Effects of the 2005 Bankruptcy Legislation on Lenders
Prepared and Presented by:
WHAT HAS CHANGED?
1. Personal Discharge is Harder. Bankruptcy has become a less comfortable haven for individual debtors. It is harder to qualify for the easier bankruptcy chapters, harder to put together a successful bankruptcy case, and harder to obtain a discharge.
2. Creditors Have More Ways to Attack the Debtor. Increased reporting obligations and fixed penalties for non-compliance may make successful completion of a bankruptcy more difficult.
3. Fewer Small Business Debtors Will Successfully Reorganize. Because of an increase in the priority payments that must be made in order to confirm a bankruptcy plan and also the proliferation of procedural traps and creditors' remedies, fewer small or medium-sized debtors will be able to confirm a plan. Distributions to unsecured, non-priority creditors will be smaller except for certain categories of creditors who were favored in the 2005 legislation, and Debtor-in-Possession lending will probably have to be in higher amounts, to cover the priority payments.
4. Preference Actions Are More Defensible. The change of a single word in the "ordinary course of business" provision under the preference section of the Bankruptcy Code, and venue provisions favoring creditors who received small preferences, will make preference recoveries smaller and more difficult for bankruptcy trustees.
5. No Monetary Maximum on Single Asset Real Estate Cases. The previous $4 million secured debt limit for "single asset real estate" cases was eliminated.
6. "Contemporaneous" Means Thirty Days. You now have 30 days to perfect a transaction to make it "contemporaneous" and insulate it from preference attack.
7. Insiders Providing Guarantees Need not Waive Subrogation. Deprizio has now been finally repealed, so there is no reason for a lender to insist that an insider providing a guarantee waive rights of subrogation against the borrower/debtor.
WHAT SHOULD BANKS DO?
1. Get Personal Guarantees. As borrowers' principals become aware of the difficulty high income individuals will have discharging personal obligations, they may become more attentive to debts that they have personally guaranteed.
2. Workout Negotiations Can be More Aggressive. In a default or workout situation, fewer concessions may be appropriate. A lender may find that it wants to be less accommodating. The threat of bankruptcy is even less daunting than before the new legislation became effective and, in fact, a bank might welcome a bankruptcy. This response may vary, however, depending upon the Bank's collateral position, and competition with other creditors.
3. But DiP Lending Will Have More Risks. The increase in priority payments for utilities and certain retail suppliers will mean that a Debtor-in-Possession Lender, calculating what will be necessary to get the debtor through to plan confirmation, will have more payments for which provision must be made. Also, the traps described above for debtors could also trip up a DiP Lender who had sunk money into a reorganization counting on recovery through plan confirmation.
4. Accept Preference Payments. Of course, try to avoid the situation where repayment is preferential (make secured loans and perfect your security interests), but, as always, when offered a preference, take it. Now you may have additional defenses.
5. Lend to Single Asset Real Estate Borrowers. If the loan might be to a single asset real estate borrower, consider putting in covenants requiring that the borrower remain a single asset real estate borrower.
6. Thirty Days to Perfect. But isn't it easier to remember to get your filings done as you deal with the closing?
7. Obtain Personal Guarantees. There is no longer any reason not to take personal guarantees.
The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 ("BAPCPA") went into effect on October 17, 2005. It created enormous changes in the availability of bankruptcy for individuals, particularly middle income people. It made many smaller changes in business bankruptcies. Nearly all of the changes were for the immediate benefit of one or more creditor groups. Of course, benefits to one group of creditors necessarily come out of the recovery that might otherwise have gone to another, because BAPCPA did not put any additional money into the system.
It will take years to see the full effect of the changes. Many will be subject to interpretation and application of the bankruptcy courts and for those, the effect will not become clear until we have more experience under the new legislation. Already, however, some general trends are apparent.
Individual Bankruptcies Are More Difficult
Before BAPCPA, high income individuals could go through a Chapter 7 liquidation, give up their non-exempt assets, discharge their debts, and go on with a lifestyle based upon post-petition earnings. Now Chapter 7 liquidations are available for individuals only if they fail the "means" test, generally showing annual income less than around $45,000 to $60,000 (depending on a long list of possible adjustments, including number of dependents, amount of secured debt, and location of debtor's residence). Essentially, Chapter 7 liquidation is now only for low income individuals and for businesses.
The idea of the legislation is to force individuals into a Chapter 13, where their "discretionary" income for a three to five year period is available to their creditors, according to certain priorities. But Chapter 13 is limited to individuals "with regular income," who owe "noncontingent, liquidated, unsecured debts of less than $307,675 and secured debt of less than $922,975 [inflation adjusted]." This means that individuals who are really big failures will have to file a Chapter 11.
Chapter 11 has always been expensive and inhospitable for individuals. Now, under BAPCPA, it is far more so. An individual's Chapter 11 has been changed so that it will have the same requirement that has always been in Chapter 13, that future earnings accruing after the bankruptcy petition are included in the bankruptcy estate, and so must be devoted to performance of the bankruptcy plan. Potentially even more significant is the new provision that no discharge will enter until completion of the plan, so that performance of the plan is a condition of the individual debtor obtaining his bankruptcy discharge. Considering the high failure rate for plans, even under the more relaxed pre-BAPCPA regime, this change alone could eliminate a great number of discharges for high income individuals.
It also seems that individuals, even those represented by counsel, are being tripped up by new procedural hurdles introduced by BAPCPA. For instance, the bankruptcy courts have generally been rigorously enforcing the requirement for "credit counseling" before the bankruptcy petition is filed, so that individuals who fail to complete the required credit counseling course have their bankruptcy cases dismissed, typically. Furthermore, there are rigorous requirements for filing financial information with the court, including tax returns and, for individuals involved in business, financial statements and projections. Again, failure to comply tends to result in dismissal of the bankruptcy case.
Another important change under BAPCPA is that dismissal of a bankruptcy now makes the filing of another bankruptcy within a year far less effective. The automatic stay will terminate automatically within 30 days after a second bankruptcy petition is filed within a year of dismissal of a prior bankruptcy petition, unless special circumstances are shown. Bankruptcy courts have, however, pounced upon the astonishingly sloppy drafting throughout BAPCPA and eviscerated this section because the lifting of the automatic stay in a bankruptcy filed within one year of a prior dismissal may relate only to actions against "property of the debtor" and not to "property of the estate," In re Johnson, 335 B.R. 805 (Bankr. W. Dist. Tenn 2006), and, in yet another problem with the new statutory language, the automatic lifting of the automatic stay may relate only to pre-petition actions taken by creditors, not to post-petition protection. In re Paschal, 2006 Westlaw WL 258298 (Bankr. E. Dist. NC 2006).
Creditors Have More Weapons Against Business Debtors
The changes in a business bankruptcy are more subtle (with the exception of three industries: real estate, utilities, and retail, where the changes benefiting those creditors are not at all subtle), but they all tend to increase creditors' leverage. Probably the biggest change is a shift in the burden of proof in dealing with a motion to dismiss in a Chapter 11. If a creditor shows that a debtor in possession has failed to comply with Chapter 11 requirements, the burden of proof then shifts to the debtor to show that "there is a reasonable likelihood that a plan will be confirmed" in timely fashion and there is "reasonable justification" for the error. This requirement that a debtor justify its existence, perhaps at a very early stage of the case, could turn out to be a significant obstacle. A possible mistake in the drafting of the new legislation (replacing "or" with "and" at the end of the list of grounds to dismiss), however, could make the entire provision on dismissal and conversion unenforceable!
Single Asset Real Estate Borrowers Are More Desirable
A significant change for the real estate industry - and for their lenders - is the elimination of the $4 million secured debt limit for application of the "single asset real estate" requirements. Under BAPCPA single asset real estate debtors will now have to start making interest payments on the 90th day after the bankruptcy. Because of the advantages of being a lender to a "single asset real estate" borrower, a lender would probably want to have thought about whether its borrower fits within the definition of "single asset real estate":
Real property constituting a single property or project, other than
Bankruptcy Code § 101(51B). Where these rules apply the debtor will not be able to languish in bankruptcy for long periods without starting to pay interest and obtaining plan confirmation. Instead, the debtor must start making interest payments by the 90th day after the bankruptcy, and the interest payment must now be at "the then applicable non-default contract rate of interest" instead of the former requirement that interest payments be made at the "current fair market rate." Alternatively, the debtor can propose a plan "that has a reasonable possibility of being confirmed within a reasonable time. . . ."
Distinguishing a "single asset real estate" borrower from a small business may not, in every case, be entirely clear, but in cases that may be in a gray area in between, it might be useful for the lender to try to clarify that the borrower is a single asset real estate borrower, and perhaps to require covenants in the loan documentation that will require preservation of this status. The requirements in the definition of "single asset real estate" are somewhat internally inconsistent, requiring that the real property "generate substantially all of the gross income of a debtor" but that "no substantial business is being conducted by a debtor other than the business of operating the real property and activities incidental." The distinction seems to be between income generated just from the property itself, as distinct from activities that the debtor pursues as a business on the property. The leading case is KKEMKO, Inc., 181 B.R. 47, 51 (Bankr. S.D. Ohio 1995), where a marina was found to constitute a business, not single asset real estate held for the production of income, where the marina offered storage, repair and winterizing services, pool and shower facilities, and food and other amenities. An analogous kind of determination has found that a golf course is more a business generating profits, not real property paying rent, because the operation of the golf course generates greens fees and rentals and sales of carts and equipment, and these would be derived from business activity, not just from the use of the real estate. In re GGVXX, Ltd., 130 B.R. 332 (Bankr. Colo. 1991) (But rental of the golf school was more in the nature of rent from the use of property, not a business? Go figure!); see also In re M. Vickers, Ltd., 111 B.R. 332 (D. Colo. 1990) (hotel operation generates income from services, which were "personalty" and not rents derived simply from the use of the building).
Priority Payments Will Eat Up Distributions and Require Larger DiP Loans
Reorganization used to be intended to make recoveries available to unsecured creditors, either by their ending up owning a part of the reorganized debtor, or by their receiving the proceeds of a liquidation. After BAPCPA, it appears that distributions to unsecured creditors will mostly become a faint memory of a fondly-recalled bygone era. Even before BAPCPA, Debtor-in-possession lenders had already arranged to soak up most of the available recovery, often through so-called "First Day" orders, by which they obtain super-priority liens securing extremely expensive loans. All that was left for the unsecured creditors was to try to recover from each other by suing for and then sharing preference recoveries, and frequently even these were made collateral for the debtor-in-possession lenders. In any event, the "transacti on costs" of the preference litigation frequently significantly depleted the net preference recoveries.
Now certain favored creditors have been granted payment priority, and so there will be even less available to distribute to the unfavored unsecured creditors. Lenders to Debtors-in-possession must include these enhanced priority payments in their calculations of what it would take to enable the debtor to confirm a plan, which is often (but not always) the articulated goal of the DiP loan. Utilities are the big winners under BAPCPA. Even where they did not have a security deposit before the bankruptcy, and where the debtor had an unblemished payment record, the debtor must Provide "assurance of payment" in cash that is satisfactory to the utility. (Bankruptcy Code § 366.) So even in "administratively insolvent" bankruptcies, utilities will be paid.
Vendors to retailers received a priority for "the value of any goods received by the debtor within 20 days before the date of commencement" of a bankruptcy case. (Bankruptcy Code § 503(b)(9).) Where the goods were received when the debtor was insolvent (aren't they always?) within 45 days of the bankruptcy petition, the vendor can reclaim the goods, but this 45-day kind of reclamation is likely to be far less productive because the reclamation claim is subject to the interest of a secured lender in such goods. (Bankruptcy Code § 546(c)(1).) Whether that is true for the 20-day type of reclamation is one of many mysteries Congress has left for us in BAPCPA.
Debtors now have 120 days to decide whether to assume or reject commercial real property leases, which is twice the length of time that they had before BAPCPA, but the statute now imposes a fixed limit of an additional 90 days on any extensions, so that all commercial real estate leases are rejected if not assumed by 210 days after the bankruptcy petition. This will be a significant issue in large retail bankruptcies, typically.
Perfect Within 30 Days
The previous requirement that perfection occur within 10 days of the transfer is now extended to 30 days. (Bankruptcy Code § 547(e)(2).) If you record your security interest (the deed of trust or the Uniform Commercial Code Financing Statement) 31 days after you fund the loan, and your borrower files a bankruptcy petition (or has an involuntary petition filed against him, perhaps because other creditors noticed your late filing) within ninety days of your recording your security interest, your security interest will be set aside as preferential, and you will have only an unsecured claim in the bankruptcy, which is likely to be a big disappointment.
Get Personal Guarantees
Deprizio is now really dead. There is now no reason to hesitate to take personal guarantees from insiders, and no reason to demand that insider guarantors waive subrogation rights against your borrower.
The notorious Levit v. Ingersoll Rand Financial Corporation (In Re Deprizio Construction Co., 874 F.2d 1186 (7th Cir. 1989) case held that payments to a bank that had a guarantee from an insider benefited the insider by reducing the insider's contingent obligation on the guaranty, and recovery of those payments from the bank(!) was, therefore, subject to the one-year recovery period for preference actions against insiders, not the ninety-day preference period applicable to others. The Deprizio rule that extended preference liability to one year for creditors holding guarantees from insiders was legislatively overruled in the 1994 bankruptcy reform legislation, but a few courts thought that only payments, and not transfers of non-monetary property, were protected by the 1994 legislation. Some lenders continued to try to solve the problem by insisting that insider guarantors waive their right to assert against the borrower (the company that they own, typically) a right of recovery for amounts paid upon their guaranty. This was thought to defeat the so-called Deprizio one-year reachback for preference recoveries.
There is no reason to be concerned any longer with Deprizio recoveries. There is no downside to having personal guarantees from the principals of your borrower (or from anyone else, for that matter). And there is now no reason to have those complicated, hard to explain, and counterintuitive provisions by which insider guarantors waive subrogation (recovery) rights from your borrower.
Preference Recoveries Are Harder
A defendant will be able to defeat a preference action if the payment was made "according to ordinary business terms" and if the debt was incurred in the ordinary course of business (which is usually the case), even if the payment was not made "in the ordinary course of the debtor's business." This will be important to an under-secured creditor who receives payments from a borrower who files bankruptcy within 90 days. This may allow a successful preference defense, despite pressure and threats, as long as the "terms" of the payment are "ordinary." So think about whether you want to change from payments by check to payments by wire (unless it means the difference between getting the money and not getting it; getting it is always better.) Are payments later than the average on extraordinary "terms"?
Preference payments totaling less than $10,000 now have little risk of recovery in a bankruptcy filed in a district other than where you are located. The bankruptcy trustee must sue for aggregate preference recoveries from one transferee of less that $10,000 in the district where the defendant resides, in most cases greatly reducing the likelihood of litigation. So you can be more aggressive against delinquent debtors to collect outstanding loans or invoices totaling $10,000 or less, and you should probably ignore demands for return of preference payments totaling less than $10,000. And if your allegedly preferential transfers were only a little more than $10,000, perhaps you'd be better off to pay it down if that would eliminate the trustee's "home court" advantage. So maybe you would be able to save money by sending a small check to the bankruptcy trustee?!