This is the second in a series of Alerts regarding the proposals made by the American Bankruptcy Institute’s Select Commission to Reform Chapter 11 Business Bankruptcies. It covers the Commission’s recommendations about the paying of “critical vendors” and other unsecured creditors at the very beginning of a bankruptcy case. The Commission’s recommendations are set forth below. 

Paying Unsecured Creditors at the Start of a Case

Ask any five business people what they think of Chapter 11 and four will tell you it is too expensive. (No doubt the fifth is a bankruptcy professional.) The Commissioners agree that a bankruptcy case needs to be less costly. But unsecured creditors already face miniscule recoveries. Sometimes their only meaningful recovery is for transactions just before the case was filed.

The Commission sought to balance the rights of secured creditors, who typically have a lien on every debtor asset, with payments to those who do business with the company just before its bankruptcy case; especially critical vendors, suppliers, and employees. The Commission’s recommendations allow the debtor to pay these crucial constituents, but under strict limits.

“Critical Vendors” and the “Doctrine of Necessity”

The “Doctrine of Necessity” allows a court to order full payment to a “critical vendor” whose refusal to sell, post-petition, could destroy a debtor’s business. A sole source provider of a crucial product would be a critical vendor. The Commissioners agreed that a critical vendor order should remain within the discretion of a bankruptcy court. However, the Commission requires that the debtor provide a strong evidentiary showing to support the request, in hopes that the debtor will be unable to misuse the order.

The Commission also recommends that critical vendor payments not be made for Section 503(b)(9) claims, regarding goods received by the debtor within the 20 days before it filed, as discussed below.

Trade Creditors and Reclamation

When the Bankruptcy Code was enacted, in 1978, it protected a right of a trade vendor to “reclaim” or repossess goods delivered in the days before a company filed. At that time, secured lenders did not typically have a lien on all inventory of a company. The right of reclamation therefore had value. In a normal case, reclamation creditors would be paid in full at the time of plan confirmation.

The growth of syndicated secured debt, and leveraged acquisitions, changed all that. Reclamation rights are “trumped” by a lender’s lien on inventory. Though the Code continues to recognize a right of reclamation, that right is essentially valueless. Instead, Code Section 503(b)(9) provides trade vendors a priority in right to payment – an “administrative priority” – for goods (not services) received within 20 days of the bankruptcy filing. The claim is paid upon confirmation of a plan. The payment priority rewards vendors who do business with the debtor just prior to bankruptcy.

The Commission agreed that vendors should have one remedy: the 20-day administrative claim expense under Section 503(b)(9). To reduce the estate’s administrative and litigation expense, and statutory confusion, the Commission recommends eliminating the illusory concept of reclamation.

Employee Wages and Benefits

Companies cannot operate without employees. Because wages are paid in arrears, however, the filing of a bankruptcy petition means employees always have claims for unpaid pre-petition wages, called the “straddle payroll.” Employee claims have priority status – below vendors’ Section 503(b)(9) administrative priority – up to approximately $12,000. A wage worker, however, can ill afford to wait months or years, until plan confirmation, to receive payment.

To avoid a strike, or hardship to employees, Chapter 11 debtors almost always file what is colloquially referred to as a “first day motion” to obtain court approval for payment of the straddle payroll. The Commission felt it important to reinforce the ability of a debtor to pay its employees, and to streamline the process through two proposed amendments.

The first is to combine employee wage and benefit claims and increase the aggregate amount to a maximum of $25,000. This would eliminate the cumbersome calculation of the time and dollar limitations on benefit plan claims. The second recommendation is to streamline the procedure. Debtors need only file a notice indicating amounts paid to employees. If implemented, this new procedure will save the debtor the costs of a court hearing and dramatically increase employee morale, both to the benefit of the debtor’s chances to save its business.

Repurchase Agreements

The Bankruptcy Code provides special treatment, known as a “safe harbor,” to parties to repurchase agreements, allowing them to liquidate their contractual positions at the outset of a case without court approval. Congress wanted to protect the nation’s financial system from the potential ripple effects of the insolvency of a company with major “repo” positions. In 2005, however, Congress expanded the repo safe harbor to include the traditional “mortgage warehouse” lines of credit; meaning a secured loan to a company that itself uses the loan proceeds to make mortgage loans. The expansion of the safe harbor dramatically increased the risks for a debtor. The safe harbor allowed secured lenders to liquidate their positions upon a bankruptcy filing, arguing their loans were repos.

Recognizing the importance of the safe harbors, but cautious about a seemingly untethered expansion, the Commission has recommended that safe harbors be restored to the pre-2005 level.

The Commission was concerned that these proposals would increase the amount of unsecured payments at the beginning of the case. However, the Commission also recognized that employees and vendors who provide essential products or services must be protected. The Commission therefore turned to other means by which the costs of the case could be lessened. Some of those will be discussed in future Alerts.