors collateral subject to the DIP Lien, including the prepetition collateral and the proceeds thereof. The DIP Lien granted to the DIP Lenders pursuant to the Interim DIP Order and the Final DIP Order, provided a security interest in, and lien upon, all of the collateral constituting the prepetition collateral. Thus the lien chain continued unbroken. Cf. Dairy Mart, 302 B.R. at 184 (holding that the transaction of releasing the prepetition lien and simultaneously granting the lien to the post-petition lender, must be viewed as an integrated transaction). The grant of the DIP Lien was a necessary condition of the DIP Lenders’ agreement to enter into the DIP Facility. Pursuant to the Final DIP Order, the Prepetition Indebtedness was refinanced and paid off using the proceeds of the DIP Facility on the payoff date. Because the reclaimed goods or the proceeds thereof were either liquidated in satisfaction of the Prepetition Indebtedness or pledged to the DIP Lenders pursuant to the DIP Facility, the reclaimed goods effectively were disposed as part of the March 2006 repayment of the Prepetition Credit Facility. Accordingly, the Reclamation Claims are valueless as the goods remained subject to the Prior Lien Defense.

Recognizing Another BAPCPA Change: Section 503(b)(9)’s New Administrative Claim. Although the Bankruptcy Court was considering only BAPCPA’s amended Section 546(c) and reclamation claims, the decision makes several comments about the impact of another of BAPCPA’s changes, the new "20 day goods" administrative claim. (A February 2007 update post described the first few decisions on this new Section 503(b)(9) administrative claim.) These include the following: 

The issues before the Court today relate solely to the Prior Lien Defense to reclamation rights under section 546(c) of the Bankruptcy Code and not to the rights to an administrative expense under the newly enacted section 503(b)(9) of the Bankruptcy Code. This new provision presents other issues concerning, inter alia, the valuing of the subject goods; what constitutes the actual receipt of the goods; how is the claim asserted; when is it to be paid; is it subject to the claims processing and omnibus bar date orders, etc.? These issues will not, and need not, be parsed here. Suffice it to say that in light of the section 503(b)(9) amendment, section 546(c) is no longer an exclusive remedy for a prepetition seller.

*         *          *

In addition, amended 546(c) provides for an administrative claim: "If a seller of goods fails to provide notice in the manner described in paragraph (1), the seller still may assert the rights contained in section 503(b)(9)." 11 U.S.C. § 546(c)(2). New section 503(b)(9) in turn allows the seller an administrative expense claim equal to "the value of any goods received by the debtor within 20 days before the date of commencement of a case under this title in which the goods have been sold to the debtor in the ordinary course of such debtor’s business." 11 U.S.C. § 503(b)(9). There is no shortage of commentary on the interplay of sections 503(b)(9) and 546(c).5

[Footnote 5]

With the introduction of section 503(b)(9) priority, reclamation claims under amended section 546(c) have decreased importance because goods delivered to a debtor in the 20 days prior to bankruptcy will have automatic priority. Thus, reclamation rights are now mainly beneficial for goods delivered in the 21 to 45 days prior to the bankruptcy filing under amended section 546(c). However, with the expansion of the reclamation period, the likelihood of early administrative insolvency will increase, and debtor companies will need greater financial resources to reorganize. See Charles J. Shaw and Brent Weisenberg, Effect of a Preexisting Security Interest in the Debtor’s Inventory on the Rights of Reclamation Creditors, 2005 Norton Ann. Surv. Of Bankr. Law Part I §15 (Sept. 2006) (hereinafter “Norton Survey”).

Where Does This Decision Leave Creditors And Debtors? While valuing all reclamation claims at zero, Judge Lifland was careful to mention the existence of the new administrative claim for goods delivered to the debtor in the 20 days prior to the bankruptcy. This comment is significant and reveals how BAPCPA has changed the old reclamation equation. While the jury is certainly still out, the early post-BAPCPA reclamation decisions in Advanced Marketing Services (Delaware) and Dana Corporation (Southern District of New York) suggest that creditors may have even more difficulty establishing reclamation claims. If so, instead of reclamation, the new 20 day goods administrative claim may turn out to be the more valuable right for creditors — and the more costly obligation for debtors — in this post-BAPCPA world.

Business Bankruptcy Issues Recent Developments

Proof Of Claim And Other Bankruptcy Forms Revised To Reflect April 1, 2007 Dollar Amount Adjustments

As reported in this post last month, certain dollar amounts in the Bankruptcy Code were increased effective April 1, 2007. The dollar amount changes meant that some of the official bankruptcy forms, most notably the proof of claim form and the voluntary petition, had to be revised as well.

After I put up that post, the Administrative Office of the United States Courts (known in the trade as "the AO") made the revised forms available and released a formal notice of the dollar amount adjustments. Copies of the revised forms — with handy arrows pointing out each place where they were revised — are attached to the notice.

Of course, you’ll need to get the forms in blank to use in bankruptcy cases. If you don’t have special bankruptcy form software, a number of the official bankruptcy forms have been designed to allow you to type in information or select choices from drop-down menus before printing the form. Printing is the only way to go because the form won’t let you save your changes. 

If you follow the links above you’ll be able to access blank copies of the revised forms from the AO’s website. That way, you’ll be sure to have the most up-to-date versions.

Business Bankruptcy Issues Recent Developments The Financially Troubled Company

Defending A Preference: Ninth Circuit Holds That Even First Time Transactions Can Be In The “Ordinary Course”

In a decision issued on April 3, 2007 in the In re: Ahaza Systems, Inc. case, the Ninth Circuit held that even first time transactions can qualify for the "ordinary course of business" defense to preferences. A copy of the Court of Appeal’s decision is available here.

The Bankruptcy Preference. As a quick refresher, preferences are payments or other transfers made in the 90 days prior to a bankruptcy filing, on account of antecedent or pre-existing debt, at a time when the debtor was insolvent, that allow the transferee (the preference defendant) to be "preferred" by recovering more than it would have had the transfer not been made and the defendant instead had simply filed a proof of claim for the amount involved. The 90-day reachback period is extended to a full year prior to the bankruptcy petition for insiders such as officers, directors, and affiliates.

Pre-BAPCPA Statute. The ordinary course of business defense, designed to protect parties who engage in normal transactions with a financially troubled business, is one of the most common defenses available to preference recipients. The Ninth Circuit examined it under the version of the preference statute, Section 547 of the Bankruptcy Code, as it existed before the 2005 amendments made in the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (known as BAPCPA). This pre-BAPCPA statute, specifically Section 547(c)(2), provided that a trustee could not avoid a transfer as a preference

to the extent that such transfer was —

(A) in payment of a debt incurred by the debtor in the ordinary course of business or financial affairs of the debtor and the transferee;

(B) made in the ordinary course of business or financial affairs of the debtor and the transferee; and

(C) made according to ordinary business terms.

The Court’s focus was on subsection (A), the "debt" issue. Usually, parties have a series of contracts or purchase orders, as well as a payment history, that gives context to the ordinary course of business between them. In this case, however, the transaction that led to the allegedly preferential payments was their first one. The Court faced the question of whether a debt can be considered as having been incurred in the ordinary course of business of the debtor and the preference defendant when there had been no other past transactions to which it could be compared.

Court Looks To Past Practices With Other Similar Parties. The Court’s answer was yes, holding that a preference defendant can indeed assert the ordinary course of business defense involving a debt created by the first contract or transaction between the parties. However, the Ninth Circuit articulated a special rule when a "first time" debt is involved:

[W]hen we have no past debt between the parties with which to compare the challenged one, the instant debt should be compared to the debt agreements into which we would expect the debtor and creditor to enter as part of their ordinary business operations. Consistent with Food Catering [971 F.2d 396 (9th Cir. 1982)], however, this analysis should be as specific to the actual parties as possible. Thus, we hold that to fulfill § 547(c)(2)(A), a first-time debt must be ordinary in relation to this debtor’s and this creditor’s past practices when dealing with other, similarly situated parties. Only if a party has never engaged in similar transactions would we consider more generally whether the debt is similar to what we would expect of similarly situated parties, where the debtor is not sliding into bankruptcy.

Both Original And Restructured Agreements Are Relevant. On a related point, since the first transaction here was an agreement that was later restructured to give the debtor more time to pay, the Ninth Circuit also held that both the original and revised agreement should be evaluated for ordinariness.

Ruling Still Important Under BAPCPA. BAPCPA revised the ordinary course of business defense so that Section 547(c)(2) now provides that a payment or other transfer cannot be avoided

to the extent that such transfer was in payment of a debt incurred by the debtor in the ordinary course of business or financial affairs of the debtor and the transferee, and such transfer was—

(A) made in the ordinary course of business or financial affairs of the debtor and the transferee; or

(B) made according to ordinary business terms.

Although different, the current statute still makes the issue decided in the In re: Ahaza Systems case, whether the debt was incurred in the ordinary course of business, a requirement. The major change is that the statute now allows the defense to be established by additionally showing that payments were made either (A) in the ordinary course of business of the parties or (B) according to ordinary business terms, rather than both as under the pre-BAPCPA version.

How Hard To Meet? Having established the new test, the Court then reversed the granting of summary judgment to the defendant because it found the proof presented was inadequate. This suggests that although the Ninth Circuit will permit preference defendants to assert the ordinary course of business defense on first time transactions, some defendants may face a challenge in meeting that standard.